Understanding Retainage in the Construction Industry

Understanding Retainage in the Construction Industry

In the construction world, it's common for contractors to enter projects knowing they won’t receive full payment until the job is done. This practice, known as retainage, allows project owners to withhold a portion of the payment until the work is “substantially complete” and signed off. For contractors, understanding retainage—why it exists, its impact on various stakeholders, and how to manage it—is crucial to ensuring they get paid in full.

The Concept of Retainage

Retainage has been a staple in the construction industry for over a century, but its importance cannot be overstated. At its core, retainage is the practice of withholding a portion of the final payment to ensure that a construction project is completed thoroughly and correctly. It’s a standard practice in both public and private projects, serving as a financial incentive to guarantee the work meets the owner’s satisfaction. Typically, the amount held back is defined in the contract, usually ranging between 5% and 10%, though it can be higher depending on the project's scope and the specific agreements between the parties involved.This financial mechanism is not merely a precautionary measure; it plays a pivotal role in maintaining the integrity and quality of construction projects. By holding back a portion of the payment, project owners ensure that contractors have a vested interest in delivering a fully completed project that meets all specified requirements. This approach protects the owner’s investment and provides a layer of security that the work will be completed to the highest standards.

Retainage vs. Retention: What’s the Difference?

While the terms "retainage" and "retention" are often used interchangeably, there is a subtle distinction between the two. Retainage generally refers to the amount of money being held back, while retention might refer to the act of withholding it. In practice, both terms describe the same fundamental process, but understanding the difference can help clarify the roles and responsibilities of each party involved in the construction contract.For example, in a contract, retainage might be specified as a certain percentage of each progress payment that is withheld until the completion of the project. Retention, on the other hand, could be the term used to describe the ongoing process of withholding those funds. While the distinction may seem minor, it is important for all parties to be clear on the terms used in their contracts to avoid any misunderstandings.

Key Points to Consider

Retainage is a critical component of construction contracts, and there are several key factors that contractors and project owners need to be aware of:

1. Retainage Percentages and Payment Structures: These are laid out in construction contracts and can vary by project. The percentage of retainage is typically negotiated at the outset and can range from 5% to 10% of the total project cost. In some cases, the percentage may be higher, particularly for larger or more complex projects where the risk of incomplete work is greater. It’s important for contractors to carefully review these terms before signing a contract, as they will directly impact cash flow throughout the project.
2. Impact on Cash Flow: Retainage can limit cash flow for contractors and subcontractors, potentially leading to financial strain. This is especially true for small to medium-sized businesses that may not have the financial reserves to cover ongoing expenses while waiting for retainage to be released. Managing cash flow effectively is crucial, and contractors need to plan for the possibility of delayed payments by setting aside funds or arranging financing to cover costs until the retainage is paid out.
3. Regulations: Government regulations on retainage vary by state and whether the project is public or private. For instance, public projects often have stricter regulations regarding retainage, with some states capping the amount that can be withheld or mandating the release of funds within a certain timeframe after project completion. Private projects may have more flexibility, but they are still subject to state laws that govern how retainage is handled. Contractors should familiarize themselves with the regulations in the states where they operate to ensure compliance.
4. Alternatives to Retainage: While retainage is a commonly used method to ensure project completion, there are alternatives that can provide similar protections. For example, some contractors may offer a performance bond or surety bond in lieu of retainage. These bonds serve as a form of insurance that guarantees the completion of the project and payment of subcontractors and suppliers. Another alternative is to establish an escrow account where retainage funds are held, allowing contractors to earn interest on the withheld money. These options can be beneficial for both parties, as they reduce the financial burden on contractors while still providing security for the project owner.
5. Financial Management Tools: Utilizing financial management software can help construction businesses better manage their retainage receivables and payables. These tools can automate the tracking of retainage, ensuring that all payments are accounted for and that funds are released in accordance with the contract terms. Additionally, software can provide real-time insights into cash flow, helping contractors plan for upcoming expenses and avoid potential financial shortfalls.

The Purpose of Retainage

The primary purpose of retainage is to provide a financial incentive for contractors to complete the job fully and to the owner’s satisfaction. Given the often thin profit margins in construction, the amount held in retainage typically represents the contractor’s profit, making it a strong motivator to see the project through to the end.Retainage also serves as a form of protection for project owners. By withholding a portion of the payment, owners can ensure that contractors are committed to completing the project according to the agreed-upon specifications. If issues arise during construction or after the project is completed, the withheld funds can be used to cover the cost of necessary repairs or to hire another contractor to finish the work.For subcontractors, retainage can be both a motivator and a challenge. While it incentivizes them to complete their portion of the work, it can also create cash flow difficulties, particularly if the project is delayed or if the contractor withholds a higher percentage than what was originally agreed upon. To mitigate these challenges, subcontractors should negotiate clear retainage terms in their contracts and ensure they have the financial resources to cover ongoing expenses until the retainage is paid out.

