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Why Retainage Delays Profitability

The word retainage can strike fear into the heart of construction industry participants. And it’s easy to see why.

Retainage is a portion of the agreed upon price that is withheld to ensure satisfactory completion of the work. Because no one likes to have payment withheld, many in the construction industry look upon retainage unfavorably. However, it can serve a purpose. It is hard to deny that retainage works to get the job finished. Because it is unlikely to go away, construction industry parties must learn what retainage means and how to minimize the financial impact.

While many states set an upper limit to the amount of retainage that may be withheld, retainage percentages can be negotiated (or just mandated by an upper-tiered party) up to that amount. This means that companies need to know their numbers and have a good grasp on their financial situation when confronted with a contract specifying a higher retainage percentage.

While having a good grasp on financials is always good practice for a business, its takes on added significance with respect to construction parties and retainage. It’s no secret that companies in the construction industry often work on razor-thin profit margins. In fact, a recent five-year average of construction industry net income hovers right around 2 percent. This number is quite a bit lower than the percentage of retainage generally withheld, which is usually between 5 percent and 10 percent. If the contractor’s profit is 2 percent and 10 percent is being withheld, it pays to actually make sure the financials of that project make sense. It may be difficult to float costs on a large extended project without sufficient money in the bank to rely on. Before agreeing to a retainage amount in a contract, the contractor should know it works for the company, and that it won’t have significant, or even financially fatal, consequences.

Because retainage is passed down the contracting chain, there is very little chance that a construction company can negotiate a smaller retainage percentage than what is being withheld from the parties above. But that doesn’t mean subcontractors should be forced to live with a bigger cut being kept until the project is finished. If a property owner is withholding 5 percent from the general contractor, second tier contractors should make sure the general contractor is not withholding 10 percent from them. Percentage points matter, and working to keep the retainage percentage equitable and fair is a worthwhile goal. Keeping the process fair and transparent helps build relationships up and down the contracting chain and makes the payment process go more smoothly for everybody.

It is clear why delaying some portion of payment that otherwise would be due until the successful completion of the project can delay profitability and cause cash flow problems. It opens up a process that is already complex and convoluted to potential abuse and even more layers of accounting difficulty. Even in the absence of payment abuse, the retainage process creates cash flow problems when working as designed. These problems can be critical for construction companies, and the inability to float significant project costs while waiting for payment can result in business failure.

While retainage “gets the job done,”in the words of The Surety and Fidelity Association of America, it also may be the straw that breaks the construction company camel’s back. The moral of the story is that construction companies should be cognizant of retainage, have a grasp on their financials and, as always, play fair.

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