At the core of every professional services engagement there is a contract structure that dictates the expectations of each party. While strong results are ultimately what every client wants, the contract structure that surround consulting a project plays a significant role. It dictates who bears risk, when money changes hands, and the how final product is to be delivered. As a result, the professional service contract structure used to pitch an engagement could easily make or break a deal. Knowing the strengths and weaknesses of the common consulting contract structures is essential.
In this post, we will look at the three most common professional service agreements, and present examples where each type will perform well. We will then dive into three additional professional service contract examples that incorporate additional components to shift risk, reduce variability, and up-sell existing work.
Regardless of which contract structure works best for your professional services organization (PSO), make sure your professional services software fully supports the time tracking, forecasting, budgeting, invoicing, and revenue management in an efficient and scalable manner.
1 – Time and Materials Contract Structures
One of the most common contract types for professional services engagements, time and materials (T&M), enables a firm to bill their clients for the amount work that they perform. Under this contract structure, time is tracked for each individual performing work and is then billed at a pre-negotiated hourly or daily rate. Individuals will also track any expenses incurred as part of the project and pass them on to the client for reimbursement.
Although time and materials engagements are a simplest type of professional service contract, the most successful firms will use robust project accounting software to track their progress.
Strengths of Time and Materials Contract Structures:
- Simple to understand
- Easy to track performance
- The client and the service provider share the risk
- Straightforward invoicing and revenue recognition
Weaknesses of Time and Materials Contract Structures:
- Underperforming projects may require write-downs, change orders, or unpleasant conversations
- High performing projects may finish early and may not generate the full revenue as initially estimated
When to use Time and Materials Contract Structures:
- If scope and deliverables have the possibility of changing throughout the course of the project
- When services are in high demand and there is no need to take the risk of a fixed price contract
2 – Fixed Price Contract Structures
An increasingly popular contract structures for delivering professional services. This is especially true in an economic environment where clients have the power to push some additional risk on to their vendors. According to SPI Research’s latest Professional Services Benchmark, nearly 39% of projects are delivered on a fixed price basis. When utilizing this model, a client agrees to pay a fixed price for a (hopefully) well-defined deliverable. These contract structures shift the risk onto the service provider, as they have agreed to deliver the project regardless of how much effort it may take. For professional services firms that know how to manage a fixed price project efficiently, the additional risk of a fixed price project will deliver a significant reward.
Strengths of Fixed Price Contract Structures:
- Simpler to sell to clients (less uncertainty on price)
- If managed well, can return strong margins
- Pricing can be based on value rather than effort
Weaknesses of Fixed Price Contract Structures:
- Poorly estimated or managed projects can return low margins, or a loss
- Revenue forecasting requires robust operational tools
- Arguments of scope can arise when projects go over budget
When to use Fixed Price Contract Structures:
- When well-defined service offerings have low risk of running over budget
- In scenarios where agreeing to absorb more risk provides a competitive advantage
3 – Not To Exceed Contract Structures
If a time and materials contract and a fixed price contract got together and had a child, it would be a not to exceed (NTE) contract. These contract structures, which are also called time and materials with a cap, are designed to reduce the amount of risk carried by the client even further than a fixed price contract. Using this model, a firm will deliver work on a time and materials basis up to a certain point. Once that point is reached, the professional service firm is no longer able to bill for additional work, but is still required to complete the deliverables of the contract.
These contract structures tend to be the worst of all possible worlds for a PSO in that revenue generated on the project cannot exceed the negotiated cap if the labor investment proves to be more than the initial estimate as there would have been in a T&M contract. However, if the labor investment proves to be less than the initial estimate, there is no upside of being able to bill the client the full contract value as there would have been with a fixed price contract. As such, PSOs tend to use NTE agreements only when they absolutely have to, when deliverables are well understood and predictable, and when it’s likely that they’ll be able to negotiate change orders or cap increases with clients in good faith.
