Pricing Strategy for Software Development

A predictable and transparent pricing strategy is essential to avoid hidden costs. The lowest day rate is not always the cheapest option.

When you first choose a supplier, their day rate is often seen as a direct reflection of the total cost of an engagement. As though your sole objective is to spend as little as possible. All other things being equal, a lower day rate may be better – but things are rarely equal.

Your primary objective should be to derive the best possible value for your investment. There are many factors that contribute to how effectively you achieve this goal. The other articles in this series examine these factors and how they can influence a working relationship. For now, let’s look at some of the core aspects of a commercial framework.

Choosing a commercial model

The way you pay your supplier is likely to be based on a Fixed Price or a Time & Material model (or some combination of both). Be aware that the model you choose will influence how your supplier behaves. Think about the incentives that you want to create and how they will encourage a positive outcome.

Fixed price
With a Fixed Price approach you define requirements up front to give a clear and comprehensive definition of the work. Your supplier reviews the requirements and estimates the effort, and cost, to implement them. It’s not unusual for the supplier to add a premium onto their estimates that is proportional to the risk of understanding and correctly implementing your requirements. This can be anything between 10% and 50% depending on the nature of the work.

In theory, time, cost, quality and scope are fixed from your perspective. In practice, it is not generally possible to fix them all. The attraction of this model for you is a risk free engagement assuming the supplier can deliver against these constraints. For the supplier, delivering early increases their margin and encourages them to do so. Choosing a fixed price engagement does not mean you should not collaborate on a regular basis.

Time and material
With a Time & Material approach to software development, you pay for effort and expertise. This is usually agreed as a cost per person per day. Time & Material is typically the commercial model for agile development. If the amount of resource is fixed then it’s easy to calculate your costs on a month by month basis. This means that, without your approval, your cost profile is unlikely to change. With this model, it is common to fix time, cost and quality while allowing scope to vary.

Role based rates & blended rates
A role based rate is the cost per person per day depending on the role that they perform. You can agree different rates for project managers, developers, test engineers, business analysts, technical architects and other role types that form part of the team.

A blended rate is a single cost per person per day regardless of the role they perform. This is generally a simpler approach and works well for evenly distributed teams. Of course, you can easily calculate the effective blended rate if you know the roles and day rates of your resources.

Working on site
When working with a non-local supplier, there are likely to be periods of time when people are working onsite with you. Equally, perhaps you will choose to visit your supplier’s workplace now and again. Site visits will increase costs and it’s advisable to consider how this affects your budget. There will usually be travel, accommodation and living expenses to take care of.

Work out a likely scenario for working onsite and cater for that in your cost projections. For example, you may budget for the whole team to be onsite for 4 weeks at the beginning of a new relationship. You may then plan for 4 people to be onsite for 2 days every month. Whatever your needs, factor these visits into your budget to avoid any surprises later on.

If you are working with an agreed daily rate, you can combine this information to produce an effective daily rate that includes all reasonable expenses. This will give you a more realistic number if you are, for example, comparing nearshore and contractor rates.

Risk and Reward schemes
You may wish to consider some form of Risk/Reward scheme. You create and agree a set of criteria with your supplier and measure progress against them. If your supplier exceeds expectations then they receive an appropriate reward. In the same way, failure to meet expectations results in a penalty of some kind.

You should approach these schemes with care; the objective is to cement your relationship rather than weaken it. Risk/Reward schemes can sometimes lead to a blame culture and that’s the last thing you need when trying to build a positive working relationship. Try to create incentives that represent a win-win outcome for both sides.

Licensing & Infrastructure
Be sure to carefully review the software and hardware that you need to support your development. There may be license fees that your agreed rates do not cover; this can all add additional costs to your project. What does your development partner supply as part of their services and equally, what don’t they supply? Are there run-time licenses that have to be in place once your systems go live? How and where will you host your live systems?

If your supplier is working remotely, what supporting infrastructure do you need? For example, video-conferencing can really help with communication but often requires dedicated hardware on both sides. Build licensing and infrastructure costs into your budget and review appropriately.

Currency exchange rates
Changes in currency can introduce significant financial risk for your business. Usually, as a client, you will pay for services in your local currency. Equally, the supplier will use their own local currency to cover their costs. Imagine an English company using Polish development services. If the value of the Polish zloty drops against the pound then the margin for the supplier increases accordingly. In effect, you end up paying more for the same investment.

There are a number of ways that you can mitigate against this risk. You might agree on an upper and lower threshold. If the exchange rate drops below the lower limit then as a client you pay less. If it rises above the upper limit then you pay more. A similar scheme may be to pay in your local currency but to tie this to the current exchange rate. A third option might be to pay in the supplier’s currency depending on how favourable you feel exchange rates may be over time. You may choose to work with an investment firm to create your own hedging strategy.

Even when the exchange rate turns in your favour, there are risks that you need to consider. The quality of service you receive may decrease to preserver your supplier’s margin. Even if you decide that there is no need to cater for currency fluctuations, you should still consider the impact. This is equally valid for established working relationships as well as for new partnerships.

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