hid. Jn. ofAgri. Econ. Vol. 58, No. 3, July-Sept. 2003 Role and Constraints of Contract Farming in Agro-Processing Industry

S.R. Asokan and Gurdev Singh*

The value of commerce in processed foods exceeds that of basic agricultural commodities by several magnitudes (Henderson et al., 1998). Though bulk of this trade takes place in developed countries and dominated by a few multinational firms the demand for processed food in the developing countries is increasing in recent years due to rapid urbanisation and changing lifestyles. The growth in agro- processing has a big potential to trigger development in other sectors of the economy through multiplier effect. It can create jobs away from farms and processing units in sectors like transportation, distribution, retailing, etc. Apart from the forward linkages such as processing and marketing agro-industries help to create backward linkages by supplying credit, input and other services to primary producers. However, in many developing countries the potential is hardly exploited. It is estimated that only 2 per cent of the fruits and vegetables produced in India are processed. It is believed that 40 per cent of fruits and vegetables go waste (CII and Mckinsey, 1997). In order to tap the vast potential of the sector to increase employment and income, the Government of India initiated various policy measures to boost private investment in the sector. Since economic liberalisation in 1991 investment proposals to the tune of Rs. 73,445 crores in the food processing sector have been approved of which Rs. 10,167 crores were foreign investment. However, not in all the projects that have been approved actual investment had taken place. There are several reasons for the delay in the • investment. One of the important reasons is the difficulty in procuring quality raw materials due to poor infrastructure for marketing of agricultural produce and the chain of middlemen between the producers and the processors. Procurement ofRaw Materials Most often the processors of agricultural commodities require a qualita- tively homogenous product but agricultural output is characterised by seasonality, perishability and variability. As most of the agricultural commo- dities go through a specific product cycle they are available in a particular season. Since most of them are perishable and cannot be easily stored, extending their supply in fresh form beyond the season is not possible. However, the demand for agricultural commodities is throughout the year. Some minimum quality has to be maintained to

* Research Associate and Professor respectively, Centre for Management in Agriculture, Indian Institute of Management, Ahmedabad-380 015 (Gujarat). ROLE AND CONSTRAINTS OF CONTRACT FARMING IN AGRO-PROCESSING INDUSTRY 567

cater to this demand through proper storage, processing, etc. Therefore, it is imperative that agro-processing firms procure raw materials in time, in right quantity and quality. In the twenty-first century customers and suppliers cannot be taken as independent entities; they form an integral part of the network. There are several players involved in fulfilling the needs of the consumer, viz., farmers, traders, transporters, processors, retailers, etc. (Figure 1). These separate organisations are linked with materials, information and financial flows. Supply chain management is a

Input Farmers Traders Processors <1. Distributors Consumers suppliers and Dealers and Exporters Retailers

Figure 1. Supply Chain in Agribusiness task of integrating organisational units along a supply chain in order to fulfill the customer demands with the aim of improving competitiveness (Stadtler and Kilger, 2000). If the supply chain is not managed properly the delivery chain is automatically affected, resulting in customer dissatisfaction and lost business (Sahay, 2000). In fact the success of a processing fin-n depends on its ability to manage the supply of , raw materials with certain specifications to meet the demand of its clientele. However, the quality attributes of a product demanded by the consumer have been increasing in complexity. From storability and prolongation of shelf life to nutritional standards to flavour to convenience and to health promoting nature the quality attributes are constantly evolving. Apart from the intrinsic qualities such as flavour, texture, appearance, shelf life and nutritional value, extrinsic factors that is the production system such as pesticide used, genetically modified- organisms, processing methods, packaging, etc. contribute to the quality demands of the consumer (Jongen, 2000). "Quality is to meet the expectations of the consumer." There is no average consumer but a specific consumer who has certain specific wants that needs to be fulfilled. Therefore, the primary focus of agribusiness firms is to identify the needs of the consumers and gear their supply chain to meet them with minimum cost. Technological advances have provided the food industry with methods required to meet the complex needs of the consumer. Apart from increasing domestic demand for processed food in recent years due to rapid urbanisation and changing life styles the huge export market can be tapped by the developing countries. The trade between developed and developing countries in agriculture is increasing. This growing trade had raised concerns about the safety of the products traded. There are some anxieties about pesticide residues in foods, on genetically modified crops, etc. The growing movement of people, live animals and food products across borders, rapid urbanisation, changes in food handling and the emergence of new pathogens or antibiotic resistance in pathogens all constitute to 568 INDIAN JOURNAL OF AGRICULTURAL ECONOMICS