How Retainage Works

The process of retainage is typically outlined in the construction contract, with specific terms regarding the payment schedule and the percentage of money to be withheld. In most cases, retainage is taken from each progress payment, with the remaining amount held back until the project is deemed substantially complete.For example, if a project has ten payments of $20,000 each and the retainage is set at 10%, the owner would pay $18,000 each time, holding back the remaining $2,000 until the project is completed. Once the retainage terms are met, the withheld funds are released to the contractor, who must then pay any withheld amounts to subcontractors.Retainage terms can vary significantly depending on the project stage and state regulations. For example, in California, retainage on private projects must be released within 45 days of the “date of completion,” while in New York, it must be released within 30 days after “final approval of the work.” Understanding these regulations is crucial for contractors to ensure they receive payment in a timely manner.

The Importance of Retainage

Retainage serves as an effective insurance policy for project owners, providing financial protection if the contractor fails to complete the job or if issues arise during construction. For example, if a contractor defaults on the project, the owner can use the withheld retainage to hire another contractor to complete the work or to cover the cost of repairs.However, for contractors, retainage can create cash flow challenges, as they are required to cover ongoing costs without receiving full payment. This can be particularly problematic for small businesses that may not have the financial reserves to cover expenses until the retainage is released. To mitigate these challenges, contractors should plan for the possibility of delayed payments by setting aside funds or arranging financing to cover costs until the retainage is paid out.

History of Retainage

Retainage has its roots in the United Kingdom during the 1840s, a period marked by rapid industrial expansion and the construction of railroads. As the speculation bubble of railroad investment grew, so too did the demand for contractors in the mid-19th century labor market. Many of the people who filled the void lacked the necessary experience, qualifications, and skill sets to complete their jobs properly. This led to issues with subpar craftsmanship, prompting railroad companies to begin withholding as much as 20% of the payments due to contractors to ensure work was done correctly and effectively.The practice of retainage quickly spread to other industries and became a standard feature of construction contracts. Over time, it has evolved into a widely accepted method for ensuring project completion and protecting the financial interests of project owners. Despite its long history, retainage remains a subject of debate within the construction industry, with some arguing that it places an undue financial burden on contractors and subcontractors.

Rules Governing Retainage

Retainage terms are dictated by the construction contract, including the percentage withheld and the conditions under which funds are released. Most states have legal limitations on retainage, which vary depending on whether the project is public or private.For example, on federal projects, the Federal Acquisition Regulation (FAR) allows for retainage of up to 10% until satisfactory progress is achieved. However, in practice, this percentage is often scaled lower as construction benchmarks are reached. Contractors may also use retainage with subcontractors, even if the government is not doing so with them. In these cases, the contractor cannot bill the government for the withheld money, effectively creating an unofficial retainage by the government.State, county, and municipal projects are subject to their own retainage regulations. Some states require retainage, while others set limitations on the percentage that can be withheld. For example, in Illinois, private projects have a 10% maximum retainage amount, which drops to 5% when half of the project has been completed. However, this rule does not apply to residential projects with 12 or fewer units.

Who Should Use Retainage?

Retainage is typically used by project owners, especially for large or complex projects where the risk of incomplete work is higher. By withholding a portion of the payment, owners can ensure that contractors are motivated to complete the project according to the agreed-upon specifications. Retainage also provides a financial cushion in case of contractor default or other issues that may arise during construction.Contractors who have money withheld by the project owner should also use retainage with their subcontractors to mirror the protection established by the owner. Passing retainage down the line helps contractors better manage cash flow and incentivizes subcontractors to complete their portions of the job. Additionally, contractors can use retainage as leverage to ensure that subcontractors adhere to project timelines and deliver quality work.

Benefits and Challenges of Retainage

Retainage offers several benefits for all parties involved in a construction project:

1. For Owners: Retainage provides a financial incentive for contractors to complete the job properly. It also offers a source of funds that can be used to cover the cost of repairs or to hire another contractor if the original contractor defaults.
2. For Contractors: Retainage allows contractors to ensure that subcontractors complete their work to the required standards. It also provides a mechanism for resolving disputes over the quality of work or project timelines.
3. For Subcontractors: While retainage can create cash flow challenges, it also incentivizes subcontractors to complete their work thoroughly and on time. In some cases, subcontractors may be able to negotiate retainage terms that allow for the release of funds as specific milestones are reached.

However, retainage also presents challenges:

1. Cash Flow Issues: The withholding of funds can create significant cash flow challenges for contractors and subcontractors, particularly if the project is delayed or if retainage is withheld for an extended period.
2. Potential for Abuse: In some cases, retainage can be abused by project owners or contractors who withhold funds for longer than necessary or use retainage as leverage in disputes. This can lead to tensions and strained relationships between contractors and subcontractors.
3. Complexity: The rules and regulations governing retainage can be complex, particularly for projects that span multiple states or involve both public and private funding. Contractors need to be familiar with the specific retainage rules in the states where they operate to avoid potential legal issues.

