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2.5 Vertical Integration of Smallholders Through Contract Farming


2.5 Vertical Integration of Smallholders Through Contract Farming

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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

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

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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