Concerns about cash flow are top of mind for construction companies and contractors — and for good reason: These businesses typically lay out tens of thousands of dollars for project-related expenses and don't get paid until the job is complete. For smaller firms with limited cash on hand, this may be especially burdensome, especially for long-term projects.
An alternative approach is for businesses to be paid when predefined stages or percentages of a project are complete, a model called "progress payments." Here we'll detail how progress payments work and how they benefit all parties involved.
What Is a Progress Payment?
In the construction industry, a progress payment is a partial payment made to a business or contractor after the completion of a predefined stage of work — for example, a demolition or the addition of a roof and siding. These installments replace other approaches, such as a single, lump-sum payment at the end of a project or a “half upfront, half at the end” arrangement.
Progress payments help companies recover a portion of their costs along a project's way, thereby maintaining a steady cash flow. They also protect companies in the case of client nonpayment; a firm may decide to stop working on a project until issues are resolved and payment is received. On the other side of the equation, progress payments give clients a chance to assess whether the billed portion of work has been done to their satisfaction before the project proceeds. This incremental approval approach may head off problems.
How Do Progress Payments Work?
Progress payments are based on the completion of specific portions or percentages of work. These are defined and agreed on by all parties — client, bank or other funder and contractor — at the time the construction contract is executed. Key considerations include determining and scheduling the intervals at which payments will be invoiced, what each payment will reflect and when payment is due.
Progress payments free contractors of the cash-flow burden of fronting all the money for a construction project and then waiting long periods of time to recoup expenses and make a profit. It also avoids the specter of a project client going bust or a bank canceling funding and leaving them empty-handed.
How Are Progress Payments Determined?
Progress payments can be set up in a number of ways. The most common methods are based on when a designated stage of a project is completed, as when plumbing and electrical are in place, for instance; a certain percentage of project being done — say 25% of the total project is finished; or a designated period of time, such as monthly.
The method a client and contractor select generally depends on a project's complexity, the necessary outlay of expenses and the impact on a business's cash flow.
Construction pricing structures
Construction businesses have a variety of ways to price and get paid for their work. Which one they select — and they may select more than one for different parts of a project — typically depends on the type of project involved.
The most common construction pricing structures are:
Time and material (T&M) pricing is used when the scope or duration of the job can't be determined before work begins, as is often the case in construction projects. T&M pricing establishes a fixed quote for labor rates, a maximum number of labor hours and the cost of materials (including freight) and specified markup. Then, payment milestones, aka progress payments, are set. Invoicing is relatively quick and easy since rates are already determined, though construction firms need to stay on top of record-keeping and receipts.
Lump-sum pricing provides a set price to be paid once the project is complete. The lump sum contract methodology is typically limited to jobs where estimating total costs is rather straightforward. This model is also most common with smaller projects that involve less time, work and associated expenses.
Cost-plus pricing covers the actual costs of construction (direct expenses and overhead), plus an agreed-on profit amount that is usually based on a percentage of direct expenses. Again, thorough record-keeping and documentation are vital so expenses can be verified. As with T&M pricing, cost-plus contracts are often written to pay out based on a project's progress — say, when 25% of a project is complete.
Unit pricing establishes prices for individual portions of work. These units include costs for materials, labor and overhead, among other variables. This type of pricing is useful for projects that can be easily and logically split into bundles of work and for which the final scope is unclear. Should a project grow in scope, a contractor can bill for additional units, thereby protecting its profitability.
Why Are Progress Payments Important in Construction?
Construction firms and contractors often foot the entire bill for materials and labor at the beginning stages of a project, then have to wait until the project is completed to get paid. This can put stress on a business’s financials, especially for smaller firms. With progress payments, companies receive a steady influx of money from clients to cover their costs, with the added bonus of having working capital to invest in the next phase of the job — or to begin a new project.
Progress payments serve other key roles up and down the construction chain. Contractors and project owners who use progress payments can track their progress and that of their subcontractors, especially if they use project accounting or have project management software in place. As payment applications — analogous to invoices — are reviewed by the client, any issues related to the quality of work can be detected and handled in a timely way, before the project moves forward.
Progress payments also encourage project momentum: The more work completed toward the next milestone in the project, the closer the company gets to the next progress payment. In addition, progress payments offer a level of financial protection for all parties should something unpredictable occur to halt a project — for example, a fire, one party goes out of business and, yes, a pandemic.
How to Bill for Progress Payments
A construction industry uses what’s called a payment application to bill clients. A payment application is more than a simple invoice. It typically includes a schedule of values, such as a list of all work items on a project and their associated costs; progress reports of completed work and materials delivered; subcontractor invoices; a timetable of work still to be done; and photos and payroll receipts.
There are two standardized payment application forms commonly used in construction for progress billing. General contractors typically use the AIA G702 form created by the American Institute of Architects. Subcontractors may use that or the ConsensusDocs 710. A construction contract should specify which form to use. Either way, the payment application needs to be completed and delivered promptly to the payor, that is, the project owner or the contractor who handles subcontractor payments. Payment applications should be notarized.
