1.3 Construction Contract Law and Types of Contracts
Key Takeaways
- An enforceable contract needs offer, acceptance, consideration, capacity, and lawful purpose; unlicensed contractors often cannot enforce their contracts.
- Lump-sum shifts cost risk to the contractor; cost-plus shifts it to the owner; a GMP caps owner exposure while allowing shared savings.
- Markup adds to cost while margin is a percent of price: a 25% margin requires roughly a 33.3% markup.
- Change orders must be written and signed; allowances are reconciled by change order; liquidated damages must estimate harm, not punish.
- Know retainage (5-10%), indemnification, and the pay-if-paid versus pay-when-paid distinction.
Elements of an Enforceable Contract
A valid construction contract requires offer, acceptance, consideration, legal capacity, and a lawful purpose. The exam emphasizes that a contract by an unlicensed contractor may be void or unenforceable, barring the contractor from suing to collect — even for work performed. Under most states' adoption of the Statute of Frauds, contracts that cannot be performed within one year, and most real-property improvements, should be in writing to be enforceable.
Contract Pricing Types
| Contract Type | Who Bears Cost Risk | Best Use |
|---|---|---|
| Lump Sum (Stipulated Sum) | Contractor | Well-defined scope |
| Cost-Plus-Fee | Owner | Undefined/fast-track scope |
| Cost-Plus with GMP | Shared (cap protects owner) | Negotiated scope with cap |
| Unit Price | Shared by quantity | Uncertain quantities (excavation) |
| Time & Materials (T&M) | Owner | Small repairs, emergencies |
In a lump-sum contract the contractor absorbs overruns, so accurate takeoff and contingency are vital. In cost-plus, the owner reimburses actual cost plus a fee, shifting risk to the owner.
Guaranteed Maximum Price Worked Example
Under cost-plus with a Guaranteed Maximum Price (GMP), the owner pays actual cost plus fee but never more than the cap; savings below the cap may be split.
Example: GMP = $1,000,000. Actual cost + fee finishes at $940,000, a $60,000 underrun. With a 75/25 owner/contractor savings clause, the owner keeps $45,000 and the contractor earns a $15,000 bonus. If actual cost hit $1,060,000, the contractor eats the $60,000 overage — the cap protects the owner.
Markup Versus Margin — The Classic Numeric Trap
The exam reliably tests the difference between markup (added to cost) and margin (percent of selling price). They are NOT the same.
- Markup: Price = Cost x (1 + markup). Cost $80,000 at 25% markup = $100,000.
- Margin: Price = Cost / (1 - margin). Cost $80,000 at 25% margin = $106,667.
To achieve a 25% gross margin you must apply roughly a 33.3% markup, because markup% = margin% / (1 - margin%). Mixing these up underprices the job.
Changes, Allowances, and Time
A change order is a written, signed modification adjusting scope, price, and time — verbal change directions are a frequent dispute and exam trap. An allowance sets a budget placeholder for an undecided selection (e.g., a $5,000 fixture allowance); overruns are reconciled by change order. Liquidated damages are a per-day amount (e.g., $500/day) set in advance for late completion; they must be a reasonable estimate of harm, not a penalty, or a court may void them.
Key Contract Clauses and Documents
Know the contract documents hierarchy: agreement, general and supplementary conditions, drawings, specifications, and addenda. When documents conflict, written specifications generally govern over drawings unless the contract states otherwise. Watch for:
- Retainage: owner withholds a percentage (commonly 5-10%) of each payment until completion.
- Indemnification (hold-harmless): shifts liability between parties.
- Pay-if-paid vs. pay-when-paid: the former makes owner payment a condition of paying subs; the latter merely sets timing.
Breach, Damages, and Excused Delay
When a party fails to perform, the non-breaching party may recover actual (compensatory) damages and, if specified, liquidated damages. Consequential damages (lost profits, lost use) are often waived by a mutual clause in standard forms. The exam distinguishes excusable delays: a force majeure event (weather beyond normal, strikes, acts of God) typically grants a time extension but no extra money, while an owner-caused delay can support both time and delay damages. A substantial completion milestone starts warranty periods, even if punch-list items remain.
A contractor's direct job cost is $80,000 and the owner wants a 25% gross margin on the selling price. What price should be bid?
Under a Cost-Plus contract with a Guaranteed Maximum Price (GMP) of $1,000,000, actual cost plus fee reaches $1,060,000. Who absorbs the $60,000 overage?
Pricing Structures and Risk Allocation
Memorize who carries the risk in each pricing model. A lump-sum (fixed-price) contract puts cost-overrun risk on the contractor — best when scope is well defined. Cost-plus (cost plus a fee) shifts risk to the owner; a GMP (guaranteed maximum price) caps the owner's exposure and often shares savings. Unit-price suits work of uncertain quantity (earthwork, paving) — paid per measured unit. Time-and-materials (T&M) bills labor at marked-up rates plus materials, used for small or undefined repair work.
Essential Elements and Breach Remedies
A valid contract needs offer, acceptance, consideration, capacity, and legal purpose. The Statute of Frauds requires certain construction agreements (and those over a state dollar threshold or longer than a year) to be in writing. On breach, remedies include compensatory damages, liquidated damages (a pre-agreed daily amount for late completion — enforceable only if a reasonable estimate of actual loss, not a penalty), and specific performance. A substantial completion finding lets the owner occupy and starts warranty/retainage release even with a punch list outstanding.
Common Exam Traps
- Trap: Liquidated damages of an excessive amount are enforceable. No — if they function as a penalty, courts void them.
- Trap: Cost-plus protects the owner from overruns. It does not unless converted to a GMP.
- Trap: An oral change order is always binding. Many contracts require written change orders; oral directives risk non-payment.
- Trap: Confusing substantial completion (usable, punch list remains) with final completion (all work and closeout done).
An owner with a poorly defined renovation scope wants to limit total exposure while allowing flexibility. Which contract type best balances these?
Retainage and Notice Provisions
Two recurring contract clauses round out this section. Retainage is a percentage (commonly 5–10%) withheld from each progress payment until substantial or final completion, protecting the owner against incomplete work. Notice provisions require the contractor to give written notice of delays or claims within a set number of days — miss the window and the claim may be waived. Read these clauses as risk-allocation tools the exam tests under "contract administration."