In the construction industry, managing financial intricacies like 'retainage' — a practice where a portion of the contractor's payment is withheld until project completion — can be as challenging as the projects themselves. General contractors and subcontractors navigate not only the complexities of the building but also the delicate balance of finances, grappling with substantial up-front costs and the waiting game that often accompanies project payments. Construction is one of the hardest industries to manage cash flow in. For many projects, general contractors and subcontractors often face large up-front costs and frequent, long delays between expenses and payment.
As a business owner, you may know that you aren’t getting paid in full until the work is completed and accepted. The construction retainage practice throws another wrinkle into the process. The retainage allows a project owner to hold off on paying the full price until the project is completed and signed off on. To ensure they’re ultimately paid all monies held back, you need a thorough understanding of the rules, the rights, and the tools available to protect your company and collect what’s due.
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What is Construction Retainage?
Retainage, also called retention, is an amount of money withheld from the contractors or subcontractor until the end of the construction project, or a time specified in the contract. It’s a standard practice in both private and public projects, especially commercial and public construction projects.
The withholding of a portion of the final payment functions as a financial guarantee that the project is completed to the owner’s satisfaction. Typically, it ranges between 5% and 10% of the total contract price.
>> More: What is Overbilling in Construction?
The Benefits, and Drawbacks of Construction Retainage
The drawbacks of retainage in construction
Although the construction retainage practice is dreamed up as a measure to reduce the owner’s risk, it’s usually used unfairly. Retainage can cause straining on cash flow for contractors, especially subcontractors at the bottom of the payment chain.
Since the profit margins in the construction industry are often low, the retainage payment of 5% to 10% usually accounts for the entire profit margin on the project. If they fail to collect the retainage back, they may end up losing the job.
Sometimes, unethical owners take advantage of the retainage as a weapon to either require constructors/subcontractors to do more work out of scope or to simply hold on to retained cash as their own.
The benefits of retainage in construction
Since a contractor gets fully paid until the project is fully completed according to the job specifications, retainage encourages timely and appropriate completion. It is considered the most effective financial incentive for a contractor to ‘substantially complete’ the project and do it well.
What You Need to Know About Retainage
Overall, contractors have more power than you may think despite the drawbacks of cash flow stress.
Retainage is up for negotiation
Because the details of retainage are spelled out in the contract between owner and contractor, as well as between the contractor and subcontractor, the percentage is not set in stone. That means it depends on the agreement between the two parties. So you can negotiate to adjust what percentage is retained and for how long.
Laws set a limit and deadline for retainage
In some circumstances, some states have regulations that the rate set out by these laws. For example, according to retainage rules in California, state law caps retainage at 5% prior to completion and acceptance of the project. On private construction projects in Taxes, the property owner must retain 10%. You need to consult to see what the rules are in your state.
These laws also set a deadline for the withholding payment, although the timeline is largely based on the contract itself. On public jobs in California, the portion of the final payment is due to the prime contractor within 60 days of the project’s final completion and the general contractor has 7 days to pass payments onto their subcontractors.
Contractors have a right to get paid
At the end of the day, construction businesses have a legal right to collect payment for the projects and materials they provide. Retainage is no exception. Therefore contractors need to understand all of their rights, responsibilities, and the retainage laws when it comes to negotiating retention construction and collecting it after the project is done.
Three Ways to Navigate Construction Retainage
Familiarize yourself with federal and state laws on retainage
The retainage laws vary from state to state, and the rates also differ on both public and private projects. Formalizing yourself with the rules and regulations in your state can help you protect your business from more retainage withheld than necessary, or avoid having to wait too long to receive what you’ve owned.
Study the contract carefully
Make sure you understand the details about how retainage will work and how it could potentially impact your business before signing a construction project contract.
Plan for your cash flow needs
While you study the contract, it’s necessary to get the details of your finances to see how retainage will impact your cash flow. By conducting the project cash-flow forecast, you can ensure to cover the costs for the work performance each period, minus retainage.
Further Strategies to Minimize the Impact of Retainage
Engage in Open Negotiations: Speak directly with project owners. Highlight the benefits of alternative arrangements like performance bonds as a more flexible counterpart to traditional retainage.
Showcase Your Track Record: If you've had successful projects in the past, emphasize this history. Your proven reliability could be a strong point for negotiating reduced retainage.
Consider Tiered Retainage: Suggest a system where the retainage percentage decreases as the project advances. As the project nears completion, the financial risk diminishes, and the withheld amount should reflect this.
Advocate for Escrow Accounts: Propose the use of neutral escrow accounts for retainage funds. This can give both parties confidence that the funds are secure and will be handled appropriately.
Stay Updated on Legal Frameworks: Retainage laws can vary by state. By understanding the legal landscape, you can navigate negotiations more effectively.
Introduce Bonus Systems: Consider proposing early completion bonuses. You could negotiate for a reduced retainage amount by incentivizing timely project delivery.
Simplifying Retainage with Irvine Bookkeeping
The intricate financial landscape of construction, particularly concepts like retainage, can often seem as complex as the projects themselves. Proper accounting and bookkeeping play a pivotal role in demystifying these aspects and ensuring the financial stability of each project.
At Irvine Bookkeeping, we're dedicated to providing specialized accounting and bookkeeping services tailored to the needs of contractors and construction firms. Utilizing the robust features of Sage 100 Contractor, we offer a streamlined approach to managing your finances, placing particular emphasis on handling retainage with accuracy and clarity.
Our commitment goes beyond mere number management; it's about ensuring that your financial records reflect the diligence and integrity you pour into your construction endeavors. As you craft and create on-site, trust in our team to meticulously manage the financial intricacies in the background.
Since a construction company makes important decisions that are based on accurate financial reports, we’re here to serve you with bookkeeping for construction. You gain an expensed construction industry partner who will take over your bookkeeping entirely and help you achieve your financial goals. Get a Free Initial Consultation.
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