Risk-Based Approach to Hourly vs Fixed-Fee Pricing

If you are a service provider, you likely bid engagements on either an hourly or fixed-fee (project, not-to-exceed) basis. You might even alternate between the two. How do you decide which approach to use? In some industries, there may be a set or unspoken standard that decides this for you. In other industries, you may have the option of using either. I use both - and have found that looking at it from a risk perspective has helped me eliminate headaches.

First: What is your time worth?

Whether your charge on an hourly or fixed-fee basis - you need to know what your time is worth. Even a fixed-fee engagement is based on time (sometimes value - we'll cover later) when you break it down into its various components. This rate is not only how you provide pricing to prospective clients, but it's also how you'll measure your effectiveness at project completion.

Next: Identify how will you evaluate your effectiveness at project completion?

As the service provider, if you have an hourly rate, you want to make sure that at the end of an engagement - when you divide your total revenue by the hours worked - it at least equals your hourly rate (and hopefully you are doing post-project evaluations). Anything less than your hourly rate and something went wrong.

Contrasting methods: Who is going to take on the risk?

Contrasting the methods yields a seemingly simple question: who is going to take on the risk - you or the client? A hourly agreement favors the service provider - every minute spent working, no matter what unknowns come up - is completely paid for. The risk shifts to the client - who is agreeing to pay some open-ended amount.

A fixed-fee engagement favors the client - the service provider is forced to estimate the time a project will take and use that information as the primary factor in the fixed-fee price. The risk here is on the service provider, who is obligated to perform a service for a fixed cost - regardless of how long it might actually take. The risk increases if the client attempts to increase your deliverables mid-project because you didn't clearly define the project scope.

With fixed-fee pricing, an alternative method is based on value. The value of your service may be fixed because it's set by the market or some other intangible (i.e. brand name). In this case, a brand-name, reputable service provider who does the same work as a qualified, unknown service provider, may charge 3-5x as much because of a perceived value - even though the value of the work itself is the same.

If given the option, which method should you chose?

It depends. In general, complex engagements are better left to an hourly model. This protects you from unexpected events that may double the amount of time you will spend on the project. When there is a general market rate, and if you work particularly fast compared to your competitors, a fixed-fee pricing model will work in your favor. You'll be able to exceed your hourly rate by completing the project in less time than your competitors.

Mitigating Risk

If you are going to offer a fixed-fee, not-to-exceed quote, how can you reduce your risk level and perhaps even increase profits?

1. Work faster
   If your fixed-fee is generally set by the market, then you have very little leeway in what you charge. Increase your profitability by becoming more efficient at what you do.
2. Increase your forecast accuracy
   If you complete projects in more hours than you forecasted only 2% of the time, you will be better off than if you were finishing over your forecasted hours 85% of the time. If you can improve your ability to forecast your time accurately, you'll successfully reduce your risk level and turn down engagements that are not profitable.
3. Include a risk-premium in your final quote
   If an engagement has a lot of potential to go wrong, make sure you account for the uncertainty by charging a risk-premium. The more complex the engagement, the greater the risk premium.

Looking at this question in a risk-return format helps improve your decision making. If you are taking on a complex engagement with a high-level of uncertainty, you need to carefully choose how you price your services. This goes beyond just profitability - if you drastically underquote a project, you will be unhappy and may not work as hard for your clients as you usually would. This just hurts your reputation and possibly diminishes the quality of the end result.

In the next post, I'll discuss the method I use to improve my forecasting accuracy.