increasing food safety risks (Unnevehr and Hirschhorn, 2000). Therefore, developed countries prescribe exacting standards of quality for imports of agricultural commodities and processed food from developing countries. The WTO Agreement on Sanitary and Phytosanitary (SPS) measures is in accordance with food safety and food standards set by the Codex Alimentarius Commission (CAC). An important component of the CAC guidelines is the implementation of food safety system called Hazard Analysis of Critical Control Point (HACCP). HACCP is widely recognised in the food industry as an effective approach to establish good production, sanitation and manufacturing practices that produce safe food. HACCP systems establish process control through identifying points in the production processes that are most critical to monitor and control thus enabling direct corrective actions. Developing countries need to incorporate this food quality system in their food processing units, else the SPS agreement can act as a non-tariff barrier for their exports (Deodhar, 2001). Procurement Alternatives The objective of an agribusiness firm is to procure the raw materials for processing in right quantity, right quality with minimum cost and in time. An agribusiness firm has the following procurement options: (a) open market (b) to produce themselves (corporate farming) and (c) produce under contract farming (Figure 2).

OPEN MARKET

If processors requirements of raw material in terms of right quantity, right quality and in time at reasonable cost are met by the primary or secondary markets, open market purchases is the ideal option of procurement. However, this does not happen because price is the primary co-ordination mechanism in the open market. Price signals become fuzzy in the channel and hence a poor guide to the growers. The presence of large number of intermediaries in the supply chain results in the weak transmission of market signals about price and quality to the farmer. The middlemen essentially pool the available surplus from the farmers paying little attention to quality. Consequently, the processors often find it difficult to get good quality raw materials in sufficient quantity. On the other hand, the farmers who produced quality raw materials are not adequately rewarded for their efforts. Hence, there are wide variations of quality in the product not only in different markets but also in different lots in the same market. In such a scenario, the search and information cost for the firm to acquire the right quality and quantity would be high. Further, the firm may incur bargaining and decision costs on each transaction. Still there is always the risk of procuring inferior raw materials despite best efforts. Therefore, ideally, the processors themselves should produce the necessary raw materials by vertical integration. ROLE AND CONSTRAINTS OF CONTRACT FARMING IN AGRO-PROCESSING INDUSTRY 569

Agribusiness enterprise

Open Contract Corporate market farming farming

V Contract Own Primary Trade farmers production market

V

Simple Resource Product contract providing specification

Figure 2. Procurement Options for an Agribusiness Enterprise

VERTICAL INTEGRATION(CORPORATE FARMING)

Under vertical integration the firm can produce the required raw materials by acquiring or leasing in sufficient land. This could enable the firm to have complete control over production from sowing to processing. Apart from the right quantity and quality of materials vertical integration helps in the logistics such as arranging transport, scheduling, processing, etc. thus adding to the competitiveness of the firm. However, organisational constraints in many cases would not allow such an arrangement. A firm may be interested in concentrating in its core activity say processing and may look for other means of procuring raw materials. Cost of production may be high in corporate farming because unlike in family farm where family labour is the residual claimant on production in corporate farming labour becomes a factor of production and is entitled for wages and other benefits. 570 INDIAN JOURNAL OF AGRICULTURAL ECONOMICS

Production risk due to poor weather, disease, etc. is borne by the company under vertical integration whereas in a family farm these are borne by the farmers. Plantation estates with processing facilities established mostly during colonial period may no longer be possible due to changed socio-political environment. In many countries including India land is a politically sensitive issue, therefore land ceiling legislation were enacted to prevent acquisition of large tracts of land by individuals or firms. Hence, instead of vertical integration, vertical co-ordination or contract farming is an ideal solution for firms to procure the required raw materials.

