Module 1: Basic concepts in contract farming

http://www.fao.org/in-action/contract-farming
Course on
OPERATIONAL AND LEGAL ASPECTS OF CONTRACT
FARMING SCHEMES
MODULE 1: BASIC CONCEPTS IN CONTRACT
FARMING

Contents
You will better understand:
• Value chain development, smallholders and
agrifood systems modernization
• Contract farming: what, who, how, why
• Pros and cons of contract farming for producers
and buyers
• Contract farming models
• Critical issues for successful contract farming
• Conclusions

1. Value chain development,
smallholders and agrifood systems
modernization

Value chain development
•VC concepts not new, but became dominant
paradigm in development thinking and practice
•Initial emphasis on efficiency, but recent concern
with other dimensions, such as inclusiveness

Why the concern with
inclusiveness in value
chain development?
Region/Country Average
Farm size
(ha)
Smallholder
s (106)
Africa 1.6 33
Asia 1.6 351
Latin America &
Caribbean
67.0 5
Europe* 27.0 32
North America 121.0 —
China 0.4 193
India 1.4 93
Ethiopia 1.0 9
Indonesia 0.9 17
D.R. Congo 0.5 4
World — >500
• Poverty is essentially rural
▫ 70% of the estimated 1.4
billion poor live in rural areas
• Smallholder farming is
predominant and essential
for food security
▫ More than 500 million
smallholder farmers in the
world
▫ 75% of smallholders are poor
•Data include Eastern Europe for farm size only
•Source: von Braun (2005), FAO World of Agriculture, Nagayets (2005), and Altieri
(2009).

Why the concern with
inclusiveness? Region /
Country
Farms with less
than 2 Ha
(%)
ASIA
China 189,394,000 98
India 92,822,000 80
Indonesia 17,268,123 88
AFRICA
Ethiopia 9,374,455 87
Nigeria 6,252,235 74
D. R.
Congo
4,351,000 97
AMERICAS
Mexico 2,174,931 49
Peru 1,004,668 58
Brazil 983,330 21
EUROPE
Russia* 16,000,000 98
Ucraine 6,214,800 99
Romania 2,279,297 58
• Small farms occupy 70 to 80%
of farm land and produce
more than 80% of the world’s
food in value terms
• Worldwide, farms of less than
1 hectare account for 72% of
all farms but control only 8%
of all agricultural land
• Slightly larger farms between
1 and 2 hectares account for 12
percent of all farms and
control 4% of the land
* Less tan 1 ha.
Source: Nagayets, O. (2005). Small Farms: Current Status and Key Trends.

Regional
Distribution of
Small Farms
Data source: Nagayets, O. (2005). Small Farms: Current
Status and Key Trends.
Smallholder farmer - Myanmar Smallholder farmer - Malawi

Why the concern
with inclusiveness ?
• Agrarian structures
▫ Inclusiveness based on the idea of
tapping into already existing structures
in order to avoid obstacles in the
business-environment
• No philanthropy – but good
business sense:
▫ In most countries, small and medium-
sized farms tend to have higher
agricultural crop yields per hectare than
larger farms because they manage
resources and labor more intensively
▫ Consumer responsiveness

Why the concern with inclusiveness?
• Dramatic changes
▫ The “industrialization of
agriculture”
▫ The rapid rise of the
supermarket
▫ The new consumer
▫ Safety and quality standards
• Changes driven by
▫ Demographics
▫ Income growth
▫ Technology advances
▫ Globalization
Livelihoods of smallholder famers under
threat: recent changes in agrifood systems

How to promote inclusiveness?
Four main drivers to link farmers to markets:
▫ Intermediary model
 Commonly led by NGO’s, involve the provision of technical
assistance and agribusiness development to
improve smallholder market linkages
▫ Public driven
 Schools, hospitals, food reserve authorities,
food aid and school feeding programs
▫ Producer driven
 Cooperatives, lead farmers, organized
farmer groups
▫ Buyer driven
 specialized wholesalers, traditional traders
 Contract farming

2. What is contract farming, who is
involved and how does it work?

Contract farming: basic concepts
• What
▫ “Agricultural production carried out according to an agreement between
farmers and a buyer which places conditions on the production and / or
marketing of the commodity”
• Who
▫ Producers
▫ Processors
▫ Traders, retailers/wholesalers
▫ Public institutions, NGO’s
• How
▫ Formal and informal agreements
 Market specifications
 Resource provision
 Production management
• Why?

Why the renewed interest?
• Contracts are not a new concept
▫ references to use in the 19th century in Asia and Latin America
▫ much use in the Americas in the 20th century
• Intensified interest and adoption in the recent past
▫ the USA: from 11% of agricultural production value in 1969 to
39% in 2008; 90% of poultry, tobacco and sugar beet production;
68% of hog production
▫ Brazil: 75% of poultry production under contracts; a new law on
contract farming passed in May 2016
▫ India, Vietnam, Morocco, Malawi, Thailand, etc.: policies to
promote contracts
▫ The literature: extensive coverage; mounting number of
references

Why the growing interest?
• The renewed interest in contract farming is a consequence
of the recent transformations in global agrifood systems
• Changing demand and requirements
• Growing competition in food markets
• Other factors such as demographic changes, technology or certain standards
• Supply chains increasingly need to be better coordinated
• alignment of operations: input provision, production operations, meeting
stringent standards, meeting delivery schedules, etc.

