One of the cornerstones of every business is customer contracts.
In particular how to invoice customers individually and recognise revenue in the financial statement. Consultancies are no exception. However, in a consultancy hours and projects, rather than manufacturing, are the basis for customer invoicing.
Typically, these organisations sell a host of services – usually consulting hours, but also courses or standard services. Some customers purchase prepaid hours (like a ticket coupon), while others purchase entire projects on a fixed-price basis.
We see that many smaller consultancies often use the common contracts on time & material or fixed price, but in some cases it might be better for business to use more complex contracts.
Overall eight contract types
In this post and in the next four weeks, I will go through the eight most commonly used contract forms and best practice especially for consultancies. Maybe it will inspire you to a more comprehensive use of contracts depending on the projects and customers you enter into agreements with.
The contract types are divided into two main categories:
Contracts on time & material
- Ongoing invoicing
- Prepaid hours
- On-account invoicing with end-balancing
- On account invoicing with periodic balancing (continuous contracts)
Contracts based on fixed price:
- Invoicing based on a payment plan with per-project revenue recognition
- Invoicing based on a payment plan with per-task revenue recognition
- Continuous service (continuous contract)
- Volume invoicing (continuous contract)
Each main type holds anomalies, for example time and material at maximum budget and special rules for revenue recognition at a fixed price.
Time & material – ongoing invoicing
This type of contract is for simple and very common contracts for which the customer is invoiced continuously based on time and materials spent. It takes its point of departure in hours x hourly rate.
You are free to define hourly rates for customers, employees or subtasks, and invoicing is based on consumption.
There are both pros and cons for using Time & material.
The contract type may cause uncertainty with regards to what amount you can invoice in a given period of time, and if the projects has a shorter duration than expected, you will see this when invoicing. You are, on the other hand, certain to get paid for the hours spent, where you run a risk with fixed price projects, if the projects e.g. are extended although the payment is the same.
Time & material – Prepaid hours
The contract type prepaid hours is especially used within the IT industry. Prepaid hours is when the customer purchases a pool of hours at a discount. The customer then spends some or all of these hours (like a voucher) on projects he needs carried out and then buys a new pool of hours, if needed.
The cons of using this contract type can be:
- The customer wants to use certain parts of the prepaid hours for one project and parts for another project.
- The customer requires senior and junior services, which are priced fundamentally different and therefore do not have the same value.
- The customer wants to pay for travel expenses using the prepaid hours.
- You end up spending more hours than purchased and must ask the customer for new hours afterwards.
- The auditor wants a statement of work in progress for these contracts, which may be a complex calculation, if you do not do it systematically.
- The customer wants a monthly statement of the consumption of prepaid hours, which may be time consuming and cause discussions about the time consumptions.
Although these contracts indicate the use of hours, financially speaking it is just a prepayment which is depreciated as the debt to the customer is settled. The advantage is that you financially get a prepayment and thereby are secured an income, and if you agree on that one hour corresponds to one voucher, it is straightforward to control the prepaid hours, and you may ask the customers for additional hours ahead of time.
Next week, I will continue on the topic contract management and describe the contract types On-account invoicing with end-balancing and On account invoicing with periodic balancing (continuous contracts).
If you want to read more about contract management in consultancies, you can find more information in this whitepaper.
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