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Which Agile contract type fits your project and budget?

A contracts expert shares common agreement types for Agile software development project outsourcing, and where companies tend to go wrong.

Agile fundamentally changes how we develop software. Which means an Agile outsourcing contract can't look like any traditional software development agreement.

Rather than see a software project to fruition as one large batch of work spanning several months, Agile breaks the work into manageable, adaptable and valuable segments. Some organizations can't handle restructuring for Agile, or they lack the resources to develop all their software projects in house. Outsourcing seems like the way to adopt Agile and reap its benefits.

"We're starting to see projects that are handed over to a vendor -- a whole development effort, and they want the vendor to do it on an Agile basis," said Chris Powers, vice president of services at ClearEdge Partners, a consulting firm based in Boston. Powers hosted a webinar called Agile Contracting Best Practices, covering challenges in choosing a third-party development partner, and common types of contracts.

Just as organizations cannot simply flip a switch to become Agile, they can't expect to outsource Agile work without giving up their Waterfall methodology. Agile work can fall under fixed-fee and time and materials (T&M) agreements that hardly differ from Waterfall approaches. But the adaptive nature of an Agile approach makes it difficult for the outsourcer and client to agree on stable contract terms. Better options include fixed-fee per iteration; incremental delivery; or T&M setups with a bonus, cap or holdback written in.

Traditional software development contracts

Software development objectives, scope and team structure vary from team to team and organization to organization. Before the rise of Agile, the customer and vendor agreed on contract terms that were stable, as development projects were often long-time efforts that were large and multipart. In those instances, two types of contracts were common; both still pop up today in some Agile agreements.

Fixed-fee contract. Common for Waterfall development projects, fixed-fee contracts sometimes also define Agile agreements. Fixed-fee contracts offer cost certainty for the vendor and customer, but that's where the benefits end for Agile.

The fluid nature of Agile development makes it difficult to predict how much work a project will need. Agile requirements change, by nature. Under an Agile fixed-fee contract, change orders get expensive quickly, and scope change becomes difficult to govern.

Chris Powers, vice president of services at ClearEdge PartnersChris Powers

Powers doesn't think it's possible to go into Agile with a fixed-fee contract from the start. "How would you ever possibly estimate the effort?"

An Agile fixed-fee contract often underestimates or overestimates the amount of work to be done, with the vendor building risk into the quote. Risk translates to cost, Powers said. Thus, the two sides often experience friction in what should have been a collaborative Agile process.

Time and materials (T&M) contract. T&M contracts for Agile ensure that the vendor gets paid for the time it spends working on a project. These contracts incentivize the vendor to produce quality work as these agreements are easier for the customer to terminate than fixed-fee deals. The vendor and customer must trust each other and collaborate, so the bill is agreeable to both. The same ambiguity applies to scope and budget changes in T&M as in fixed-fee contracts.

Most Agile clients settle on a T&M contract, Powers said, but often not the traditional version of one. "I don't know that I would do one of these contracts with a vendor you've never worked with before," Powers said. "There's still a complete leap of faith on the client's side that they are going to collaborate; there is going to be trust; they're not going to run the meter, they are going to truly realize the benefits of Agile."

Editor's note: While a common contract in business partnerships, T&M is a misnomer in the context of Agile. It really refers to the time the vendor spends developing the software -- typically by the person, or by the hour. There are no material costs.

Hybrid Agile contract types

Most businesses and software development outsourcers benefit from a hybrid Agile contract. This contract sets practical spending limits, similar to a fixed-fee contract. However, it also accounts for the fluctuating nature of Agile development, like a T&M contract. Try out one of these hybrid Agile contract types.

Fixed-fee contract per iteration or story. Rather than agree to an entire development project at once, the two sides can build a contract that mimics the iterative nature of Agile. Fixed-fee contracts per iteration or story break software development work down into bite-sized increments. Vendors like these contracts because the work is predictable; requirements changes have minimal impact, since each contract lasts only one iteration. Customers like these agreements because termination is easy.

