Custom software development pricing strategies

2. Pricing models in software development

Pricing Models.

Historically, organizations approached software development outsourcing as a black box where you throw away things you don’t want to do. The field is changing as the emerging markets have proved to provide quality and shown the advantages of higher dollar purchasing power.

With so much at stake, traditional outsourcing engagement models thus moved towards partnership models. So now, businesses increasingly outsource things they can’t do.

As a result, the emerging cooperation models have created numerous pricing models.

However, once you start digging deeper with your research and evaluating IT contractors’ proposals, you’ll start to see not only the big difference in total cost but also the difference in pricing models used to calculate the cost.

Ultimately, you may feel like companies are trying to take advantage of your lack of experience, and you can’t identify a potential long-term partner.

In this publication, Mad Devs Customer University addresses your puzzling questions about pricing models with clarity and transparency.

Fixed Price Model / Waterfall 

Fixed Price Model.

As the name itself implies, a fixed price model is an agreement between a business and an IT outsourcing company on a strictly predefined set of requirements to be accomplished for a predefined price.

Note: The terms “fixed price model” and “waterfall model” are used interchangeably.  

A fixed price model is an ideal mechanism for projects with a clear scope, established project management methodologies, and a stable set of requirements. For a successful collaboration, a team and a service provider should have a good grasp of project requirements and a conducive working environment in place and should be aware of each other’s skills and needs.

Clients with tight budgets and those who require absolute certainty tend to incline towards the fixed price model.

IT service providers absorb the majority of the risk. However, this risk coverage is, in fact, coming from the customers’ pockets. Keep in mind that in 100% of cases, the service provider charges a 20%-50% premium on top of the real cost because the provider must consider various risks and ensure profitability for the entire project timeline.

In the early stages of IT outsourcing, almost everybody worked using the fixed price model, and it created numerous inconveniences and issues for both service providers and clients.

Problems and pitfalls of the Fixed Cost pricing model 

The above explanation of the Fixed Costs pricing models is what you’ll commonly hear and read on the Internet. Let’s dig deeper; here is what they don’t necessarily tell you.

  1. Negotiation mess: As the contract defines the scope of the work and specifications, any deviation from this scope will create a negotiation mess. As problems and new needs emerge, it’s difficult to understand which party should absorb the additional cost. So instead of moving the project forward, both parties will be sending new additions to the contract back and forths, so a lot of time can be wasted.
  2. Undeniable utopia: Dealing with a list of clearly defined specifications and requirements, unfortunately, is a utopia. In a normal project, adjustments and alterations will inevitably be needed at some points. Unless, of course, you are required to automate a 100-year-old process that will maintain the status quo forever. Or your project is tiny.

Time and Material (T&M) pricing model

User behaviors and needs change faster than a typical software development project lasts. Often, you as a client can only predict possible intentions and perceptions of users. Meanwhile, MVP requirements can’t be defined precisely. Thus, during the development process, new product requirements and new flows will appear, and they will affect the total software price as well. 

The time and material price model provides agility. Flexibility in software development enables you to create a product that the market indeed needs and will use.

Also, this model is the most transparent one. In the fixed price models, where the probability of risk is high, IT outsourcing companies charge an extra 20%-50% on top of their real estimation to be able to absorb the risk and ensure profit. In the Time and Material model, you as a client always pay the real price without any premiums. Thus, you always know where your money goes.

With this pricing model, the service provider and the client organization normally agree upon an hourly rate. The billing is based on the developers’ levels of education and experience.

Problems and pitfalls of the T&M pricing model

  1. Uncertainty: The company operating under the time and material pricing model should provide specific processes designed for the partners to be able to control the costs. Otherwise, you might fall into a disadvantageous situation of overpaying.
  2. Deep involvement: T&M pricing models require your deep involvement in the development of a solution to make sure that the IT company is moving in the right direction and spending the correct number of hours.

How to estimate the final price using the time & material pricing model?

Answers to this question will vary from company to company. We can describe our best practices in approaching price estimation. Our methods are not unique: they can be found in other transparent IT outsourcing companies. 

At Mad Devs, we approach every new customer as a new case. We don’t send to customers proposals we’ve already used in other projects. 

    During the first meeting, we meticulously examine the clients’ vision and the users’ needs. A special SWOT analysis team consisting of senior-level developers with expertise in the required field then creates a detailed roadmap and estimates the scope of the project.

    The roadmap created by the SWOT analysis team consists of:

  1. Typical tasks (team onboarding, DevOps, test);
  2. Specific tasks;
  3. Team composition.

Total estimation for typical tasks can easily be calculated, and the SWOT analysis team creates approximate estimates for specific tasks and multiplies them by the developers’ hourly rate. 

This approach enables us to determine the right pricing and answer all potential questions regarding how the final estimate was calculated. Additionally, the clients themselves have the power to shape the final price by altering the scope of work or suggesting changes in the team composition.

Pricing Models.

Outstaffing pricing model

Outstaffing means handing tasks over to individual specialists working for a service provider company. Organizations engage in outstaffing when they lack the expertise or capacity to complete the tasks in-house. Usually, hiring experienced developers might take a lot of time, and sometimes, you don’t have enough authority to attract the best personnel. This model provides human resources for whole projects or just parts of projects as needed.

The model is ideal for clients who are looking to hire specialists on a short-term basis. The clients don’t have to pay for recruiting, and terminating the contract is easy. 

The outstaffing pricing model can use predefined rates like the time and material model or fixed price in the form of a regular salary without covering additional benefits, taxes, vacations, and coffee breaks.

And since the project is managed by the client organization, closer monitoring of performance provides more accurate cost control. To confirm the seniority level of the professionals being hired, most IT outsourcing companies let clients interview and test outstaffed team members. 

Gain-sharing pricing model

Future unicorn startups having great ideas but unable to attract the best employees and financial resources to boost their growth can pitch their product to IT outsourcing providers.  

The providers in some cases might operate as investors and become co-founders of a startup. In contrast to traditional monetary investments, the startups ask for labor expertise. It is called the gain-sharing pricing model. 

However, this pricing model is usually not the most attractive to IT service providers. These pitches often come from startups that lack a solid foundation and are looking for freebies.

    To those who are interested in this pricing model, we have a few recommendations:

  1. Develop a clear monetization strategy and make sure you know how your project is going to generate profit in the future.
  2. Conduct market-fit analysis.
  3. Have a clear vision of how your product is going to meet users’ needs.

Also, IT outsourcing companies never cover 100% of costs but only provide a discount. It puts the responsibility for faster success on startup founders’ shoulders, and thus they take their idea more seriously.

No matter how much Mad Devs or any other vendor is interested in supporting startups and becoming a responsible partner, we can accept only a limited amount of projects under our umbrella.

Conclusion

Most IT outsourcing providers have specific preferences in certain pricing models. Fixed Price, Time & Material, Outstaffing, and Gain-Sharing pricing models are only a few of the most common models of determining the final price for your project. Some projects feature a combination of pricing models: different models are used on different development stages.

You as a client can have full control over the expenditure and choose a transparent IT partner who will explain the final price composition in detail.

Altynai N. Alamanova.

Altynai N. Alamanova

Head of marketing department
Contributors:
  • Oleg Puzanov
  • Tamara Mun.
Pricing Strategies in Custom Software Development.