Why are fixed price projects a financial risk?
Nearly any project can sometimes go over budget. However, fixed price projects are particularly prone to such problems. To solve them, we first need to understand why it happens.
The scope crawl
Fixed price projects operate on a limited budget. However, just like any other project, they are prone to a scope crawl - a sudden change in the deliverables that is often the root of all the delays and problems with budgeting. In case of fixed price projects, this process is as harmful as it can possibly be, as it often leads to the operation being unprofitable.
Changes in costs over time
Long fixed price projects do not change their price, but their costs change over time. Things such as:
- changes in salaries and wages,
- changes in the currency rates,
- scope crawl,
have a huge impact on the expenses of the project - and they are often unavoidable, as they are a result of the current economic conditions in the region. As a result, they can quickly turn even the most profitable projects into failures.
Project scope and economic factors are not the only things that can change in a fixed price project. Sometimes completing such an operation requires some additional, unexpected expenses that were not a part of the financial forecast, and yet they need to be made. Things such as additional equipment, software or simply a bit of help from another specialist may generate huge costs, contributing to the failure of the project.
How to accurately estimate the costs of a fixed price project?
As you can see from the examples above, fixed price projects are mostly threatened by the changes they are particularly prone to. However, that doesn’t mean that these changes cannot be taken into account while planning the project. Here’s how to do that.
Estimate the cost of the project for the time being.
Before you decide to accept a project, first make sure that the cost of work won’t exceed your expectations. In other words, create a project schedule to see how much work you need, and add some additional information ro get a bigger picture of the project’s finances.
- wages and hourly rates of employees that will be assigned to the projects (no estimates or average values here - just create a draft allocation and calculate its costs to avoid mistakes!), as well as the typical changes in those wages over time,
- historical data on the costs of similar projects in the past,
- project overheads, both typical and project-specific,
- a part of organizational overheads - we talked about them in detail in our article about cost allocation.
In the end, add some money for the desired profit margin. That will be a base for your further calculations.
Include change over time in your estimates
As we have stated before, the costs of your fixed price project will probably change over time. However, you can take that into account, too, by calculating the Net Present Value.
What is Net Present Value?
Net Present Value is an indicator that can help you determine whether your investment (or, in this case, a fixed price project) will be profitable over time. It sums all the expenses and incomes to tell the managers whether there will be some extra money left over after the project is completed.
Net Present Value formula
You can calculate the value of your project over time using the formula below:
In this formula:
- Cash Flow is the sum of money spent and money earned on the investment or project for a given period of time.
- n is the number of periods of time.
- r is the discount rate.
How to interpret Net Present Value?
Net present value has three potential outcomes:
- Positive NPV - your project is profitable. Congratulations!
- Negative NPV: - your project is losing some money and you definitely need to fix that.
- Zero NPV: An NPV of zero means the project or investment is neither profitable nor costly. Maybe there’s something you can do to help it generate profits?
What types of fixed price projects are likely to be profitable?
Of course, not all of the fixed price projects are deemed to fail in terms of finances. There are some such operations that are destined for enormous profits - and you can use them to your company’s advantage.
There are some projects that simply require a short period of intense work, and they have a little chance of changing their scope. Such projects are widely known as quick fixes, and they usually make a perfect candidate for a fixed price project.
That’s because they have:
- a very limited scope of work that is unlikely to change,
- they are resistant to inflation and financial adjustments over time, as they typically last up to 3 months,
- they typically address simple problems that can be solved with a ready-to-go product or a simple implementation.
As such, quick fixes have very predictable costs and profits.
Gray-haired projects are all the projects your company knows very well, as it has done it multiple times over and over again. They are the safest project to sell for a fixed price as they:
- can be very accurately estimated in terms of both budget and time,
- do not require hiring any additional specialists - having worked on similar projects, you probably have very experienced employees already on board,
- are likely to be completed before the scheduled time, generating additional profits,
- they can be accelerated by using the code that was previously used in similar solutions.
In other words: gray-haired projects have a huge chance of succeeding and generating profits.
What else can I do to keep my projects profitable?
Of course, sometimes going over budget is simply inevitable. Still, you can prevent the unpleasant consequences of such situations, or even prevent it altogether.
First, you can limit the number of fixed price projects to a minimum. This type of financing should only be chosen for gray-haired projects and quick fixes; other types of projects are very unlikely to be profitable here, especially if you have never worked on similar operations before.
Secondly, you can precisely describe the scope of work in a contract with a customer, all while stating that any changes to the project will result in additional costs. This may not attract new customers, but it definitely prevents you from losing money.
Last but not least, you can simply convince your customers to switch to (or to choose) Time and Material projects. These are an optimal solution for both provider and customer, as they allow for a flexible management of the scope of work without threatening both parties with unexpected charges.
What should I do if my fixed price project is already unprofitable?
Unfortunately, if you already began working on a project that turns out to be unprofitable later on, there is little you can do. Of course, you can:
- try to limit the costs of work by replacing more expensive employees with the cheaper ones,
- use the code from previous projects to speed up or simplify the work,
- limit the project overheads to a minimum.
However, these methods may often not be enough to turn the profitability of the project around. In that case, renegotiating the contract may be the best way to avoid losing money, even if that means some organizational problems on the way.
How can I manage the finances in my projects even better?
With a bit of our help, of course!
We have prepared a huge guide for all of those who wish to expand their knowledge of finances in business. To do so, simply visit our blog or go straight to our articles to read about:
- improving the profitability of an IT company,
- saving some money on employee bench,
- cost allocation,
- financial performance measurement,
- billable and non-billable hours.
Or, if you are already looking for a system capable of calculating the profitability of a fixed price project (even in the long run!), test our financial features in Primetric or book a demo with our advisors - they will show you everything you need to know!