- October 19, 2016
- UpperEdge
- Reading Time: 6 minutes
Research firms, consultants, and academic institutions have been researching the success and failure drivers of large transformational projects for numerous years. A key takeaway from all of this research is that the majority of these large system implementation initiatives experience schedule delays and budget overruns. Multiple factors can impact the budget and schedule of an implementation, many of which are not easily predictable and therefore difficult to mitigate. Legitimate scope changes will naturally occur over the course of your implementation; however, grounding your program with rigor and tight controls by way of a well-designed financial construct will reign in the potential for and the magnitude of any schedule slippage and budget overrun.
UpperEdge recommends project teams employ a financial construct that provides the mechanisms necessary to drive on-time, on-budget and quality delivery of your transformation projects. Although your system integrator may push for an outcome-based model or other alternative financial structures, UpperEdge recommends re-orienting the discussions towards a fixed fee with incentive or a time and materials not-to-exceed (T&M NTE) structure to balance the overall risk profile of your project.
Fixed-Fee Model with Schedule Incentives
Contracting under a fixed fee model is quite common within the industry and a significant number of project teams feel comfortable with this model given its simplicity and ease of administration.
Although the parameters of the fixed fee structure are typically well understood, there are several key considerations to keep in mind when negotiating this construct with your system integrator:
Estimate transparency
Be sure to request full transparency into your system integrator’s estimating model and the proposed project cost early in the negotiation before tipping your hand as to your desired fixed fee construct. Given the nature of a fixed fee model, system integrators will push back on providing a complete staff loading chart to support the baseline estimate from which their proposed fixed fee is derived unless you ask for this level of transparency before converting your negotiation focus to fixed fee. We recommend requesting a staff loading chart and baseline set of assumptions as early as possible to validate the estimating model used to support the fixed fee (resource rates, effort, staffing levels). In addition, a complete staff loading chart will constitute the baseline for understanding change as the project progresses. Without this documented baseline, it will be very difficult for project teams to assess the cost and schedule impact of any subsequent change orders.
Fixed Fee Contingency Amount
The total fixed fee amount reflects the agreed-upon fee for an agreed upon baseline scope and set of assumptions. As mentioned previously, it is critical to review and fully understand the baseline estimate that builds up to the project cost so you can understand and assess the premium or magnitude of contingency applied by the system integrator to arrive at the total fixed fee amount. Fixed fee contingencies as high as 30% are commonly pursued by the system integrators which helps reinforce their opportunity to drive additional profit on the project. Fixed fee contingencies of 30% or greater are not market competitive from UpperEdge’s point of view. In fact, there are many levers that we have helped clients apply during the negotiation process to significantly tighten the level of contingency.
Schedule
In our experience, a milestone based payment structure will incentivize your system integrator to stay on schedule by tying payments to the acceptance of key milestones and deliverables. We recommend ensuring the payment amount be correlated to the importance of each milestone or deliverable to drive overall system integrator accountability. The most significant payment is typically tied to the final deliverable / go-live event. For schedule critical projects, UpperEdge will often overlay a holdback as well that is subject to forfeiture based upon the degree of lateness.
Reward
The lure of the fixed fee model for system integrators is directly tied to their belief and ability to complete the project under their initial baseline estimate of effort. Given the model is fixed fee, the system integrators ability to deliver more efficiently and effectively than planned extends the profit capture on the project and serves as an additional motivator. Given the potential business benefits associated with certain transformational projects, some teams have also included additional bonus pool opportunities for the system integrators based upon the overall quality of delivery and timeliness.
T&M Not-to-Exceed Model (Inclusive of Holdbacks and Step-Down Rates)
The T&M NTE is a lesser used financial construct that offers the benefit of a fixed fee without the downside of paying a premium. Should your company be fortunate enough to have actual costs come in under planned costs, you can benefit by sharing in the underrun with your system integration partner. If actual costs exceed planned costs, then your system integration partner will share the burden of the incremental costs by way of step down rates. As you can imagine, this type of structure can be complex and challenging to negotiate given the many ways the structure can be operationalized. Tier 1 system integrators tend to be more comfortable with this structure and the allocation of risk. Tier 2 and 3 providers will require a deeper understanding of the model and more persuasion to become comfortable with the level of accountability and management required with the structure.
Key considerations for the T&M NTE include the following:
Management
The T&M NTE structure requires a greater degree of oversight in order to ensure proper management and tracking, especially when combined with a holdback and forfeiture incentive schedule. When considering this construct, it is important to ensure your company has a solid understanding of how to operationalize the structure and the capabilities to manage it. Otherwise, a fixed fee model may be more appropriate.
NTE Amount
Like the fixed fee structure, there is typically a variance range between the estimated cost and the NTE amount. Procedural measures tied to baselining scope and assumptions coupled with certain negotiation levers can ensure a market competitive NTE variance is achieved. The amount ranges from 10% to 20% of the estimated T&M baseline.
Step-Down Rates
A best-in-class model includes step-down rates whereby the system integrator resource rates are further discounted as actual costs begin to exceed planned costs and approach the NTE amount. These step-down rates serve as an additional motivator to compel the system integrator to come in under the overall NTE amount.
Schedule
To drive schedule performance, UpperEdge recommends a portion of the monthly invoices be held back and accrued up until the final milestone. The accrued holdback amount is then either released upon timely completion or forfeited in part or in whole based upon the degree of lateness.
Reward / Bonus
To promote a balanced structure, we also recommend the construct includes opportunity for reward. In our experience, system integrators are receptive to sharing in the underrun should actual costs come in under planned costs. A key parameter to this reward being available is that the schedule must be ahead or on plan to be eligible to share in the cost underrun. It’s also important to place a limit on how deep the sharing extends for significant underruns so as not to motivate the systems integrator to baseline on a bloated estimate.
Additional Considerations
Regardless of the financial structure chosen, your company will only achieve the right level of protection and shared risk by properly baselining the scope and key assumptions prior to contract signature and again during the design phase. In addition, obtaining contractual commitments from your system integrator on the process for acceptance and the handling of errors and omissions is key.
Acceptance
Acceptance of milestones and deliverables should be subject to your company signoff and approval (i.e. no auto-acceptance). This will drive the appropriate process to ensure deliverables are developed in a quality manner and in accordance with your project team’s expectations. Without a strong acceptance provision, the benefits of a milestone based payment or holdback structure are significantly diminished.
Errors & Omissions
Your system integrator should be held accountable for the estimating models utilized to determine the fees, effort, and staffing associated with your initiative. There are two key inputs that feed into such estimating models; (1) the information and requirements provided by your company and project team and (2) your system integrator’s experience and expertise providing similar services. If we agree that any change to the requirements due to inaccurate information provided by your project team should warrant a change order, it is reasonable to expect your system integrator to take accountability for any errors and omissions in its estimating models should the requirements remain the same. Given a change order would result in additional fees beyond the level of protection guaranteed by your financial construct, it is critical to establish clear accountability in the contract for the events that would or would not constitute such a change order.
If you are preparing for or currently in the process of evaluating a system implementation partner for an upcoming initiative and want to know more about how UpperEdge can help you maximize the value you receive from that relationship, please do not hesitate to contact us at info@upperedge.com
