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2.5 Vertical Integration of Smallholders Through Contract Farming

Modern forms of contract farming in dairy have been around in Europe since at least the 19th century, as the traditional Danish dairy coop was in fact a form of contract farming. The contract is an institution that reduces the pernicious effects of information and asset asymmetries across market actors, and especially smallholders and those who deal with them. It allows all producers to reduce the transaction cost of selling a perishable product in uncertain or thin markets, and to get higher prices from a buyer who is fairly certain that the farmer will deliver clean, fresh milk on time. The institution also shares risks and captures economies of scale in bulk purchasing of inputs. Dairy cooperatives in India, Brazil, and Thailand have all taken slightly different forms, but they share the common advantage of leaving more wealth to share between producers and processors through the reduction of transaction costs that are a net loss to producers, processors, and consumers combined. While it is clear that the cooperative mode will reduce transaction costs, and that transaction costs are especially high for smallholders, it is unclear if the latter would remain involved without a government subsidy of some form.

More recently, contract farming has appeared in all the study countries in swine and poultry. Within the later, contracts are more common in broilers than layers, but the latter were once prevalent in India when industrial processors required quality control of inputs for specialized industrial outputs, and may be coming back again for the same reason (see Mehta et. al., 2003).

The form of contract varies greatly across countries, regions and commodities. It tends to be driven by four things. First, the changing needs of markets require changing product attributes, and these changing attributes may not be observable at the time of sale (such as food safety). Contracting may permit processors a higher degree of quality control under these circumstances than employer-employee relationships would do. Second, different commodities embody different types of transaction cost, and thus require different forms of institutional solutions. The information asymmetries between market participants in milk sales are fundamentally different than those for swine sales, for example. Third, contract farming is a sharing of risks and benefits between seller and buyer. As such, the precise form it takes depends greatly on the distribution of power (market and political) between buyers and sellers, as does enforcement of contracts. Fourth, some risks may be much easier for large numbers of small-scale producers to bear jointly than one large farm by itself; the risk of environmental pollution penalties are a typical case. The latter has probably impacted more on contracting in the developed countries than the developing ones, but is already becoming an issue in Southeast Asia.

Thus the contracts observed in the country cases differ somewhat across countries and commodities. Forward price contracts for Indian broilers are more informal than in the Philippines, where in turn they are more informal than in Brazil, for example. Nevertheless, contracting addresses the same general issues in each country; the discussion below is drawn primarily from experience in Southeast Asia (see Costales, 2003; and Poapongsakorn, 2003), but is useful for understanding the institutions of the other countries studied.

A contract growing arrangement in broiler and hog production is generally a contract between an "integrator", who supplies the intermediate inputs and procures the output, and a grower, who provides the primary inputs in the production process. The integrator provides the growing stock (day-old-chicks; fatteners), feeds, veterinary supplies and services, and implements the final marketing of the output. The contract grower typically provides the space and facilities (land and housing), manure and dead animal disposal, equipment, utilities, labor (family and/or hired), day-to-day farm management, and deals with the neighbors and local authorities. There are two main types of contracts: fee (or wage) contracts (by animal or by weight) and forward-price contracts (guaranteed or/and with profit-sharing). They differ mainly in the mode of grower compensation, in the accounting and shouldering of the growing stock and feeds, in the need to monitor production activities, and in the need for enforcement of actual deliveries. They also differ accordingly in the incentives, penalties, risks, and the provisions for defaults.

2.5.1 Fee or Wage Contracts for Poultry and Hogs

These contracts are mostly issued by the large multi-national or national integrators; the scale of these contracts is generally around a 'commercial' scale of operations (10,000 birds or more for broilers; 200 heads of fatteners or more for hogs). There are, however, fee contracts that cover as low as 6,000 birds in the Philippines and 4,000 in Southern India.

In fee contracts, the integrator typically fully bears the cost of growing stock, feeds and veterinary supplies and services. Thus, the price of stock and feed are zero from the viewpoint of the grower, possibly leading to a temptation to resell them clandestinely or use them on private stock. The integrator bears all market and production risks. However, the grower typically does not share in the benefits of increasing output prices (nor share in the losses due to falling output prices). Integrators need to monitor production fairly closely, to prevent slacking off by the grower, and diversion of the integrator's inputs such as feed to non-contract uses.

The grower receives a guaranteed a fixed fee for each live animal (in cash per bird or slaughter hog, or in some cases, per kg) that is successfully harvested in a condition that is acceptable to the integrator for the purposes of live sale or slaughter. Payments by kg under some contracts, rather than per head, are designed to give the grower a stake in performance. To ensure effort by the grower, fee contracts also typically have built-in incentive and penalty clauses tied to the grower's ability to meet the integrator's set of specified minimum performance standards. These standards typically refer to feed conversion ratios (FCR), harvest recovery (HR, or percent of live animals harvested), and average live weight (ALW for broilers) or average daily gain (ADG for hogs). Additional compensation to the fixed fee is given to the grower for surpassing each of the performance standards. For growers who fall below the set standards, corresponding amounts per bird or hog are subtracted from the fee.

While fee contracts may be attractive to growers, they have two disadvantages that limit their widespread use with smallholders. First, the onus on integrators to closely monitor production makes this an uninviting option for all but the most locally-based integrators. Second, to be able to participate in fixed fee contracts, a potential contract grower must typically post a bond per bird or head of animal with the integrator prior to engaging in the contract. The most common form of the bond is a cash bond, verifiable as a deposit in a bank or another financial instrument. The average cost of the bond per bird or head of hog is very close to the cost of one day-old-chick in broiler contracts, and to the cost of one head of fattener (weanling) as delivered to the contract grower. If the grower defaults on the contract, the integrator keeps the bond.

2.5.2 Forward Price and Profit-Sharing Contracts for Poultry and Hogs

In price contracts, while the integrator advances the cost of growing stock, feeds and veterinary supplies and services, these are later charged in full to the contract grower at the time of harvest and sale of output, when all costs are accounted for, before compensation is paid. In essence, growing stock and feeds are provided by the integrator on credit. The stock used and feed consumed are, in fact, evaluated at prevailing market prices, with a mark-up imposed for relevant charges (transport to the farm, cost of money for stock or feeds credit). Price contracts are more suitable when close supervision is not possible, as it reduces the incentives to divert integrator inputs to other uses. Four-fifths of Thailand's broiler contracts are now produced under a price guarantee system (Poapongsakorn, 2003). As in wage contracts, market risk is born by the integrator. However, production risk (such as mortality) is now fully born by the grower. The integrator however now has to find ways to deal with the incentive that growers have to default when output market prices rise. In general, the integrator has the exclusive right to choose when and to whom to sell the harvest, as in fee contracts.

Solutions for getting around the problem of grower default when prices rise include a bonus for weight gain (Thailand) and profit sharing (50-50) (The Philippines and India). Possibly greater ability to enforce contracts in Thailand and India may explain the popularity of price contracts in those countries. In the Philippines, price contracts are mostly undertaken by relatively small local feedmillers with contract growers that they know well, with scale of contracts generally around a 'smallholder' scale of operations (in the Philippines for example, less than 10,000 birds for broilers; less than 100 heads of fatteners for hogs).

One important difference for smallholders between price and fee contracts is that there typically are no prior bond requirements for engaging in price contracts, unlike fee contracts. The main deterrent to bad faith on the part of the grower in price contracts is that the cost of stock and feed are to be charged to grower at the end of the cycle, whether the activity makes a profit or not. It is in the interest of both parties that the activity itself generates positive profit.

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