Supply chains in practice: the frozen
vegetable processor dilemma
• How to organize my raw material
supply chain?
▫ Produce my own vegetables?
▫ Buy from farmers?
▫ A bit of both?
Contracts,
Alliances, etc.
External
(markets)
Internal
(full
vertical integration)

2. Pros and cons of contracting to
link smallholders to value chains

The pros and cons of contract farming
•Advantages for agribusiness firms
▫ greater regularity of agricultural product supplies to
the firm
▫ greater conformity to desirable product quality
attributes and to safety standards
▫ access to land is facilitated.
▫ input costs per unit are reduced
▫ access to agricultural credit and eventual financial
incentives and subsidies is facilitated
▫ labour costs are reduced
▫ expansion and contraction of production is facilitated
▫ managerial efficiency in farming may be favoured

•Advantages for farmers
▫ inputs can be provided (less uncertainty regarding
availability, timing, credit, etc.)
▫ services can be provided (mechanization,
transportation, etc.)
▫ technological assistance can be provided
▫ production and management skills enhanced, with spill-
over effects
▫ market outlet is secured
▫ income stabilization is promoted
▫ credit access enhanced (in kind or via banks)
▫ by-products can be used

• Disadvantages for agribusiness firms
▫ risk of contractual hold-ups
▫ transaction costs of dealing with large numbers of
farmers are high
▫ risk of misuse or side-selling of supplied inputs and of
final products
▫ internalization of support service costs
▫ loss of flexibility to seek alternative supply sources
▫ risk of undermining the corporate image

• Disadvantages for farmers
▫ firms might renege on contractual terms if market
circumstances change or if other conditions for
opportunistic behaviour arise
▫ vulnerability to output and productivity manipulation
by agribusiness firms
▫ delivery schedules might be set by firms so as to
influence prices paid to farmers
▫ unintentional lack of transparency in price discovery
▫ loss of flexibility in enterprise choice

• Disadvantages for farmers
▫ former linkages with markets are lost
▫ traditional farming practices lost
▫ risks associated with monoculture are enhanced
▫ social structures might be disrupted
▫ risk of indebtedness grows
▫ risk of dependency on the contracting firm on
non-farming issues

IMPORTANT:
The business environment has to be
carefully assessed in order to ensure
the long-term success of the
contract farming arrangement for
all involved parties.

3. Contract farming models and
the contractual instrument

Contract farming models
• The Centralized Model
▫ A company negotiates contracts with farmers, who supply the
desired agricultural products
▫ Common with commodities such as tea, coffee, cotton, tobacco,
poultry, etc.
▫ Normally, this model offers farmers a high level of technical
inputs, fertilizer/chemical advances and in-field management
through experienced extension officers.
 Fertilizer, chemicals and seed are usually bulk ordered by firms and issued on credit to
their farmers.
▫ In some instances machinery and farm infrastructure linked to
the contracted crop or livestock are also advanced.

• The Nucleus Model
▫ A variation of the Centralized Model in which firms
cultivate crops or raise livestock themselves, but also
negotiate contracts with satellite growers.
▫ Useful for teaching and demonstration purposes when
introducing new crops or animal rearing enterprises to
farming communities.
▫ Popular in Asia for resettlement and transmigration
schemes.

• The Multipartite Model
▫ Jointly involves multiple actors, such as government entities,
farmer cooperatives and sometimes private companies.
▫ Normally each partner has separate responsibilities, such as
finance, management, processing and marketing.
▫ In Mexico and a number of African countries, governments have
encouraged CF in harmony with private sector interests.
▫ In China, multipartite CF ventures are made with village
committees, county governments and overseas private firms.
• Others
▫ Informal model
▫ Intermediary model

The contractual instrument
• Contracts establish the terms and conditions for
the commercial transaction agreed among
farmers and buyers
▫ Characterizes who is involved
▫ Specifies the objective of the transaction
▫ Sets forth a number of clauses specifying what is
expected from the partners
• We will discuss contracts and legal issues in
detail during this workshop

4. Critical issues for successful
contract farming

Maximizing impacts of CF: critical
issues
• Basic principle
▫ Contractual relationships will only be sustainable if partners
perceive that they are better off by engaging in it
▫ Consequence: contract farming will fail if parties do not
develop mutual trust and reciprocal dependency (synergy/
cooperation is the key word)
• The importance of the enabling environment
▫ No successful contracting scheme can exist or remain
sustainable where the institutional and political setting is
not conducive to it

Critical Issues
• Minimization of contractual hold-ups
▫ farmer: enhancement of bargaining power via collective action
▫ firm: group lending; improved communication; quality and scope
of services provided; strict treatment of defaulters; extend
contract duration
• Need to countervail uneven balance of power (an
element of enabling environment)
▫ promote farmers association
▫ third party mediation
▫ legal provisions

More critical issues
• Need to reduce the
transaction costs of
dealing with multiple
contracting parties
▫ work with groups
▫ the preference for larger
farmers
• Need to ensure gender
equality
• Need to promote
environmental concerns

More critical issues
• Appropriate consideration of production and
marketing risks in the design of contracts
▫ some risk sources can be known ex-ante; others not
▫ insurance funds; arbitrage mechanisms
• Choice of enterprise
▫ no a priori exception but: high value, processing and
exports are better candidates
• The legal framework
▫ to be discussed later

In sum
• As agri-food systems change, supply chains will become
increasingly coordinated
▫ Need to deal with new asset specificities and uncertainties
• Contracts are an appealing mode of coordination
▫ Evidence suggests that potential advantages outweigh potential
disadvantages
• But! Contracts are no universal cure: may be ill-advised under
some circumstances
• Good planning, fairness, transparency and sound
implementation are essential
• Need for measures to maximize development impact
▫ A task for all involved!

Module 1: Basic concepts in contract farming

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Module 1: Basic concepts in contract farming