CONTRACT FARMING

In contract farming a processing unit purchases the harvest of independent farmers under certain pre-negotiated terms and conditions on price, quantity, quality and input supply. It enables the firm to ensure a steady supply of the desired raw materials. Roy (1963) defines contract farming as those contractual arrangements between farmers and companies whether oral or written specifying one or more conditions of production and/or marketing of an agricultural product. This definition was considered too broad as it included marketing or forward contract. Contract farming needs to be distinguished from such simple marketing contracts. Little (1994) provide a more comprehensive definition of contract farming. They define it as a "form of vertical coordination between growers and buyer processors that directly shape production decisions through contractually specifying market obligations such as value, volume, quality and at times price, provide specific inputs and exercise some control at the point of production." Thus, contract farming or vertical co-ordination stands between open market and the vertically integrated agribusiness firms. The advocates of contract farming view it as a dynamic partnership between agribusiness companies and small farmers that benefit both without sacrificing the rights of either. It is offered as a vehicle for the transfer of technology and the modernisation of peasant small holdings. However, critics allege that it would lead to disruption of subsistence production and the inevitable impoverishment of the rural poor. It has been criticised as being a tool for agribusiness firm to exploit an unequal power relationship with growers (Key and Runsten, 1999). Clapp (1994) refers to contract farming as a "form of disguised proletarization" as it secures the farmers land and labour while leaving him with the formal title for both. The control exercised by the company is indirect but effective, the "farmer'' control is legal but "illusory" making him a "propertied labourer." Contract farming is fundamentally a way of sharing of risk between the firm and the farmer, however, the distribution of risk depends heavily on factors like bargaining power, availability of alternatives and access to information. Contract farming as a corporate strategy requires that the farmers may remain a source of reliable and inexpensive raw materials. In case these materials become ROLE AND CONSTRAINTS OF CONTRACT FARMING IN AGRO-PROCESSING INDUSTRY 571

either unreliable or expensive the company would have to find a more effective way to maintain its control over the farmers. Successful contract farming arrangements require a long-term commitment from both the parties, i.e., the agribusiness firm and the farmers. Exploitation of the farmers by the firm would result in breakdown in supplies jeopardising the investments made. Similarly, farmers should not be tempted by occasional spurt in prices in the open market and honour their commitment in the contract which would be beneficial in the long-run. There are several types of contract farming from just buying certain quantity at a pre-determined price to having complete control over production from supply of seed to harvesting. Broadly speaking, there are two types of contract, viz., marketing and production contracts. Marketing contracts refer to a oral or written agreement between a contractor and a grower that sets a price and an outlet for the commodity before harvest or before the commodity is ready to be marketed. Most management decisions remain with the growers since they retain ownership till the final disposal of the commodity. The producer bears all the risks of production but share price risk with the contractor. On the other hand, production contract specifies in detail the quality and quantity of a particular commodity to be procured and the type of compensation the producer would receive for his efforts. In a resource providing contract the firm may supply all the inputs to the growers. In a product specification contract as the firm closely monitors the quality produced and the production practices it followed tends to dominate the terms of the contract. The type of contract depends on the nature of the crop, the company's objective, area of operation, etc. Contracting out production is a commercial decision to facilitate adequate supply within a designated period at an economic price (Easton and Shepherd, 2001). The merits and demerits of various procurement options are depicted in Table 1.

TABLE 1. MERITS AND DEMERITS OF PROCUREMENT OPTIONS

Price Quantity Quality Timeliness (I) (2) (3) (4) (5) Primary market Low Uncertain Uncertain Low Secondary market Low Uncertain Uncertain Low Corporate farming High Certain Certain High Contract farming Low Certain Certain High

Apart from facilitating the firm to procure raw materials in right quantity, quality and in time contract farming offers other advantages to it. If a firm wants to introduce new production techniques to increase production or impart other characteristics like aroma, flavour, etc. into the product it can be done relatively easily with contract growers compared to others where the adoption rate of the technique would be slow. The contract farmers are more likely to take up new techniques introduced by the firm rather than the government extension machinery as they are aware that the interest of the firm is at stake in the technique. Therefore, contract farming helps an 572 INDIAN JOURNAL OF AGRICULTURAL ECONOMICS

