How to Manage AP Retention in the Construction Sector: An Overview

Outsourced Accounting

How to Manage AP Retention in the Construction Sector: An Overview

Published By 
May 22, 2024

Managing accounts payable (AP) is a critical aspect of financial operations, especially in the construction sector where transactions are significant and frequent. Although managing accounts payable (AP) in the construction industry can be a complex task, it’s  essential for maintaining a healthy cash flow and building strong relationships with suppliers and subcontractors. Here’s a straightforward overview on Accounts Payable (AP) Retention, its benefits and challenges, to give you an idea of the importance of this account in your construction business.

Before diving into Accounts Payable (AP) Retention, let’s clarify what we mean by accounts payable. In simple terms, Accounts Payable (AP) is the money you owe to others for services or materials they’ve provided.

Among the various accounts payable management practices, the accounts payable retention process stands out as an important element in ensuring the financial health and trust between construction companies and their subcontractors.

Here's a simplified guide to help you understand and manage retentions in your construction business.

What is Accounts Payable (AP) Retention in Construction?

In the construction industry, a retention is a portion of the payment that is withheld by the client or main contractor from the total due to the subcontractor. This amount is retained to ensure that any defects or incomplete work that may arise can be corrected after the completion of a project or certain milestone is done. Typically, this amount ranges from 5% to 10% of the total contract value.

Accounting for Accounts Payable (AP) Retentions

Accounting for AP retentions in construction can indeed be a complex topic, but it’s crucial for maintaining a healthy cash flow and ensuring compliance with tax regulations.

Managing the Accounts Payable (AP) Retention Process

How does the accounts payable retention process start? The accounts payable retention process basically starts with the retention terms being agreed upon and clearly outlined in the contract before any work begins.

As work progresses, payments are made to subcontractors, excluding the agreed-upon retention amount.

Once the project is completed, or a specific phase of the project is done, an inspection ensures all work meets the required standards. If the work is satisfactory, the withheld retention is then paid out, completing the financial transaction.

What is the Significance of AP Retention?

Retention serves several purposes in the construction industry:

  • Quality Assurance: It motivates subcontractors to adhere to quality standards, knowing that a portion of their payment depends on their work’s quality.
  • Financial Security: It provides a form of financial leverage to construction companies, ensuring that there are funds available if additional work or repairs are needed.
  • Project Completion: It acts as an incentive for subcontractors to see the project through to its end and not abandon it midway.

Challenges with AP Retention

While retention is a standard practice, it’s not without its challenges:

  • Cash Flow: Withholding a percentage of payment can strain the cash flow of subcontractors, especially smaller businesses.
  • Timing: Sometimes disagreements arise over the quality of work or the timing of the release of retention funds.
  • Bad Record Keeping: Accurate record keeping, though essential to track retention amounts and ensure timely payments, can be administratively burdensome.

Best Practices for Managing AP Retention

Effective AP retention strategies ensure that payments to suppliers, contractors, and vendors are accurate, timely, and contribute to maintaining strong business relationships.

To handle retention effectively and avoid challenges in AP retention, consider the following best practices:

  • Clear Communication: Ensure that all partiesunderstand the retention terms before work begins.
  • Timely Inspections: Conduct inspectionspromptly to avoid delays in releasing AP retention payments.
  • Accurate Accounting: When it comes toaccounting for retentions, it’s important to record them accurately to reflectthe true financial position of your company. Keep detailed records of allretention amounts and related transactions. Accurate and proper aids inproperly determining net income, monitoring cash flow, and evaluating return oninvestment.
  • Adhere to the rules: Release retentionpayments as soon as the criteria are met to maintain good relationships withsubcontractors.
  • Use of Accounting Software: It is alsoimportant to note that accounting software can significantly simplify theretention process. Modern accounting software can automate much of the workinvolved in processing invoices. These systems electronically capture, code,and route invoices, eliminating the need for manual data entry and approvalprocesses. These tools can also automate tracking, calculate retention amounts,and even send alerts when it’s time to release retention payments. Byleveraging technology, construction companies can reduce errors and save timeand benefit from stronger subcontractor relationships and improved financialstability.
  • Effectively managing accounts payable:  Accounts Payable (AP), which are funds owedfor services or materials provided by others, is crucial for financialstability, particularly within the construction sector. Overseeing AP inconstruction is important in maintaining cash flow and building relationshipswith suppliers and subcontractors.

In conclusion, the accounts payable (AP) retention process is a vital component of financial management in the construction industry. AP retention emerges as an important element, ensuring financial well-being and trust between construction firms and their subcontractors. By understanding the purpose of retention, its inherent challenges, and adhering to best practices, companies can ensure a smoother financial operation that benefits all parties involved.

The accounts payable retention process begins with setting retention terms in the agreement. During the project, subcontractor payments deduct the agreed retention. After inspection and approval of work quality, the withheld retention is paid out.

Clear communication, timely inspections, accurate accounting, and leveraging accounting software are needed in order to streamline the retention process and ensure timely payments. Following these practices not only allows smoother financial operations but also builds trust and reliability among stakeholders, which contributes to the overall success of construction projects.

Outsource AP Retention to RedHammer

Providing Outsourced Construction Accounting Management Services with flexible contracts, RedHammer can handle the challenges of accounting so construction businesses can focus on their core operations.

RedHammer focuses on offering tailored accounting services to help you improve your operations and cash flow. Among its services are operational guidance, system implementations, bookkeeping, job cost reporting, and advanced accounting solutions such as capital advisory and fractional CFO services.

Back to Articles