Fixed vs. variable pricing strategies

Which is better: fixed pricing or some version of variable pricing with incentives?  While the answer depends on the situation, I think it’s helpful to consider the implications of each.  You should also realize that the answer will shift with time.  Not that many years ago, incentivized pricing was considered very creative and an excellent way to drive continuous improvement with a partnership element.  The “innovative” thinking is now shifting back to fixed pricing as a better solution for both parties as it minimizes the risk and directly rewards or punishes the efficiency of the process.

Fixed pricing works well when the scope is clearly defined, well understood by both parties, and with only limited variability.  It simplifies many aspects by streamlining the quote process and minimizing risk.  It also should reduce challenging discussions about why a project costs more than originally anticipated.  The problem arises when there are uncontrollable variables such as adverse weather delaying construction or significant material cost increases (or decreases).  If the client insists on a fixed pricing strategy, the vendor will build contingency into their quote to ensure they are protected from the unknown, resulting in a higher average cost.

Variable pricing works better when the scope is less clearly defined or there are uncontrollable elements.  In theory, the vendor should be protected from cost overruns and the client needs to manage the change process to ensure the original scope is maintained.  This can feel very comfortable to the client but represents considerably more risk to the vendor and may also drive pricing increases.

I believe the key element, especially with variable pricing is to build trust into the relationship.  Trust that the vendor will fairly price their products and trust that the client will collaborate in efficiently executing the agreed scope.  An incentivized contract bolstered by a trusted relationship is likely to yield the lowest cost solution and to encourage innovation to further reduce cost and/or speed delivery.

Tagged as: Fixed pricing, Negotiations, Pricing strategies, Trust, Variable pricing