agribusiness enterprise in incorporating changes in the market place to the product through the new production techniques or practices at a relatively faster pace. The concern about pesticide residues, genetically modified organism in food is increasing among the consumers. Therefore, the processors and retailers are worried about the legal liability for the quality of the products they buy. 'Due diligence' provisions require them to be able to trace the quality problems back to their source which may be the farm or even supplier of inputs (Schaffner et al., 1998). Contract farming enables the firm to trace the problem to its origin. As the firm is assured of regular flow of supply and fairly knows the quantity and the time of its arrival, it helps in managing the inventory of other supplies like packing materials, preservatives, etc. thus enabling the firm to reduce the overall cost and increase its competitiveness. The major advantage to the farmer in contract farming is that he is insulated against volatility of the market and assured of a stable price. The responsibility of the farmer is less and he has to make fewer decisions regarding production. In many cases, the farmer is supplied with necessary inputs such as seed, fertiliser, pesticides, etc. This reduces the working capital needs of the farmers. The farmer gets good technical advice of the company staff. There is often spillover effect of the extension advice as the farmers use the knowledge acquired to other crops to improve productivity or prevent pest or diseases attack. The farmer is freed from marketing hassles as most firms take delivery of the crops at the farm gate. The major risk for the farmer is that he is entering into a new type of production relation may be without full information about the company, the crop and techniques. The difference between the yield promised and the actual yield realised may be quite wide. Companies may fail to honour their contract due to their incompetence in planning, marketing, etc. The problems in other areas like marketing, processing, getting supplies, etc. may affect the company's ability to honour its commitment to the farmers who are affected for no fault of theirs.

CONTRACT FARMING IN INDIA

In India, contract farming can be traced back to colonial period when commodities like cotton, indigo, etc., were produced by the Indian farmers for English factories. Seed production has been carried out through contract farming by the seed companies quite successfully for more than four decades in the country. However, the concept of contract farming has come a long way from such origins. In the last couple of decades contract farming is viewed as a tool to provide technology, extension service, credit, etc. to the farmers. It is perceived as a mutually beneficial arrangement between the firm and the farmer by the governments and international aid agencies. The New Agricultural Policy of 2000 announced by the Government of India sought to promote growth of private sector participation in agribusiness through contract farming and land leasing arrangements to accelerate technology transfer, ROLE AND CONSTRAINTS OF CONTRACT FARMING IN AGRO-PROCESSING INDUSTRY 573

capital inflow and assured market for crops. There are several agricultural and horticultural crops such as tomatoes, potatoes, chillies, gherkin, baby corn, rose onions, cotton, wheat, basmati rice, groundnut, flowers, medicinal plants, etc. produced in some form of contractual arrangements with the farmers in India. Big corporate houses such as Hindustan Lever, Pepsi Foods, A.V.Thomas, Daburs, Thapars, Marico, Godrej, Mahindras, Wimco, etc. undertake contract farming for many crops apart from several small players. Broiler chicken production in Tamil Nadu is entirely under contract arrangement. Though many of them follow a bilateral contract arrangement between the firm and the farmers there are tripartite, multipartite arrangements as well. For example, Rallis organised wheat production in Chattisgarh under contract farming. State Bank of India took care of the credit needs of the farmers by treating the contract as collateral. The wheat was supplied to Hindustan Lever for processing and marketing. Marico Industries in their scheme to procure safflower seeds in Maharashtra retained the commission agent but his role was changed to that of the company representative for this crop: The idea seems to be to use the resources of the agent such as his license, labour, space, etc. instead of investing on such resources on their own. Daburs had taken forest lands in some states on lease from state governments and through the tribal community produced several medicinal plants. Their contract was with the community and the community in turn decided the individual's share. Thus, there are several variants of contract farming emerging depending upon the crop, the company's objective, local conditions, market regulations, etc. Constraints in the Contract For the neoclassical economists and proponents of agribusiness the contract ensures a sort of mutualism between the parties. Freely entered into the contract allows growers to make better use of their specific endowments in imperfect markets and to arrive at combinations of income, effort and risk reflecting their resources and tastes (Little and Watts, 1994). The relationship between the firm and the farmer in a contract would be smooth when both are locked in asset specific investments. The reason why asset specificity is critical is that once the investment has been made the buyer and seller are operating in a bilateral (or quasi-bilateral) exchange relation for a considerable period thereafter. In as much as the value of highly specific capital in other uses is much smaller than the specialised use for which it has been created the supplier is effectively locked into the transaction. The buyer, on the other hand, cannot turn to alternative sources of supply and procure the item on favourable terms. The buyer is therefore committed to the transaction as well. Accordingly where asset specificity is great, the buyer and seller make special efforts to design an exchange relation that has good continuing properties. Such investments are hostage to each other to a large extent. As the survival of both parties is closely linked the contract is self-enforcing. For example, certified seed production is carried out under contract for more than four decades in India quite successfully. The seed growers are not in a 574 INDIAN JOURNAL OF AGRICULTURAL ECONOMICS

