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Delivering producer and buyer benefits with cost of production contracts

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Developing fair contracts for the sale of agricultural raw materials is a complex process which is vitally important for buyers and sellers.  While there are many types of contracts available, cost of production contracts have been shown to benefit both buyer and seller by sharing the price risk and ensuring security of supply.  ADAS has provided independent input to support complex negotiations between producers and processors which has led to improved relationships within red meat supply chains as well as the development of new outlets to market.  This article reviews several case studies based on ADAS experiences with contract negotiation in the livestock sector. 

Delivering producer and buyer benefits with cost of production contracts

Types of contractual arrangements 

Fixed price contract - This is a contract where the payment amount does not depend on resources used or time expended in production, and the price is agreed in advance of production.  These types of contract can provide the producer with certainty and is particularly valuable if producing a product that is very exposed to market fluctuations.  

Cost of Production, Cost plus contracts – There are various types of cost of production contracts including cost-plus fixed fee, cost-plus incentive fee, and cost-plus percentage of cost. In all cases the supplier receives a price for their product that covers cost of production plus a bit more, ensuring sustainable profitability of their business. 

Spot Market Sales – The price is determined on the day with no contractual obligation.  Here the producer has complete flexibility regarding sales, but market fluctuations mean that it can be a ‘feast or famine’ situation.

Cost of Production contracts – benefits and risks

Cost of production type contracts have proven their worth where there are strong working relationships and trust along the supply chain and as such have many benefits.  For raw material buyers, cost of production type contracts can help develop better relationships with suppliers, aids

control over product quality standards and can improve the ability to plan ahead.  Paying a price that covers production costs helps demonstrate good corporate responsibility to consumers. 

If set up from a base of trust and genuine farmer engagement, producers have much to gain from contracts that are based on their cost of production.  Principally, their risk is covered by the buyer, ensuring labour, materials, supplies, equipment and overheads are covered within the price they are paid, which is especially beneficial if there is an element allowed for profit.  Farmers are incentivised to supply on time ensuring the output meets the required quality standards and may also be encouraged to conform to other buyer requirements such as enhanced biodiversity or reduced carbon footprint. Overall this ensures a sustainable, profitable business plan for farmers which limits risk and promotes greater resilience to ensure security of supply.

Cost of production contracts however, are not without risks.  Buyers take on an element of the price risk which may mean paying more than their competitors in some cases.  Also, developing fair cost evaluation systems is time consuming as formulas must be regularly adjusted to ensure calculations reflect current market conditions.   For producers, cost of production contracts can restrict profitability meaning that producers may miss out on global market price increases.  

Calculations are complex

While cost of production type contracts offer benefits to producers and buyers, developing formulas that are appropriate for a wide range of producers over a broad geographic spread is complex and often leads to conflict between buyer and seller.  The diversity of agricultural businesses means that costs vary enormously between farms even where they have similar production systems, with land ownership, labour and machinery policy all impacting on the costs of production. 

In most cases where cost of production contracts are used, an independent third party is called in to pull together data on cost of production based on geography and farming system to form the basis of price.  Producers and retailers have appreciated the impartial nature of a trusted, independent third party to manage price calculations and negotiations between players.  ADAS is well positioned to supply this independent advice to producers and processors to support contract negotiations.   

In order to get producer engagement, the farmer needs to see that the data set used to establish the contract is a realistic average for that sector, rather than just from top performing businesses.  The supply chain concerned needs to provide a robust rationale why there are added benefits from using  own data, rather than merely basing it on the farming figures already in the public domain such as the annually updated Farm Business Survey and levy body statistics.

Cooperation in the lamb sector

The steep decline in farm gate prices within the lamb sector in early 2015 created increased pressure on farmers, many of whom are questioning whether their business model is sustainable and feasible going forward.  Several of the major retailers have set up dedicated lamb producer groups in recent years to ensure they are able to achieve their commitments to source more high quality British lamb and to extend the season as long as possible.  For the producer these groups offer a more secure market outlet for their supply, give clarity to required specifications and can give some bargaining power to producers in setting price. 

The National farmers Union (NFU) and the farm press have recently reported[1] on Tesco’s move to introduce a cost of production lamb contract. The retailer has been in discussions with farmers in Wales and although a formal written contract or details for the cost of production lamb contract have yet to be finalised, it is promising to see that steps are being taken to develop ways of providing sustainable pricing structures for British lamb producers.  Tesco already runs a Sustainable Lamb Group which pays a premium above the market price for lamb, for a limited number of producers.  