Alternatives to Retainage

While retainage is a common practice, there are alternatives that can provide similar protections without the associated cash flow challenges:

1. Surety Bonds: A surety bond acts as a form of insurance that guarantees the completion of the project and payment of subcontractors and suppliers. The bond protects the project owner by providing a source of funds in case the contractor fails to meet their obligations.
2. Escrow Accounts: Retainage funds can be held in an escrow account, where they earn interest until the project is completed. This approach benefits both parties by providing security for the project owner while allowing the contractor to earn interest on the withheld funds.
3. Construction Trust Funds: In some states, construction trust fund statutes require that money received by a contractor for payment of subcontractors be held in an interest-bearing trust account. This ensures that funds are available to pay subcontractors and suppliers, reducing the risk of non-payment.
4. Negotiated Retainage Terms: Contractors with a solid reputation and a history of successful project completions may be able to negotiate lower retainage percentages or phased release of retainage as specific milestones are reached.

Navigating Retainage with Software

Efficient management of retainage is essential for construction businesses, particularly those managing multiple projects simultaneously. Cloud-based financial management software can streamline the process by automating invoicing, tracking retainage, and ensuring that payments are made accurately and on time.These tools allow contractors to standardize their forms across all projects, increasing efficiency and reducing the risk of errors. Additionally, financial management software can provide real-time insights into cash flow, helping contractors plan for upcoming expenses and avoid potential financial shortfalls. By automating retainage management, contractors can focus on delivering quality work and maintaining strong relationships with subcontractors and suppliers.

Conclusion

Retainage remains a critical component of construction contracts, providing security for project owners and ensuring that contractors are motivated to complete their work to the highest standards. However, it also presents challenges, particularly in terms of cash flow and the potential for abuse. By understanding the rules governing retainage, exploring alternative methods, and leveraging financial management software, contractors can navigate these challenges and ensure successful project completion.Whether you’re a project owner, contractor, or subcontractor, a thorough understanding of retainage is essential for managing construction projects effectively. With careful planning, clear communication, and the right tools, you can minimize the risks associated with retainage and ensure that your projects are completed on time and to the satisfaction of all parties involved.NetSuite doesn’t natively support retainage tracking, so this requires some customization. In this guide, we'll outline one effective way to set up retainage tracking in NetSuite for project-based businesses. Note that while this method is comprehensive, other ways might work better depending on specific business setups.

Here is a method for tracking Retainage in NetSuite:

Project Customization:

• Retainage Percentage:
  • Field to record the retainage percentage for the project.

Sales Order Customization:

These fields can be created at the line level for move of a Schedule of Values (SOV) feel.

• Total Contract Value:
  • Field to record the total value contract line.
  • What might be best would be to rename the native Amount field to something of this nature.
• Retainage %:
  • This field would source in the Retainage value from the project record.
• Total Contract Value Less Retainage:
  • A field to calculate the contract value less retainage (Total Contract Value - Retainage Withheld)
  • This formula can be set right on the field so that the calculation occurs automatically.
  • With this in place you know right away the value, less any change orders, of the contract to be paid by the customer before the time of project competition comes around.
• Retainage Withheld:
  • Field to capture the total retainage to be withheld from customer billings for the project. (Total Contract Value * Retainage %).
  • The formula can also be set right on the field so that the calculation occurs automatically.
  • With this in place you know right away the value, less any change order retainage, of the retainage to be paid by the customer before the time of project competition comes around.
• % In Progress or % Complete:
  • This is where some scripting would come into play and it should relatively simple.
  • This could be the representation of all Open and Paid customer billings compared to the contract line value.
  • A script to arrive at a value of this nature would be (All Open & Paid Customer Invoices / Total Contract Value)

Invoice Customization:

These are all fields that can be displayed on the customer invoice pdf to ensure they have visibility into what they are being billed for along with the accrual of the retainage to expect at the end of the project. These fields should also be created at the line level as invoicing from a Sales Order with similar fields simplifies the data entry process.

• Retainage %:
  • This field would source in the Retainage value from the project record.
• Amount with Retainage:
  • This field would be the invoice value before retainage is deducted.
  • This is expected to be a manual entry.
• Retainage:
  • This would be calculated field to arrive at the amount of retainage to be withheld from this invoice. (Amount With Retainage * Retainage %)
  • The way that I found it easiest to calculate this was through the use of a Workflow that would perform this calculation and populate the value after a user modified the Amount with Retainage field.
• Amount Less Retainage:
  • This is the native NetSuite Amount field renamed.
  • The formula for this field would be (Amount with Retainage - Retainage)
  • This is another calculation that I have used in a workflow just as stated above. Once the retainage field updates, the Amount Less Retainage field updates as well.
• % In Progress:
  • This is spot some scripting would come into play.
  • This should be the representation of the current customer billing compared to the contract line value.
  • A script to arrive at a value of this nature would be (Current Customer Invoices / Total Contract Value).
• % Complete:
  • Yet another spot for scripting.
  • This should be the representation of All customer billings compared to the contract line value.
  • This should look something like this (All customer invoices / Total Contract Value).

This is all just some basics to achieve progress billing. There are other ways to get here and I am sure you will find a method applicable for you.