Retainage in construction is a financial practice where a portion of the payment due to a contractor or subcontractor is held back by the project owner or general contractor. Though grounded in logical principles, retainage can be a complex topic that hurts construction businesses.
But it doesn’t have to.
To safeguard your business from abusive retention practices, you must know the rules, rights, and available methods to secure prompt payments. While the task may seem daunting, it is an essential part of the construction business you must dominate to avoid challenging scenarios that can lead to cash flow problems and delays.
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Retainage in Construction, Defined.
Retainage is the process of withholding a percentage of a contract’s total amount from a contractor or subcontractor during a construction project. In other words, the developer withholds a small amount from each installment payment as insurance for the project’s successful completion rather than paying in full.
How Does Retainage Work in Construction?
The contract between the owner and contractor, and between the contractor and subcontractors, must clearly state the details of retainage. In other words, to ensure retainage works for your construction business, you must negotiate retainage terms and ensure that the contract is transparent, especially regarding the definition of the project’s completion.
Although the exact retainage percentage varies, the money withheld per installment usually ranges between 5% and 10% of the overall contract value. Usually, the project owner withholds the retainage percentage from the contractor and/or subcontractor on each payment. That means that if you agree on a 10% retainage fee, your progress payments will have that precise deduction. Only after the successful completion of the construction project are the retainage amounts paid to contractors and subcontractors.
State laws on retainage differ. Some are clear, some are vague, and some have no rules. That means that contractors and subcontractors should know the specific regulations in the states where they work and build a successful financial and executive plan to complete projects successfully. On top of that, it is essential to understand the differences in retainage when it comes to private, public, provincial, and municipal projects.
The project stage and construction benchmarks may also dictate specific retainage conditions, such as assigning milestones to release certain retainage upon project delivery. In other cases, the entire retainage funds may be withheld until the project is complete.
Retainage is a tricky subject, so contractors and subcontractors must create a financial plan that accommodates such conditions to ensure cash flow and prevent delays.
Benefits and Challenges of Retainage in Construction.
The historical significance of retainage was essential to ensure successful project completion back in the 19th century. Today, contractors and subcontractors work entirely differently, but the practice still stands, given its benefits for the industry.
- Quality Assurance: Contractors and subcontractors must maintain specific quality standards for each project. Retainage is the mechanism that acts as a contingent to protect developers from malpractice and contractors and subcontractors from predatory withholding practices.
- Defect Correction and Disputes: Developers use retainage as leverage to face disagreements that may arise in any given project.
- Project Completion: Withholding a percentage from each installment motivates contractors and subcontractors to complete projects successfully and timely.
- Risk Avoidance: The financial risks in the construction industry are extensive. Retainage is a way for developers to ensure contractors and subcontractors successfully deliver.
On the other hand, retainage also represents a significant challenge in the construction industry.
- Cash Flow Issues: Contractors and subcontractors typically run their businesses on narrow profit margins. Retainage, even as a small percentage, significantly strains financial management.
- Financial and Admin Management Burdens: Bookkeeping is challenging for any construction business with multiple moving parts and teams that affect all aspects of project delivery. All additional financial withholdings make accounting an even more complex task.
- Abusive Payment Practices and Delays: Delayed payments may occur if parties do not sign a crisp contract with mutually beneficial agreements and a precise timeline for the completion and the release of retainage.
How to Handle Retainage in Accounting.
Projects in the construction industry tend to run on small profit margins, and retainage is an additional challenge for contractors and subcontractors. Since retention is taken from each payment and paid later (until the project’s completion), contractors and subcontractors must accurately record these withheld funds.
Before we dive into how to record retainage, it’s important to point out two essential components of retainage that help contractors and subcontractors succeed:
- Include retainage into the contract price: Running out of cash in a construction project can affect the entire project. Therefore, including the retainage costs in the contract you initially negotiated is a common practice to avoid financial strains.
- Watch out for cash flow leaks: Make sure you track and manage the money you receive for each project. Knowing exactly where every dollar is going and its impact on project completion makes a difference between a timely and troublesome project.
When it comes to best accounting practices, contractors and subcontractors should clearly understand and differentiate the receivable from the payable retainage upon completion of the project.
Retainage Receivable refers to the money the project developer owes to contractors and subcontractors. Since they will pay these funds later, keeping them separate from the primary bookkeeping records is essential to avoid financial errors and cash flow issues based on untimely budgets.
Retainage Payable is the amount project owners and contractors record to track what they must pay once the project is completed and the remaining balance is paid.
As a rule of thumb, what matters is ensuring that the retainage percentage of any given project gets recorded separately. The more clarity you have, the better you can keep track of your margins.
Retention vs Retainage: What’s the Difference?
Nuance is crucial in every industry, especially in construction, where the terms ‘retainage’ and ‘retention’ often mean the same thing. However, it’s important to note the distinction: ‘retainage’ refers explicitly to the agreed-upon amounts withheld until a project’s completion. This previously agreed-upon fee aims to incentivize quality fork and maintain project schedules while serving as financial protection for project owners.
On the other hand, ‘retention ‘means any case where the project owner withholds money for purposes beyond quality assurance. Some examples of these scenarios are warranty periods, defects upon completion, and disputes.
Difference of Construction State Laws for Retainage.
According to the U.S. Department of Labor, contractors, subcontractors, and project owners must abide by their state’s retainage laws. While this seems straightforward, multiple specific laws and requirements must be considered, given the nature of each project.
Varying Caps and Rates: States differ in maximum retainage rates. For instance, California caps it at 5% for public works, while Texas sometimes allows up to 10%. Knowing these caps is something to consider to ensure the financial success of every project.
Public vs. Private Projects: Some states have strict retainage guidelines for public projects, while private projects are often more flexible. All contractors and subcontractors must know their projects’ legal nature, given that a successful bidding strategy may differ.
Release Timelines: Retainage release also changes drastically between states. In New York, it’s within 30 days of substantial completion. Other states, such as Illinois, limit retainage to at most 5% after completing 50% of the contract.
Each state and type of project (public vs. private) is unique. Contractors and subcontractors who understand how these retainage releases work often meet all project deadlines and keep a healthy cash flow.
Protection for Contractors and Subcontractors: Some states, like California, have specific provisions to protect contractors and subcontractors, mandating prompt payment of retainage upon satisfactory job completion. Contractors must receive payment from the owner within 30 days of their payment request, while subcontractors should be paid within ten days.
How eSUB Cloud Helps Subcontractors Elevate their Business.
Most commercial construction subcontractors face numerous challenges when managing complex projects including:
- Unclear labor costs.
- Change Orders that are poorly managed and cause delays and cost overruns.
- Material costs that are inaccurate and increase costs.
- Error-Prone pen and paper processes by multiple people on your team.
- Inefficient communication leads to missed deadlines, rework, and delays.
- Lack of visibility and data in silos that makes accounting and management a trial.
- Retainage issues that arise from poor communication and data management.
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