Choosing the Correct Financial Model for IT Service Vendors

How to Choose the Correct Financial Model when Conducting a Large-Scale System Implementation

IT Services contracts for transformational programs require lengthy negotiations, and the program itself can span 3-5 years or more.  Choosing the correct financial model for such programs is imperative, as they serve as a means to hold suppliers accountable throughout the life of the initiative.

Most contracts settle on one of two options:

  • Time and Materials (T&M) — The vendor provides resources necessary to complete your program and the client is charged for actual hours incurred by these resources, regardless of how far it may be from initial estimates.
  • Fixed Price — A price is determined during the negotiation, and the vendor completes the scope of work for this price regardless of how much effort actually ends up being necessary.

Many vendors prefer a T&M model because the vast majority of IT projects are underestimated.  The vendor would be happy to continue charging your business as the project falls behind schedule, or worse, it changes scope entirely.  While some projects do come in under the estimated budget and your business actually has savings, these cases are rare.

A fixed price financial model assures that the budgeted costs will not be exceeded, which is attractive to many businesses, but comes at the price of ‘contingency’.  Contingency means there are added costs from the vendor above the baseline T&M resource costs, by way of additional resource hours or inflated rates, in order to combat the risk they are assuming by committing to a fixed outcome and price.

Note that your IT service vendor will often push for a higher contingency percentage allocation for the blueprint or design phase as there typically is a greater level of uncertainty at this early stage.  You can make sure that this higher contingency percentage is only applied to the design phase and that the lower contingency percentage be applied to subsequent phases.  Your vendor should be more willing to accept the greater risk profile in the execution phase given the additional clarity and definition gained during the design phase.

Between the T&M and the fixed price options, as a general rule of thumb, fixed price tends to be the safest for customers, as it protects the company from cost overruns and caps the overall value.

Defining With Additional Commercial Constructs

A third financial model exists, which vendors will rarely propose themselves, and that is “time and materials with a not-to-exceed cap,” or “T&M NTE.”  In this model, a baseline is established for the resource workload required to complete the program (T&M baseline).  If the T&M baseline is passed during the course of the program, work will continue at a reduced rate until a ‘hard cap’ is reached, upon which no more fees will be paid, but the vendor is still required to complete the program.

For clarity, I’ll provide a simple example. The project in question is scoped and baseline fees are established at $100.  If the vendor collects the $100 and the project is not complete, the vendor may continue work but can only charge additional hourly fees at 50% of the established hourly rate until $120 is reached.  If the project is still not finished, the vendor will complete the additional work at no cost.

The percentage by which the fees above the baseline are charged, and the ‘hard cap ceiling’ would be negotiated and unique to each situation, but this is the general structure.  This model favors your business more than the previous two in that you can safely budget for the ‘ceiling’ and be assured no additional costs will be incurred, while also allowing your business to reap the savings should the program be completed for less than what was estimated.  More complex variations of the “T&M NTE” model can even be negotiated, including a ‘savings sharing’ model to incentivize the vendor to achieve a ‘program underrun’ by delivering ahead of time and/or under budget.

T&M NTE financial models are less common and getting a vendor to agree to a model in which they assume such a significant risk is difficult.  You will need ample negotiating leverage, an understanding of the necessary ‘levers’ to pull, and the timing in which to do it.  Hiring an IT negotiation advisor can give you the knowledge and leverage you need to protect your business from disadvantaged program financial models.

Adopting a straight T&M commercial agreement is tantamount to giving your SI a blank check.  Conversely, you can try to “buy certainty” up front with a fixed-price contract, but not only are you going to pay a steep premium for this, in reality there’s still no guarantee.  Finding the middle ground that both incentivizes your SI while limiting your exposure is the hallmark of a solid SoW, and this can be accomplished through a variety of commercial constructs like:

  • Not-to-exceed clauses
  • Slide-scale fee structures
  • Holdbacks

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