Red meat processors Dunbia are currently working with Cambrian Mountain Lamb producer group to achieve a number of objectives which include: establishing weight specifications and developing contract prices.  ADAS is working closely with Welsh lamb producers to secure existing, and develop new value added contracts for light lamb (15 kgs) and has been instrumental in developing improved reporting arrangements.  Finding new markets in the UK for light lamb which is a niche product, has meant fewer producers being disadvantaged by unfavourable exchange rates, as much of the light lamb from Wales is otherwise exported.

Improving trust, reducing wastage and generating premium prices in the beef sector

There are some good examples in the beef sector where producer groups provide a forum for price and quality specification discussions to take place.  The beef sector, well known for the lack of vertical integration and fiercely independent producers, has much to gain from improved communication of quality requirements and the establishment of fair pricing.  Some of the well -established retailer and processor led producer groups include:

  • Dovecote Park/Waitrose,

  • Dunbia/Hereford and Aberdeen Angus Schemes,

  • Sainsburys Beef Development group,

  • ASDA/Beef Link (ABP).

These relationships have helped to improve trust between producers and processors lessening producers’ concerns that processors aim to impose ever lower prices, and dispelling processors belief that beef producers are inefficient.  Working together can help create mutual trust and more of an appreciation of how each business operates.

ADAS has recently begun to work with a small group of beef producers to negotiate on pricing and specifications.  New relationships have been formed with wholesalers in lucrative London markets.  With farmer engagement at the contract negotiation stage, it has been possible to secure a contract that generates a premium price for the producer, and the wholesaler gets a product that meets their precise specification.  The high level of farmer-wholesaler engagement results in a very active relationship dialogue.  In this situation, the farmer group priority was to sell on a whole carcase basis, in order to reduce wastage, maximise returns and to ensure a direct relationship with the customer. 

Benefits and risks of cost plus contracts in the dairy sector

Though more vertically integrated than the red meat sector, the dairy sector has also struggled with poor supply chain relationships.  One example of where cost plus contracts have benefited both seller and buyer is in the dairy industry, where the removal of EU milk quotas, world market volatility and shrinking producer and processor numbers have all posed threats to the dairy industry.

Milk prices in the UK have fallen rapidly, from 34.6p/litre in November 2013 to just 24.1 p/litre in May 20152. This has resulted in many farmers unable to survive as production costs outweigh the farm gate price received.  This has led to significant re-structuring in the dairy industry as farmers in England and Wales have declined by 37% in the last decade to 9,800 producers3.

Some retailers have responded to this trend through implementing contracts based on calculated cost-of production, ensuring that suppliers receive a market price which at least covers their costs. Most of the major retailers have established dairy producer groups who are able to provide cost of production data and who provide a negotiating forum for establishing milk prices.  The number of producers involved in the various retailers’ dairy producer groups varies from just over 100 to more than 600 dairy producers. However, the dairy sector continues to struggle with pressure on prices as non-aligned dairy producers receive significantly lower prices for their milk. 

Prices received by dairy producers was highlighted in Agriculture and Horticulture Development Board (AHDB) Dairy research that shows the annual average milk prices paid to a small majority (~1%) of farmers by certain retailers was around 30-34p/litre4 in the last year - enough to cover costs with a small profit.

Each supply chain is different so it is important to understand the specific needs and issues to be addressed and the value that might be gained from working together to balance the needs of buyers and sellers through fair contractual arrangements.  ADAS consultants are experienced in managing complex contract negotiations between stakeholders.  ADAS provides a unique blend of in-depth knowledge of agricultural systems and business practices and is well respected in the farming community and in the agri-food sector which makes us a trusted partner for impartial contract negotiations. 

For more information on ADAS’s work with producer groups on contract negotiations contact Leslie Berger leslie.berger@adas.co.uk

References

1http://www.nfuonline.com/news/latest-news/blog-tesco-signals-commitment-on-british-lamb/?utm_campaign=general&utm_source=twitter&utm_medium=social

2https://www.gov.uk/government/statistics/uk-milk-prices-and-composition-of-milk

3http://dairy.ahdb.org.uk/market-information/farming-data/producer-numbers/uk-producer-numbers/#.VbdcDfmYa00

4http://dairy.ahdb.org.uk/market-information/milk-prices-contracts/milk-calculator-and-contracts/league-tables/

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