Benefits of Progress Payments
Generally speaking, construction businesses, contractors, subcontractors and project owners all stand to benefit by being paid, or paying, in installments based on predefined stages of project completion. Among the main reasons partial payments work well:
Stable cash flow: Progress payments provide construction firms and contractors with a steady stream of income, thereby reducing the amount of working capital needed as a project advances. They make it easier for firms to cover costs for supplies and labor and greatly lessen the chance of going into debt to finance a project. Smaller and newer businesses not yet liquid enough to wait for a lump-sum payment at the end of a project may find progress payments especially helpful.
Source of motivation: Reach that next milestone, get that next progress payment: Being paid for work is always a great motivator in the construction industry — or really, any industry. Being paid along the way may also drive productivity, reduce material and labor expenses and result in higher profits in an industry where profit margins are traditionally very small.
Potential payment problems: As stated in the first point, getting paid based on progress establishes a steady expectation of how much money is coming in and when it should arrive. However, if payments begin coming in late, or not at all, it could be a sign that the client is having a financial issue. Progress payments help flag this early on and could prevent the need to take legal action.
Time to pause: If a client doesn't pay its progress payment for work completed, a company may decide to pause work until the issue behind nonpayment is resolved and it gets paid. Consult the construction contract for any stipulations regarding this tactic in dispute resolution.
Drawbacks of Progress Payments
Despite the advantages — keeping cash flowing into a construction business chief among them — progress payments bring a few relatively minor disadvantages that contractors should be aware of. Understanding and having a plan in place to tackle them can help minimize their impact.
More payments, more accounting: It falls on the construction firms or contractors to make sure they are paid, and many don't have a dedicated financial or accounting department to handle that function. Progress payments mean multiple payments, so it stands to reason that tracking and processing them involves more work and time — and that's assuming a client pays without incident. Subcontractors, too, have to be paid for each installment of work.
Disputes over work: Owners and contractors may differ in their opinions about the work completed and reflected in an invoice. For example, a contractor may submit an invoice based on 50% of work being completed, but the owner maintains only 40% was done and pays accordingly. This can hurt the contractor financially. The time it takes to come to an agreement also could lead to delays in completing the project, which then spirals into additional delays on future payments. This highlights the importance of clear contracts and constant communication.
How Does Retainage Impact Progress Payments?
Withholding a percentage of payment to contractors or subcontractors until project owners ensure their work is finished completely, correctly and per terms of the contract, a process called retainage or retention, is common in the construction industry. The amount held back, frequently between 5% and 10%, should be specified in the construction contract.
Retainage is typically deducted from each progress payment. For example, if a project calls for 10 payments of $50,000 and a 10% retainage is negotiated, then the owner pays $45,000 each time. The remaining $50,000 in retainage ($5,000 per progress payment) is released upon completion of the construction project or a specified period after completion, depending on terms of the contract. Some contracts allow contractors and subcontractors to apply for partial retainage payments before completion of the project, so that those involved at only the start of a project can be compensated early on for their work.
Manage Progress Payments With Accounting Software
Construction projects require a great deal of financial and accounting work. From managing progress payments that come in and progress billing that goes out, cloud-based software solutions, such as NetSuite's financial management software, can meet the needs of construction businesses of all sizes. NetSuite's accounting software automates invoicing, with specific line items for retainage, and tracks payments, taking the heavy lifting off contractors' shoulders. In particular, NetSuite's SuiteBilling invoice and billing management software creates, manages and supports recurring billing operations, including progress payments. SuiteBilling provides full integration to advanced revenue management, as well as ASC 606 compliance. It also lets contractors standardize their forms across all projects, including payment applications. The more streamlined and efficient these tasks are, the more resources can be devoted to the client-facing aspects of a construction business.
Construction projects require significant outlays of money just to get started. Among the expenses, job materials must be ordered and shipped, and subcontractors and crews have to be paid. Rather than waiting until the end of a project to get paid in a lump sum, process payments let construction firms and contractors bill in installments, after predetermined stages or percentages of work are complete. All parties benefit from this arrangement. For construction companies, progress payments keep a steady stream of cash flowing into the business. For project owners, progress payments give them the opportunity to first review a completed portion of work and make sure they're satisfied before actual payment. Project management and accounting software can help move the entire payment process — and, in turn, the construction project — forward.
Progress Payment FAQs
Q: What are government progress payments?
A: Progress payments on government contracts operate under the Federal Acquisition Regulation (FAR). There are two common types of payments under FAR: those based on costs incurred and those based on percentage or stage of completion. Per FAR rules for costs-incurred progress payments, governments will pay at a rate of 80% or 85% of allowable costs, depending on the size of the business. For percentage-completed progress payments, governments are allowed to withhold up to 10% of the amount due if they deem some of the work unsatisfactory.
Q: What are progress payments and why are they important to the contractor?
A: Progress payments — money paid to contractors and subcontractors in installments as a job progresses — help reduce cash flow problems, a major concern in the construction industry. They also help identify and track any quality-of-work issues early enough to rectify them. Progress payments help incentivize contractors and subcontractors to complete their tasks in a timely manner.