Strengths of Not to Exceed Contract Structures:
- Further reduces client-side risk, and in turn becomes easier to sell
- Helps delivery teams to stay focused on staying within budget
Weaknesses of Not to Exceed Contract Structures:
- Limits profit potential of the project
- Revenue recognition rules become complex if significant amounts of work are required after exceeding the project’s cap
When to use Not to Exceed Contract Structures:
- Excellent for building trust with a new client
- Good for teams that are exploring new service offerings and are still moving up the learning curve
4 – Retainer-Based Contracts
Not just for lawyers anymore, retainers are making their way into all sorts of professional services agreements. In a professional services context, retainers are often used when there is uncertainty around when work will be performed and quick turnaround times are needed. The terms of retainer-based contracts can vary widely, but the basic premise is the client will pay a set amount up front for delivery of services during a set service period. If the PSO works less than what the retainer covers, then the PSO will keep the balance. If the PSO works more than what the retainer covers, then the PSO will invoice for any overages on a time and materials basis.
Strengths of Retainer-Based Contract Structures:
- When a client does not request services, higher margins are possible
- The client carries the majority of the risk
Weaknesses of Retainer-Based Contract Structures:
- When a client does not request services, they receive less value
- Workload is less predictable and often reactionary
When to use Retainer-Based Contract Structures:
- If there is uncertainty in scope and work requires fast turnaround times
- When having a defined resource or team reserved for when the client needs them is valuable to the client
5 – Recurring Service Subscription
Subscription based services are quickly becoming a core offering in a professional services firm’s arsenal. Depending on the types of services a PSO is offering, using a subscription model can be powerful. Under this approach, clients will pay an ongoing monthly fee for recurring deliverables. Those deliverables could include access to a proprietary software solution, detailed monthly reporting and analysis, or smaller deliverables that accrue overtime.
As of late, there has been quite a bit of conversation surrounding the productization of services. The recurring service subscription model is perfect for services that have been successfully productized.
Strengths of Recurring Service Subscription:
- Consistent and predictable revenue stream
- Scalable deployment model
- Well positioned as an add-on to other service offerings
Weaknesses of Recurring Service Subscription:
- Margins are highly dependent on the const structure of the offering
- Underutilized subscriptions could result in a poor customer interaction
When to use Recurring Service Subscription:
- As an add-on to other service offerings
- When an aspect of a service package is highly repeatable
- When a technology component complements a service offering
6 – Managed Services Contracts
Managed services agreements are also becoming a common tool that traditional professional services firms deploy. Historically, managed service providers (MSPs) sold managed services agreements, which focused on providing a specific level of services for an extended period of time. Common examples would include outsourced IT services, equipment maintenance, and outsourced business functions such as payroll.
Under a managed services agreement, the service provider will make specific guarantees around their availability, response time, resolution scope, and overall responsibilities. The client will likely pay a fixed rate in return for these guarantees.
In the traditional professional services context, managed service agreements are becoming popular as an add-on to custom software development work. Instead of charging clients to fix problems as they arise on a time and materials basis (which can be costly and unpredictable), follow-on support services are being sold as a packaged offering.
Strengths of Managed Services Contracts:
- Consistent and predictable revenue stream
- Projects tend to be high margin if the items supported are stable
Weaknesses of Managed Services Contracts:
- Labor pool staffing must account for peak demand
- Work load is reactionary and unpredictable
When to use Managed Services Contracts:
- If business process outsourcing services are a component of a service portfolio
- When follow-on support or administration services can add value to a product or implementation
Choosing a Professional Service Contract Structure
Choosing a professional service contract structure for delivering a project is a delicate balance. Quite often the contract structure selected will depend on client relationships, experience with the services, and the professional service software used to manage the business. Regardless of which professional service contract structure you select, managing the project to that contract is essential. The most successful professional services firms will utilize their professional services automation (PSA) solution for this purpose.
PSA software helps PSOs to install tight controls around the planning, tracking, and invoicing of work. This is especially important for professional service contracts that shift risk away from the client. Having a clear picture of progress, mid-project profitability, and budget health gives the project management team the tools the need to ensure professional service contracts deliver their expected returns.