Pricing rates rarely change in the first few iterations, Powers said. Then, the two sides refine the next contract as they learn about ways of working and project requirements. In these contracts, the vendor should get better with each iteration, as they incorporate feedback from the customer.

"That's a true collaboration effort, so they're making changes collectively as they go on," Powers said.

To get the most out of a fixed-fee iterative contract, the business needs to apply strong vendor governance as the work changes hands, he said. When work is completed in smaller batches rather than one lump project, it's difficult to verify that it meets expectations and fits within the context of the desired application or software.

Incremental delivery contract. In this type of Agile contract, the customer pays each time the vendor reaches an agreed-upon milestone, such as 50% or 75% project completion. Incremental delivery contracts include quality review points to ensure the work meets expectations. They are easy to terminate on these grounds.

You'll find incremental delivery contracts in the construction industry, where the customer gains a level of control during the project and can approve or deny payments.

"It isn't like you start and there's a beginning and an end that could be one year or two years," Powers said. "These are all small, little projects." The increments allow the business to adjust if they don't like a vendor's work, he added, pointing out the flexibility is a key benefit.

T&M contract with a bonus. Customers don't want to waste money, and vendors want to make as much money as possible. T&M contracts with a bonus are one of the best ways to align the two.

In these contracts, the Agile outsourcing contractor receives a bonus when they meet or surpass a particular goal. These contracts allow for some creativity, Powers said, as the bonus can be based on any mutually beneficial criteria. Consider goals such as turning in a project ahead of schedule or below target cost.

T&M contract with a cap or holdback. Both caps and holdbacks protect the customer from unnecessary expenses. These types of development contracts are common for Agile and for Waterfall projects.

T&M contracts with a cap set a ceiling for the amount of work. When the two sides agree to a cap on payment, they can both set realistic budget expectations.

While the terms differ slightly, T&M contracts with a holdback also give the customer controls. In these agreements, the customer withholds a percentage of the payment for a predetermined amount of time after project completion. The holdback provides the customer more time to find quality defects and it reduces the amount of risk they take on.

The dangers of a bad Agile contract

After the two sides sign on the dotted line, it's hard to find wiggle room. This arrangement is not the same as in-house software development. Agile outsourcing contracts cover some key details of the work and the product expected, but they aren't simple. Some development contract types come with caveats that can drive a customer over budget and leave it frustrated.

Hybrid Agile contracts tend to protect both sides and set clear expectations, but the customer must ultimately choose which contract works best for it. Ambiguity ruins Agile partnerships.

Powers has seen plenty of customers burned by bad development contracts. One company in the banking industry tried to outsource a large project with a professional services firm. The project was a core banking system, developed in an Agile structure, under a fixed-fee contract.

The fixed-fee contract left the banking company in a vulnerable position. With little transparency into the pricing estimate, it opted to trust the outsourcing firm. This setup created two problems for the client. "The vendor probably built so much risk into that number that you know they made money. At the same time, the vendor also wrote an incredibly tight contract. So, they also protected themselves in that sense," Powers said.

By the time the project was finished, the customer paid double the original estimate. The cost was just one indicator of a project gone awry. "It was the wrong technology, the wrong project, the wrong vendor, the wrong everything," Powers said. "They didn't get the benefits they wanted financially. They certainly didn't get the benefits they wanted in terms of time to market, which is why people do Agile."

The banking company simply wasn't ready for Agile, Powers said, no matter who was actually writing the software. Their preference for fixed-fee contracts and large-scale development work led to an overly costly outcome. A T&M or hybrid contract would've been a better fit, he said.

Organizations can't buy their way into Agile development. Adjust old habits, assess potential challenges, then -- and only then -- determine the Agile contract type and terms that work best.

About ClearEdge Partners

Founded by senior sales executives from large IT suppliers and informed by current market analytics, ClearEdge enables CIOs and their teams to make more competitive IT investments. By combining rigorous inspection and IT financial expertise, they identify risk and opportunity, align internal teams and maintain leverage throughout the lifecycle of supplier relationships. As a result, their clients maximize the value of their investments by unlocking millions of dollars from legacy spending and redirecting funds toward IT modernization, digital and cloud transformation with confidence and speed.

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