Disclosure: The following content was written and sponsored by Flashtract.
In most industries, workers aren't paid before completing a job. Typically, an employee works for a set period of time before getting paid for hours worked. Payments in the construction industry are radically different. A large construction project requires the primary contractor to purchase materials and outsource parts of a job that will take weeks, months, or years to complete.
Finding a way to protect the interests of the property owner and contractors working on a large construction project can be difficult. If the entire bidding price is paid before work begins, the landowner has no guarantee the job will be completed. Yet, construction companies need incoming cash flow to keep their business alive and the project moving forward. The answer is typically retention. While retention payments make an effort to address the payment problems of long-term projects, the results are rarely ideal for contractors.
What Are Retention Payments in Construction?
When a contractor wins a bid for a large construction project, some of the money is released immediately to fund the start of the project. Retention payments (also called retainage) are the amount of money held back until the project is complete. Retainage is usually a percentage of the total project cost and is typically 5 or 10%.
At first glance, this arrangement doesn't sound horrible. After all, it was designed to prevent partially completed projects and poor workmanship. With incentive to complete the job properly, ethical contractors will receive the final payments when the job is complete. What this idea fails to consider is the amount of money that's involved, the extended time frame for full payment, and the profit margin for the project.
When a project takes several months or years to complete, retention payments are basically the legal withholding of payment for work already completed.
3 Ways Retention Payments Negatively Affect Ongoing Projects
Retainage is built into the construction industry and is completely legal. It's a part of practically every ongoing construction project and affects both primary contractors and subcontractors. While the practice creates incentive for contractors to complete projects as specified, it creates issues that make completion difficult.
Limited Cash Flow
Contractors must outbid one another to win a project that will help keep their company afloat. This means profit margins are razor-thin. When retention is 10% of the total bid price, it's not uncommon for profit margins to be lower than the construction company's profit margin. When retainage puts a construction company in the red, they must have cash on hand or financing to complete the project as directed.
Lower Tier Subcontractors Are More Heavily Impacted
Retention isn't reserved for the primary contractor alone. For the project to be completed within budget, retention payments trickle down the chain of payment to each individual working on the project. Even worse, retention percentages for subcontractors can be higher than that of primary contractors.
When a project takes several months, or even years, to complete, retainage payments should be in the mail immediately upon project completion. Unfortunately, this often isn't the case. Subcontractors usually finish their portion of a project long before the general contractor is finished with the job. If you're a subcontracting company, this means you don't receive retention even when you've completed the project.
Retention Clashes with Mechanic's Liens
For most contractors and subcontractors in construction, mechanic's liens are a well-known subject. Liens allow contractors and subcontractors to leverage their right to payment. However, the laws surrounding liens require contractors to act quickly. Liens are often subject to strict deadlines. This means you might be required to file a lien for missed payments before retention payments are even due. Since liens usually include all payments owed for a project, they can include retention payments. Construction companies need the ability to leverage lien rights to avoid missed payments. However, lien payments occasionally affect retention payments in construction.
Easing the Burden of Retainage in Construction
Practically all construction contracts include provisions for payment retention. This means construction companies learn to work around the burdens they bring. While it's unlikely that retainage will be removed from construction contracts in the near future, there are steps your company can take to ease the burden and get paid faster.
Contracts outline the amount of money withheld for retainage and the milestone (typically project completion) that must be reached for payment. However, many other details are left unclear. In a perfect world, payment would be received immediately after project completion. In the real world, this rarely happens, especially for subcontractors. Asking these questions can help you negotiate fairer retention payments in construction.
- Will retainage be held in escrow?
- Can retained funds be used as compensation for workmanship deficiencies?
- Can retained funds be used to take care of a mechanic's lien claim?
Simplify the Payment Process
Retention payments aren't the only flaw in the construction payment process. Late payments, unapproved change orders, and missing paperwork are common problems in most construction projects. Creating a billing process that works for your company can lead to faster payments and eliminate errors. Construction billing software can help finance and accounting teams address many problems at once. For instance, the ability to create standardized documents, automate payment reminders and consistently update billing reports will lead to more accurate income percentages and more efficient payments.
Plan for the Impact of Retention
Your contract outlines the terms of your retention payments. Simply accepting the terms isn't enough. In order to successfully complete a project with low profit margins, it's essential to plan for the impact of retention on your company's cash flow. If retention payment will cut into your company's profit margins, create a plan to access working capital to float the project through completion.
Retainage is an unfortunate reality for most contractors in the construction industry. While you can't get rid of the problem completely, proper preparation can help you avoid losses related to the process. Learn more about how you can use construction billing software to help eliminate problems that plague the construction payment process at Flashtract.