Module 1 basic concepts

http://www.fao.org/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!


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Module 1 basic concepts

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