Retainage is a common construction practice in which a portion of the funds holds back from a contractor or subcontractor until the project’s completion. As a result, retention can have a significant impact on contractor cash flow. Here let’s see how to determine the retainage fee and see strategies to help contractors manage their cash flow and receivables.
What is Retainage?
Retainage is a percentage of a contract’s total price that is held back until the project is at completion level. This withholding is to intend that the contractor’s work is of adequate quality. If the final inspection uncovers issues with the contractor’s work, the retainage will be held by the client until the identified issues are resolved.
Because it (typically 10%) can account for a contractor’s entire profit, it is regarded as a strong incentive to ensure that a project is completed in accordance with the client’s wishes. It should not be so high that the contractor is forced to finance the project.
Because there is more uncertainty about the contractor’s performance, a client is more likely to impose a retainage on a new contractor.
Retainage and the law
Some states have prompt payment laws that limit the amount of money that you can withhold from contractors, while others do not. Some states have ambiguous regulations, such as requiring “reasonable” withholding. You must consult your state’s rules—look at the retainage map to see what the rules are in your state.
Withholding money from contractors may be a requirement by state law in some rare cases. In Texas, for example, the rules require the property owner to keep 10% of the proceeds from private construction projects. On the other hand, New Mexico law prohibits withholding it.
Retainage in Construction
Simply put, retainage in construction is a percentage of a contractor’s or subcontractor’s earnings held back during the duration of a project. The amount is specified in the construction contract and is typically between 5 and 10% of each progress payment, depending on the type of project.
Though retainage is common, it is not always required—if the contract does not address it, there is no retainage for that project. However, there are federal laws requiring retainage on federal projects, including requirements on how to calculate or release it as well as state laws that vary by state for both public and private projects. Any construction contract that violates these rules is null and void.
A retainage fee is a money that a client or project owner withholds from a contractor. Before the start of a project, it is usually negotiated and agreed upon. The purpose of this fee is to assure the client that the work will be completed on time and to his specifications.
Although the successful completion of a project is anticipated, contractual details must be documented. Although a retainage fee can be used in any business setting, it is most commonly used in the construction industry.
The complexity of construction projects has necessitated this. Changes introduce during the course of the work frequently cause these projects to be delayed. If you are a contractor, it is critical that you actively participate in the retainage fee negotiations.
If you are not available, an attorney can assist you. Just keep in mind that it will cost you. Aside from attorney fees, a construction attorney may be the best option for you, especially if you are inexperienced. Hiring an experienced attorney to negotiate your first project with a large client can be extremely beneficial.
How To Determine Retainage Fee?
The retainage fee is calculated as a percentage of each progress payment, which can range between 5 and 10% depending on the type of project. Retainage limits and regulations vary by state, and there are also federal rules for federal projects. Private construction projects typically have higher retainage amounts, whereas federal, state, and municipal withholding amounts are lower.
How long can you keep retainage?
How long retainage is held back depends on the agreements in individual construction project contracts, though it is been released once a project is substantially complete. Because subcontractors frequently complete their work before general contractors, they typically have to wait much longer to receive it, which can range from hundreds of days to several years.
When is a construction project’s retainage paid?
The amount of time retainage is withheld depends on individual project contracts, though it is held until the project is “substantially” complete. As a result, subcontractors frequently have to wait for much longer than general contractors to receive theirs, sometimes for hundreds of days, because they complete their work earlier than GCs.
With so many variables associated with retainage, from amounts to timelines, it’s easy to see how this practice can jeopardize the success of so many contractors, subcontractors, and other construction industry professionals further down the payment chain.
The Advantages and Disadvantages of Construction Retainage
The concept of retainage was first introduced nearly two centuries ago as an economic incentive; to ensure contractors performed quality work and completed their projects successfully. If a general contractor defaults, retainage provides the owner with a quick source of funds to remedy the situation; from securing another GC to finish the work to paying subcontractors and suppliers.
If you’re a construction entrepreneur already operating on razor-thin margins, large amounts of retainage fees withheld for extended periods of time can be disastrous to your bottom line.
What effect does retainage have on a contractor’s cash flow?
