The Garrison Report #2005-6

Retainage---Should It Be Eliminated?

Special Note: Before starting this month's issue, the author wants to report that the last few Garrison Reports have created a wave of e-mails from readers explaining potential problems with the Best Value Procurementapproach. The good news is that the problems described are not the result of the Best Value Procurement approach; instead the problems are about people attempting to use Best Value Procurement as a smoke screen while manipulating the process to their benefit. Don't blame the system because some people misuse the terminology. Would you abandon "quality" because low- performing contractors claim to offer high quality? Would you abandon being "customer friendly" because some contractors that claim to be "customer friendly" are actually rude and even unethical? The true Best Value Procurement approach seeks win-win situations and is transparent. To assure better understanding of the Best Value Procurement approach, the author requests that you send in e-mails of any problems you have seen with so-called "Best Value" systems, or in fact any questions about Best Value. The author will then address all of these issues in a future report. Thank you for interest.

Sincerely, Ted Garrison

Now this month's report!

One of the most volatile issues in the construction industry is whether the concept of retainage should be kept or abandoned. The author wonders why. Polls indicate that most subcontractors are against the practice, while owners and general contractors believe it's necessary. For example, a poll in Engineering News Record (ENR, October 23, 2000) indicated that 60% of owners, general contractors, and subcontractors were in favor of keeping retainage, while 40% were in favor of abolishing the practice. However, if everyone reviewed this practice with an open mind, the results might be totally different.

In earlier Garrison Reports , the author defines client as "someone under the protection of." General contractors have two sets of clients: One is the building owner, and the other set includes their subcontractors and workers. Therefore, it could be said, it's the general contractor's responsibility to protect its subcontractors, instead of punishing them with retainage.

Retainage is one of the biggest obstacles to creating a feeling of cooperation on projects. Retainage creates an environment of "them against us." The author understands the prevailing logic for retainage, but he's not about to try to explain that logic to subcontractors because they won't buy it. In the referenced ENR article, one proponent of retainage said, "People in companies have become more dishonest, more untrustworthy, [which is] even more reason to keep it." This sounds like a great way to build cooperation. Only kidding! The author's question to that individual: "Why are you working with someone who is dishonest and untrustworthy?" Could it be that you beat his price down to a level that is unprofitable for the contractor and you are afraid the contractor will try to get even? In reality, a lot of criticism about contractor's practices is about them attempting to level the playing field. The problem is this creates ill feelings.

Others believe retainage is necessary to provide sufficient leverage over contractors to insure they will perform. Still others believe retainage is necessary to protect the owner in case a contractor refuses or can't make necessary repairs. The author asks those who believe retainage is necessary, "Does it work?"

Unfortunately, the answer is no. But when a contractor doesn't perform the logic is, "See, if we didn't have retainage, it would be worse." The problem is this logic is flawed. The reality is that low-performing contractors don't perform whether there is retainage or not. High-performing contractors perform whether there is retainage or not. In other words, retainage doesn't convert nonperforming contractors into performing contractors.

The cost of retainage

Even without retainage, the owner always has a tight financial noose around a contractor. For example, a contractor must pay all the expenses on a project for a month then submit an invoice and usually wait at least 30 days to get paid. Often the time frame is even much longer, which is another mistake. However, for discussion the author assumes that the subcontractor is paid within 30 days after the invoice is submitted. If it's assumed the average expense is incurred in the middle of the month, the subcontractor carries most costs for an average of 45 days. When payment is made to the subcontractor, the subcontractor has already accrued another month's expenses. If a project is less than twenty months, the accrued expense exceeds 5%. The longer the project, the less the accrued expense is as a percentage of total project cost, but the greater the impact of retainage because the retainage is held longer.

If subcontractors don't maintain their cash flow, then they may not be able to take advantage of vendor discounts, and that only increases their costs. Then when owners throw 5% to 10% retainage on top of the normal amount of money tied up, the burden on the subcontractor becomes excessive. In the end this cost is passed on to the owner since these costs are reflected in higher material costs and/or higher overhead costs. In essence, the owner is trying to use retainage as insurance against poor performance. The problem is it's a costly and ineffective approach.

While general contractors have retainage held against them, in most cases the retainage is only against their fee and job site overhead expenses. This results in a relatively small dollar amount. Typically, general contractor still get paid some of their fee even after retainage. In contrast, subcontractors carry a much heavier burden since they have retainage held against their labor and materials. Therefore, subcontractors often receive no fee until retainage is paid, especially when the retainage is at 10% during the first half of the project. While general contractors love the added leverage from retainage, it's really unfair since they pay nothing for this benefit, since the owner pays the cost of retainage. Instead the general contractor should solve the problem by selecting high-performing subcontractors.

Further, there are abuses pertaining to retainage. The first abuse is keeping all subcontractors' retainage because one subcontractor hasn't performed. Another abuse is not releasing retainage on all subcontractors until the project is complete even though many or most subcontractors have completed their work. On some projects, subcontractors who complete their work early in the project must wait until the entire project is completed before getting their retainage. These practices only increase the cost to the subcontractors and, ultimately, the owner. Thank goodness, not all general contractors or owners use these abusive practices, but a significant number do.

Potentially, the worst practice is where some owners and general contractors use the withheld retainage to unfairly beat up subcontractors to eliminate or reduce legitimate change orders. They say, "If you don't accept our offer or eliminate the change order, we will hold your retainage until the change order is settled." The author realizes that the standard process is to settle all issues including change orders before final payment. This paragraph is not about those owners and general contractors who negotiate the change orders in good faith, but it's about those who use retainage to squeeze "unreasonable concessions" from subcontractors. This approach hurts the entire industry.

The author is not suggesting that money shouldn't be held for nonconforming work or a reasonable amount be held for open punchlist items at the end of the project. No one expects that owners should pay for incomplete or defective work, but why should they hold money for completed satisfactory work?

A better alternative to retainage

Hiring only high-performing contractors is the solution. High-performing contractors perform regardless of whether they have retainage held or not. Dr. Kashiwagi's Best Value Procurement offers a better solution because it eliminates the non-performing contractors; instead of trying to convert nonperforming contractors - a hopeless effort. In essence, in an effort by owners to protect themselves from low-performing contractors, they use retainage that punishes everyone, including high performing contractors and themselves because they will pay higher costs. A better solution is to eliminate the bad apples. The Best Value Procurement approach can be used whether bidding the project through a general contractor or hiring a design-build contractor or construction manager and taking subcontractor bids.

Not only does the Best Value Procurement approach solve the retainage problem, it also offers owners a legitimate way to reduce their risk in other areas of the project. The benefits of the Best Value Procurement approach include increased quality, reduced or eliminated contractor-generated orders, eliminated litigation, and a minimizing of the threat of delays or budget overruns. The selection of high-performing contractors is a better solution because it creates a win-win environment instead of the confrontational atmosphere created by retainage. This report is about trying to protect those who believe retainage is good from themselves. The time has come for everyone in the construction industry to work together to find true solutions instead attempting to use economic force.

 

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