A subcontractor either didn’t finish the job or did unacceptable work. Hopefully you followed best practices around withholding a percentage of the full invoice amount.
Construction is an industry of alliances, where deals with subcontractors and specialists are often sealed with a handshake. But how do you as a general contractor manage the financial relationship with your subs in a way that protects your cash flow and the overall health of the project while getting the job done on time and on budget?
In any contract, payment terms should be negotiated so that there’s crystal clarity for all parties. Construction companies are very familiar with payment disputes and the delays they cause. They are so frequent, they’ve almost come to be expected. But it doesn’t need to be that way.
By including specific and detailed terms in the contract, you can protect the project and your own business from the financial and brand damage that comes from work that’s incomplete or unsatisfactory. This is done through retainage.
What is Retainage?
Job costing,(opens in new tab) a precise method of tracking all the costs and revenue associated with a particular project, is the backbone of any construction project. But right in tandem with that is the management of when and under what conditions money is paid out to subcontractors. In Canada, you might hear the term “holdback,” which essentially means the same as the commonly used US term “retainage.”
Retainage is a concept developed in the UK almost 180 years ago. The purpose is to protect the customer from deficient or unsatisfactory work in a construction project. A customer, construction company or general contractor will withhold payment of a certain amount, usually a maximum of 10%, of subcontractor invoice amounts.
Why? Let’s say you’ve withheld 10% on an invoice. At the end of the project, when you’re certain all the work has been done and done correctly, you release 5% of that in payment to the subcontractor. Then you could release the remaining 5% at a later designated time or possibly at the end of any warranty period.
Retainage on Accounts Payable vs. Accounts Receivable
When you think about the typical structure of a construction project, the customer is at the top, with a general contractor next, then a certain number of subcontractors and specialists.
A general contractor dealing with a customer on the accounts receivable (AR) side may assume a 10% retainage by the client and seek to pass that on subcontractors on the accounts payable (AP) side.
But there’s a lot of inconsistency in this approach across the industry. Many construction companies think they’re engaging in best practices, even as they’re all doing retainage differently. Sometimes the customer will withhold 10%, but the general contractor turns around and withholds 12% from subcontractors. Others are only withholding 5%, which puts them at risk.
Risks? What Risks?
A general contractor having 10% withheld by the customer but only withholding 5% from subcontractors is at risk of a cash flow crunch.
The margins are already thin in construction, with most projects at around 10%, maybe 20% max. If you don't manage your project properly on both the AR and AP sides, you could easily wind up with negative cash flow. And when that happens, you’re at best funding the project for the customer at 0% interest. At worst, the business faces risk.
One other factor to watch is costs related to purchasing materials, especially with inflationary pressure. Even if retainage is balanced, you could slide into negative cash flow on material purchases because retainage isn’t applicable to suppliers. If you want your lumber, you have to pay 100% of the cost.
Again, this needs to be managed in contract negotiations, so the type of contract matters. If it's a fixed price contract, the retainage is 10% of every payment. If it's a time and material or cost-plus contract, the general contractor may inform customers they can withhold retainage only on subcontractor costs, not materials costs.
Why Software is Required for Responsible Retainage
Withholding retainage is one thing. Paying out that retainage to subcontractors properly and on time is another.
If a general contracting firm subs out 90% of the work on a project, it could be dealing with 20 to 30 different subs. That’s a lot to keep track of. Releasing retainage on all the appropriate schedules manually using spreadsheets is time consuming and can lead to expensive errors. Get it wrong and you could face legal issues, including property liens.
Research shows that in as many as 30% of projects, stakeholders struggle to get retainage where it needs to go and when, both on the general contractor and subcontractor side. Busy project managers can easily forget to send an invoice for retainage owed or neglect to pay retainage due.
Software systems are critical to keep clients, contractors and subs on the same page. NetSuite ERP(opens in new tab), implemented by a solutions partner with expertise in the construction industry, like Appficiency(opens in new tab), delivers accurate and timely reports that keep management of retainage on point.
NetSuite plus Appficiency can help companies:
- Allow retainage to go into effect from the very first period and very first transaction where it's relevant.
- Capture retainage on a per-project basis to accommodate different retainage rates.
- Produce customer-facing forms that show retainage aging and scheduling.
- Reconcile to each line of every transaction, so every payment is retained and applicable to recovery depending on its categorical qualification.
- Provide multicurrency support in multiple regions and localizations for taxation.
- Complete reconciliation for the accounting team.
- Deliver an integrated proposal from estimate through project closure.
On a $35,000 invoice the 10% retainage would be $3,500 and moved out to a future date.
As transactions happen, the ERP immediately starts aging that receivable on the customer side. On the AP side, you're receiving the payable.
Once the retainage has been carved out, you need to know where it sits. The retainage is reconciled against the general ledger so that the project manager has a balance, by project, for the total or vendor-side retainage in effect. All transactions are visible in a cash flow report.
When it’s time to create a catch-up invoice against the retainage balance, the system depletes the retainage balance ledger and provides a new aging as a new invoice.
The uniqueness of the construction industry means contractors need management software that is optimized for how their administrative and accounting systems operate. From digital invoicing to lien management to holding and paying retainage, cloud-based financial management software customized for how a firm does business can keep cash flow on track, increase customer satisfaction and make you someone subcontractors enjoy working with.
Look for a system that can automate invoicing, with specific line items for retainage in both directions — accounts receivable retainage and accounts payable retainage.
Financial management software should also allow contractors to standardize their processes across all projects, increasing efficiency. That will help the finance team pay subcontractors more quickly, reduce errors and risk, and free up resources to focus on clients.
Without Technology, Retainage Can Be Tricky
Retainage is for everyone’s protection, but it works best and preserves relationships if it is consistently managed, accurately and automatically.
What seems like a simple calculation at first can get highly complex over time, especially across multiple projects and various work codes. Add to that contracts that are signed by multiple parties, potential communication breakdowns, possible delays in scheduling, and domino effects of non-payments, and it’s clear that construction firms need technology to make the retainage process work as intended — to protect all parties involved, without generating problems of its own.