Fixed Price or Time-and-Material Pricing?

June 29, 2009
At First Glance, Fixed-Price Looks Better Than Time-and-Material Because Total Project Costs Are Defined Up Front
This article was printed in CONTROL's June 2009 edition.
By Dan Hebert, Senior Technical Editor

When you’re planning a project for your process plant, one of your most important decisions is whether to execute the work on a fixed-price or a time-and-material basis. This month’s column will look at time-and-material projects, and next month’s column will focus on fixed-price work. At first glance, fixed-price looks better than time-and-material because total project costs are defined up front. But looks can be deceiving as fixed-price bids will always exceed bare engineering, procurement and construction costs because of built-in price adders.

One price adder is a type of insurance premium to cover project risk. On projects that are well-managed and executed according to plan, the fixed-price bidder pockets the insurance premium as additional profit. When projects go south, fixed-price bidders try to recover some of their extra costs as change orders, but must often dig into or even exceed their insurance premium to complete the project.

The second main price adder is project management. Fixed-price jobs require much more project management and administration on the bidder’s side. These costs are built into the price and can often be substantial.

Another issue with fixed-price projects is change orders. Most fixed-price bidders will attempt to extract change orders from their customer during the course of the project. In the best case, change orders will be agreed to by both parties and will add only a few percent to total project costs. In the worst case, change orders can turn into major disputes and cause dramatic cost escalation and schedule slippage.

The best way to reduce the bidder’s insurance premium, reduce the total bid price, and minimize change orders is to get a precise definition of the project scope prior to bid. But detailed scope documents cost money, and even with a detailed scope, it’s often difficult to find reliable fixed-price bidders.

[pullquote]So what are the advantages of time-and-material pricing? First, it’s much easier to solicit time-and-material bids than fixed-price bids.

Instead of spending lots of time, money and effort preparing a detailed project scope and locating qualified bidders, an owner can simply solicit labor rates from qualified contractors. Assuming each bidder has the required expertise, the best contractors can then be selected based on labor rates.

The total project costs for time-and-material jobs will be lower than fixed-price bids for the same job because the owner is paying only for actual labor and materials with no built-in additional markups.

The bidder’s profit margin is known to a large extent, and time-and-material bidders accept lower profit margins than fixed-price bidders because the owner is sharing some of the risk. Because labor rates are pre-negotiated and bidder profit margins are lower, change orders become much easier to agree on and price.

Instead of spending time and money on detailed up-front scope definitions and change order negotiations, projects can be commenced and completed quickly. Of course, this assumes that the owner has a good handle on the project scope and competent project management.

Good in-house project management is essential to successful time-and-material projects. On time-and-material projects, the owner’s project manager must monitor multiple contractors and a host of suppliers. Coordinating their work is often a complex task, requiring considerable expertise. But if this expertise is available, then time-and-material can be the lowest-cost option.

Time-and-material also shines when the project scope can’t be defined up-front. For example, a system integrator may need to conduct extensive evaluation of an existing control system’s software and hardware to define the scope of a project. It’s often best to pay the integrator on a time-and-material basis to do the evaluation, rather than to demand a fixed-price bid up-front which will typically be very difficult to obtain and/or wildly overpriced.