How do I explain to my client diplomatically that what they wanted can’t be achieved because they substantially cut costs?

I like my client because they’re hands off, pay on time, and fairly responsive when I need them to make a decision. I quoted them a minimum of $40k to do a job. There were 5 milestones. This is an actual physical product with mechanical, software, and electrical engineering. Milestones 1 and 2 were documentation, research, design, and manufacturing approval. Milestone 3 was generation 1 functional prototype. My team and I were about half way through building before they decided they didn’t want to spend more than $25k and asked if I could deliver milestone 3 for that. There was about $3k left in the budget at that point. So I said, alright, I will deliver milestone 3, generation 1 functional prototype, but it won’t be robust and not fit for regular use. It will work, but I don’t know for how long, and it will look great for investor demos and pictures. Contract stipulates repeatedly that these prototypes are not meant to be used in real life and are strictly for investor demos. Well, basically I’ve been making 0 on this and have been hands off with my employees to keep billable hours down as we critical path to delivery. Now client is asking about all these features that would only be in gen 2 and 3 and why won’t these have them etc etc. They also insist that it is fit for regular real world use because they’re going to test them out on their children. I said, wtf (diplomatically), you are contractually obligated not to do that. I am not happy with what I am delivering now that I know she plans to put her kids at risk with a rickety gen 1 prototype. Besides documenting all of this to cover my ass, how do I tell them diplomatically not to do that. I’m really frustrated because I can’t do a high quality job because they basically stopped paying and they’re planning on using it for things out of scope of the contract and it’ll probably break after a dozen uses.

Edit: I should mention that we had a proposal to modify a pre-existing product for real world testing which would be much safer and reliable, but they don’t want to do that now. The plan was to have one fully original gen 1 prototype for investors, and hacked versions for testing. Now they’re planning on using the polished looking, but unfinished, cheap, gen 1 prototype for both.

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