position to exploit the market by diverting the produce and the firm cannot renege on the contract, as it had to run the processing plant on which it had made huge investment. Sharing of the transaction cost advantage between the firm and the farmers is the crux of contract farming. The distribution of this advantage depends heavily on factors like bargaining power, availability of alternatives and access to information. The advantage to a party in any one of these factors ex-post that is after the investment has been made leads to its opportunistic behaviour which is defined as unanticipated non-fulfillment of a contract (Williamson, 1986). This leads to strains in the contractual relationship and may result in failure of the contract. In agribusiness an ex-post advantage for one party can arise in various ways such as change in weather affecting production,. price, change in technology, changes in consumer preference due to emergence of alternatives. These changes may not be comprehensively anticipated and built into the contract. In plantation and horti- cultural crops where the economic life is a couple of decades it is not possible to anticipate all the contingencies. This is called 'bounded rationality', that is, economic actors though rational are not hyper-rational. They experience limits in formulating and solving complex problems and in processing information. The incompleteness of the contract may lead to ex-post opportunistic behaviour of one party. When an agribusiness firm is not an exclusive buyer of the commodity (monopsony)the farmers behave opportunistically. The situation can arise when there are rivals in the market or the commodity has alternative uses. For instance, tomatoes produced by the farmers for a processing firm under contract in Punjab were diverted to the open market when the prices were high and the farmers supplied the entire quantity to the firm when they were lower. When many farmers indulge in such practices it is not prudent to drag all the farmers to the court as it would affect the future goodwill in the area of operation of the firm. Likewise there are several instances in which the firms renege on contract. For example, a popular chocolate manufacturer introduced cocoa farming in Kerala promising certain price, a match manufacturer entered into contract growing of poplar trees, a paper unit entered into contract with farmers in Karnataka for bamboo production. As the farmers were trapped in the contract with huge investments these firms tried to exploit the farmers by reneging on their commitment. The imposition of quality standards provides opportunities to abuse grading and pricing procedures. Glover (1984) found many unethical practices in grading and taking delivery of the products by an agribusiness firm in Latin America. If a firm is in a monopoly position due to location, the structure of the market or human capital investment, it presents an opportunity to extract economic rent from the producers by exercising market power (Hennessy, 1996). Roth (1992) listed out ten ways in which firms exploit the poultry growers in the United States. ROLE AND CONSTRAINTS OF CONTRACT FARMING IN AGRO-PROCESSING INDUSTRY 575

Third party assistance in resolving disputes had advantages over litigation. Co- opting the non-government or local community organisation at the time of contract would help prevent exploitation of the farmers by the firm. These organisations can monitor the enforcement of the contract by the firm and bring to notice any violation to the appropriate authorities. Otherwise they themselves can act as ombudsman in monitoring the contract. They can also take up the violation of the contract by the farmers and initiate remedial action to prevent recurrence of such violation thus avoiding litigation and other legal recourse by the firm. Harmonising the interest of both the parties would prevent them from pursuing antagonistic sub-goals, which are detrimental. Therefore, the solution to the opportunistic behaviour must be found within the framework of the contract. The firm may include innovative pricing policy to prevent the diversion of the product. It may introduce bonus schemes to encourage farmers to supply certain quantities, reward the loyal farmers, etc. In short, farmers must be convinced that the firm is interested in a long-term relationship with them. For the contract farming to be successful agribusiness firms must treat the farmers as partners rather than view them as mere suppliers of raw materials who are at their mercy. The farmers must feel that the company will reward them appropriately for their efforts. For example, Benziger (1996) found in Lam Nam Oon province of Thailand an agribusiness firm writing off loans and costs of inputs supplied if the crop failed through no fault of the farmer. Some farmers even reported having received a small payment in the case of natural disasters as encouragement for the farmers to continue in the subsequent season. This signals a long-term commitment of the company in the growers and their develop- ment. This will reinforce the trust and result in mutual benefits. Contract farming is emerging as an important tool of procurement for agro- processing fin-ns. This is more so in situations of market failure. However, there are several constraints in the functioning of the arrangement. These need to be addressed to make the contract farming mutually beneficial to the firm and the farmers.

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