As a subcontractor, you’re probably already dealing with the challenge of anticipating project needs, such as materials; equipment, and skilled labor, in the face of notoriously slow payment cycles.
Furthermore, if the retainage fee is greater than your project profit margin; you will be in the hole on the project until you receive the retainage. In either case, it means you’ll need enough free cash or financing to compensate so you can keep running your business.
So, how can you lessen the financial impact of construction retainage? Here are five approaches to think about.
Five Strategies for Construction Retainage
#1. Become acquainted with federal and state retainage laws.
The federal government has enacted laws governing retainage on federal projects, and state laws govern the specifics of retainage on both public and private projects.
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#2. Carefully read the contract.
Before signing a construction project contract, carefully read it to ensure you understand; the details of how it will work and how it may affect your business. This is where knowing your state’s laws come in handy.
#3. Perform the math and plan for your cash flow requirements.
As you read the contract, go over your finances in detail to see how retainage will affect your cash flow. Negotiate if necessary to ensure that the progress payments are sufficient to cover your costs for the work performed each period, minus retainage.
#4. If necessary, exercise your lien rights.
A mechanic’s lien is a powerful tool for resolving payment problems. However, the deadline for filing a lien on a project may arrive much sooner than you expected.
#5. Think about contractor financing options such as material financing.
Contractor financing can help you operate and grow your construction business if you lack the funds to purchase materials and equipment while you wait for retainage payments. Each financing option has advantages and disadvantages, so it’s critical to weigh them against your company’s specific requirements.
Paying for a construction job is not like paying for most other purchases. It’s not just the high purchase price, but also the lengthy construction period. The contractor does not want to do all of the work for free, and the customer does not want to pay until the completion of the whole project. The customer typically hangs on to some money until the completion of the project.
Accounts Receivable Retention
Retainage works in two ways for a contractor. Accounts receivable retention refers to money the customer holds back that they’ll eventually pay to the contractor. Accounts payable retention is the money the contractor retains until disbursing it to subcontractors.
Assume your contracting company is constructing a new shipping center for a wholesale company. The total cost is $225,000. The wholesaler pays you on a regular basis as you complete major portions of the project, such as pouring the foundations or installing the wiring and plumbing.
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You record $202,500 as an account receivable when you begin the project. The $22,500 is allocated to account receivable retainage or due. It is critical to separate retainage from other receivables. If you combine it with regular receivables, it will appear that your customer is not paying you on time, which will reflect negatively on your company.
Retainage in Accounts Payable
You, like your customer, will not want to pay subcontractors such as plumbers, electricians, and insulators for work that is not completed. Retainage is the final portion of the payment due after you accept their completed work. You record it as accounts payable retainage in your books. You report retainage payable as a current liability on the balance sheet if you expect to make the payment within the next 12 months.
Billing More Than the Actual Cost
Construction does not always go as planned. At any given time, a contractor’s expenses may be greater or less than the amount paid by the customer. Billings that exceed costs and estimated earnings are payments that exceed the costs and earnings for the work completed thus far. Accountants treat this as a liability because the contractor must do enough work to justify the billing; the company owes the customer the work. Costs and estimated earnings in excess of billing work in the opposite direction; the customer owes the contractor.
Retainage has long been used in the construction industry. The concept aims to ensure that the contractor completes the job on time. Normally set at 10% of the total project cost, it can stymie the smooth flow of work, particularly for subcontractors further down the line.
This practice may come to an end as more options are considered. The underlying intentions, however, will remain: the contractor must demonstrate that he will complete the work he promises to do.
Frequently Asked Questions
How long is retainage withheld?
Retainage is typically withheld from a contractor for the duration of the project and paid only after substantial completion.
What is a normal amount of retainage?
Retainage is typically withheld at either 5% or 10% of each payment on a project. However, because retainage is unregulated in many states and is determined by the terms of the contract, there is a great deal of variation.
When can I file a mechanics lien for retainage?
The short answer is that you have every right to file a mechanics’ lien if you haven’t received your payment, and you can do so at any time up until the state’s lien deadline.
What's the difference between retainage and retention?
Retainage and retention are commonly used interchangeably, though “retainage” often refers to the amount of money withheld, and “retention” refers to the practice of withholding that money.
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