11 November 2002 Risk evaluation not price shown to be determining factor in contract choice

Risk assessment rather than price advantage is the driving influence determining livestock farmers' choice of contract arrangement with meat companies, according to a Lincoln University study supervised by Professor of Marketing Tony Zwart and Senior Lecturer in Farm Management Dr Sandra Martin.

The study, carried out by Master of Commerce candidate Marcelo Monteiro of Brazil, examined "vertical coordination" in the New Zealand beef industry. "Vertical coordination" is marketing jargon for the process of harmonising the various paddock-to-plate stages in the industry's operation.

At one extreme the coordination can be as minimal as "spot market" selling, while at the other end of the scale the coordination can be as comprehensive as a set of specific and detailed requirements binding on all the parties concerned.

Generally speaking, beef industries worldwide have low levels of vertical coordination, and that includes New Zealand's.

In recent years, however, a move towards closer vertical coordination has started to characterise agrifood sectors everywhere, driven by changes in consumer demand, the need to reduce risks related to issues of food safety, requirement of traceability and the desire for assured and consistent year­ round supply without seasonal peaks and troughs.

"The world's meat and grain industries are undergoing tremendous structural change," says Marcelo. "These changes apply to product characteristics, market segmentation, technology use, consumer preferences, size of operation and ownership of resources.

"This process of structural change, referred to as the 'industrialisation of agriculture', is forcing many industries to now create closer vertical linkages."

Between the two extremes of spot market transactions and full "vertical integration" (full paddock-to-plate coordination) there are numerous other ways of conducting business.

The Lincoln University study examined five types of vertical coordination strategy in the beef industry. The five systems are the meat company Schedule System – the most widely used method of livestock buying in the New Zealand beef industry under which price is based on a weekly schedule issued by the meat company – (SCH); Schedule Contracts with delivery date premiums (SCH+); Fixed Price Contracts (FP); and two forms of alternative supply contract arrangements that provide the processor with greater control of the final product (SC1) and (SC2).

New Zealand's red meat industry has traditionally been the country's largest single earner of overseas revenue. All up in the year to June 2002 the meat processing and export sector had a turnover of $6 billion with about $2 billion earned from beef and veal exports. New Zealand was ranked sixth among global beef exporting countries.

Most trading of livestock in New Zealand is conducted on the "spot market" and the degree of coordination within the beef industry is low. Only about 15 percent of total New Zealand beef is marketed through arrangements other than the spot market.

While the "industrialisation of agriculture" has created new opportunities to make value-enhancing and profit-boosting production and marketing arrangements, risk assessment has also come to be identified as a significant element in the overall equation emerged. In his research project Marcelo sought to provide a better understanding of the nature of the economic benefits and countervailing risks.

Marcelo's study set out to provide a framework for producers which would enable them to analyse and compare different types of vertical coordination arrangements taking risk assessment into account. He also identifies the incentives which can influence changes in the arrangements.

The types of contractual arrangements compared in the study were selected to represent general types of marketing options available to the producer.

To assess their performance and behaviour it was necessary to examine the different risks involved in each case and Marcelo used computer simulation models to do this.

There was no intention to rank the arrangements and in fact the study makes no claim to suggest any one system is better than any other. The aim was simply to compare different forms of contract and evaluate their performance under different situations.

The model makes it possible to simulate the expected returns and the variability of these returns for farmers and processors in the export beef industry.

As might have been expected, differences emerged in terms of risks and returns across the five different arrangements. However for most of the contractual arrangements there were not large differences in expected returns.

The difference in expected or average return must be compared with the associated risks. Higher levels of return are associated with higher levels of risk in those returns, says Professor Zwart.

This means that no single arrangement is clearly better than any of the others and that the choice of system comes down to individual attitudes towards risks and returns.

There is of course a wide range of sources of risk that affect agriculture, ranging from weather and pests to legislative changes. Some risks are unique to the sector, for example adverse weather reduces yields such as the growth rate of animals. Some other risks such as marketing and institutional risks are common to all types of business but can have a higher economic cost to farmers, such as through the value of by-products and the level of exchange rates. The main risks in agriculture are however variability in prices and yields.

Vertical coordination produces its own risks too – called contractual or relationship risk and this concerns uncertainty over the continuation of contracts.

Sources of risk are related to each of the dimensions of contracting – price, quantity and other terms of exchange. Therefore the design of contractual arrangements directly influences the amount of risk as well as the distribution of risk among the parties involved.

"It can be concluded then that risks are one of the driving forces for the formation of closer arrangements in agriculture and the source of the risk affects the nature of the contract.

It is a focus on the role of risk in contractual arrangements that distinguishes the Lincoln University study from other vertical coordination studies in the general literature on the subject.

In New Zealand the proportion of beef cattle marketed through contractual arrangements or supply chains is still very low compared to Australia or the United States. Estimates put it in the range of only 10 to 15 percent.

The numbers do however vary significantly from company to company. For example, with Canterbury Meat Packers and Phoenix Meat Company in the South Island forward contracts make up a significant portion of the total cattle slaughter. In addition CMP procures all of its lambs and 85 percent of its bull beef through forward contracts.

The main goal of processors when offering contracts in New Zealand is still guarantee of supply. Consequently deliveries of contracted animals are more common in periods when supply is critical – winter and early spring. In some meat companies like PPCS there is almost no contract trading outside this period.

Supply chain arrangements are new structures for the industry in New Zealand and are only just starting. They have the aim of providing stable, year-round, high quality supply of beef cattle to meat processors.

They are also a response to the increasing demand for more sophisticated products, higher standards of food safety and accountability and greater product "traceability".

Beef's share of total meat consumption worldwide has diminished significantly in the European Union and the United States in recent decades, one reason being the influence on consumers of food safety (e.g. the BSE scare) and environmental issues.

Marcelo believes that the findings of his research could benefit farmers and processors in a number of ways –

"Considering the low uptake of contracts in New Zealand and the presence of adversarial relationships and 'lack of trust' in the meat industry the use of this framework could be an initial step in building better relationships in the industry. An awareness of results and their implications by all parties involved in a vertical arrangement helps participants to create marketing structures with more complete information, thus increasing the likelihood of future success.

"If farmers could look at the results they would conclude that having contracts is not necessarily going to disadvantage farms in periods of low pasture production in the New Zealand beef industry. Comparisons are stable under production extremes for both farmers and processors across the different contractual arrangements.

"In addition, the framework could also be applied to other agricultural industries. It could help to design new value added contracts and analyse actual forms of vertical arrangement in agricultural industries. The principles of identification and quantification of the risks and returns would be the same. However there would need to be a better understanding of the nature and sources of risks of the specific industry."

Professor Zwart stresses that Marcelo's work was not aimed at trying to select the "best" marketing strategy for producers since there is no "ideal" or "recommended" strategy that fits all farmers and processors or even one strategy that fits a specific firm in every situation.

Rather the research provides a mechanism for modelling new forms of contractual arrangement that can provide incentives to change production systems. These are especially important in order to meet higher levels of product specification plus food safety and traceability requirements, he says.

"An important element of success for food industries in the future is an improvement in their capacity to meet consumer demand and add value to the final product," says Marcelo in the conclusion to his study.

"The increase in vertical partnerships around the world is an indication that these two issues are being addressed."

Ian Collins, Journalist, Lincoln University, Canterbury, New Zealand.