Needless to say that payments and payment models are some of the most important aspects of an outsourcing contract. While these items typically well understood and relate well to similar terms in any other consulting contracts they still require extreme attention and caution especially considering caveats off the offshore outsourcing.
The payment models in offshore contracts derived from the underlying contact execution models with most popular being Time & Material and Fixed Bid, see Offshore Model Selection: T&M vs. Fixed Bid.
Time & Material model typically translates to a payment per hour model. The rates / payment approach could be defined at a coarser granularity (e.g. week or month) but the nature of the payment methodology remains the same. If the hourly rate is used the vendor submits invoices with agreed upon frequency (most typical is monthly, small vendors often ask for bi-weekly or even weekly payment schedule). The invoice or its supporting material include hours of allocation for each resource for the corresponding period, rate and totals.
There are a few elements related to that pricing model, most important being a concept of minimum allocation. Minimum allocation defines the minimum number of hours in a month that a resource supposed to be engaged independently of buyer’s induced failures in work allocation.
You need to be careful in analysis of the associated contract language as a minimum allocation could become extremely costly.
Another set of contract elements highly relevant to hourly payment schedules is similar to minimum allocation and is related to work allocation / assignments. If a developer is waiting for business requirements clarifications from the buyer and is not engaged in any meaningful activities, who is paying for his/her time? The fair approach is for the buyer to pay for this time and for the vendor to make reasonable business efforts to keep developer productively engaged on project related activities. Make sure to have corresponding language in your contract.
One of the most popular forms of coarse granularity time based models is one often referred as an FTE model; here FTE stands for a “full time equivalent”. Under that model the rate is most typically negotiated on a per month basis. There are a few issues associated with that model that basically bringing it back to the hourly model. The first question is the workload allocation for the month with most typical number being 168 hours. The next set of issues comes from dealing with overtime, handling time off, vacations, holiday, etc. All these elements need to be understood and agreed upon by both parties.
My approach to negotiating FTE contracts is typically based around following mind set – “It is my responsibility to provide you with workload of 168 hours a month, if the employee can not be allocated for that number of hours the rate must be proportionally reduced. I also expect you to do your best to keep the employee meaningfully engaged in case I hit any obstacle or experience delays.”
Fixed Bid engagement models require a different approach for invoicing / payments. For FB engagement of a project nature the most common methodology is Milestone Payments. The idea is fairly simple – the cost of the project is divided in portions that to some degree correspond to the effort for delivery of a specific milestone. If the milestones are separated by substantial time some additional, often artificial, milestone are inserted in the project schedule to accommodate for smoother cash flow. The most important item to consider when following Milestone model is the process of had-over and acceptance of the milestones. The most frequent payment issues associated failures on FB projects related to small problems that pass through accumulate and accumulate towards the final milestone.
There are multiple variations in payment models that based on one or a combination of the models above. A few are worth mentioning:
- “Prepayment” a form of milestone payment associated with initiation of project. It is most frequently used by small vendors who can not afford the risk and expense of ramping the project up. I personally prefer to avoid prepayments. It doesn’t mean that you should exclude vendors asking for prepayment, it only means the some additional work in contract negotiation is required, for example if the resource / environment ramp up is the reason for prepayment, it could be shape as a milestone. In other cases an escrow could be considered to avoid some of the obvious risks of prepayment.
- Time-based (e.g. monthly) installments on FB contracts. I strongly recommend against that approach. In my view it really increases inherit risks of FB model. There are some meaningful situations where monthly payment associated with FB contract; that in particular common for non-project FB engagement, e.g. provision of services under SLA.
- “Bonuses and Penalties.” This is an interesting concept which could be productively applied in FB contracts for example for delivering before / after specific deadline. The concept must be dealt with a great caution though, it could become a wrong motivator and promote bad practices. Thus one of the mandatory conditions is for the vendor to receive a bonus all aspects of the delivery must be considered / met. Another important aspect to consider is the size of the bonus (as a percentage of the overall payment amount). If the size of the bonus is too small it stops making any difference if it’s too big it could ruin the project – just consider the situation when the vendor realizes in mid of the project that there is no way the deadline could be met and a huge penalty is inevitable.