Originally published as PIH-6.
Authors: John D. Lawrence, Iowa State University; Marvin Hayenga, Iowa State University; James Kliebenstein, Iowa State University; V. James Rhodes, University of Missouri
Reviewers: John C. McKissick, University of Georgia; Dale Lattz, University of Illinois; Kevin and Audrey Rohrer, Manheim, Pennsylvania; Clem E. Ward, Oklahoma State University
There is increasing interest in hog contracting, due in part to the difficulty for many producers to obtain adequate financing. Contracting also is being used to coordinate pork production from genetics and nutrition to the retail meat counter. Currently, a small but growing percentage of hogs are produced, fed, or marketed under contract. It is estimated that about 14-16% are under production contracts, and a smaller percentage under marketing contracts.
Forward pricing (marketing) contracts for market hogs have been available from most major meat packers for a number of years. They are the most commonly used marketing contracts in the industry.
Production contracts for market hog finishing are relatively new but are increasing in the Midwest. However, they have been used for some time in portions of the Southeast where contract hog production is more widely accepted. Feeder pig production contracts are not as popular in the Midwest. The following is an overview of the most common contracts in the pork industry.
The forward sale contract is a contract between a buyer (normally a meat packer or a marketing agent) and a seller (normally a producer), where the producer agrees to sell, at a future date, a specified number of hogs to a buyer for a certain price. The buyer normally will have taken an opposite position in the futures market to offset any price fluctuations between the signing of the contract and the delivery date. To cover margin and commission, the contract price offered by the packer may be lower than futures adjusted for expected basis. Terms typically found in a forward contract include:
The producer retains all production risks, other than the selling price, under a fixed price forward sale contract. A producer uses a forward sale contract to reduce the risk of price fluctuations and to lock in an acceptable selling price. While the forward sale contract allows the producer to lock in a particular selling price, it may cause him to miss out on greater profits if prices rise. Thus, the decision to contract must be based upon each producer’s willingness or ability to bear the risk of price uncertainty. Some producers may be forced to contract due to a lack of diversification, indebtedness, or at the request of creditors, while other more financially stable or diversified producers may be in a better position to withstand the risk of price movements.
Price risk may be reduced by hedging in the futures market. A marketing contract may be preferred to hedging for the following reasons.
A floor price contract is a variation of the forward sale contract, however it is not as widely used as the forward sale contract. The seller agrees to deliver a specified number of hogs to a buyer at a future date and the buyer guarantees the seller a minimum price (the floor price) for his hogs. Usually, the seller receives the higher of the floor price or market price at delivery minus a discount. The discount compensates the buyer for the costs (options premiums and other variable costs associated with the contract) of providing the guaranteed minimum price. Both the forward fixed price contract and floor price contract reduce only the risk of hog price fluctuations. The producer must still bear the other risks associated with hog production.
Typically, feeder pig marketing contracts are between a marketing agency, often a cooperative, and a pig producer, where the marketing agency agrees to market the pigs for the producer in exchange for a fee.
A marketing contract might contain the following provisions:
Producers are essentially hiring marketing expertise to enhance their market prices and minimize the time and effort of locating buyers for their pigs.
To expand more rapidly their own production, many larger producers use contract production as a way to hold down risk and capital required. Investors, feed dealers, farmers, and others often are interested in producing hogs, but are unwilling or unable to provide the necessary labor, facilities, and equipment. Therefore, they search out producers who are willing to furnish the labor and equipment in exchange for a fixed wage or a share of the profits. The resulting contacts, between owner and producer, vary considerably in form and responsibility of each party involved. These contracting arrangements are attractive to young or financially strapped producers and would-be producers who do not have the capital to invest in a herd, and for producers with under-utilized facilities.
There are three basic types of hog finishing contracts offered, each with variations on payments and resources provided.
Option 1: A fixed payment contract guarantees the producer a fixed payment per head as well as bonuses and discounts based on performance. Under a fixed payment contract for finishing hogs, the producer normally provides the building and equipment, labor, utilities, and the necessary insurance. The contractor supplies the pigs, feed, veterinary services and medication, and transportation. The contractor usually provides a prescribed management system and supervises its conduct. The contractor, as the owner of the hogs, does the marketing. The producer often receives an incoming payment based on the weight of the feeder pigs when they come into the producer’s facilities. For example, $5 for a 30lb pig and $4 for a 40lb pig. The remainder of the producer’s payment is made when the hogs are sold. The method of calculating base payment varies by contract. Some contracts offer a fixed dollar per head regardless of the weight gained. Other contracts pay a fixed amount per pound of gain based on pay-weights in and out of the facility. Others pay a fixed amount per head per day spent in the facility.
Most contracts contain bonuses for keeping death loss low and improved feed efficiency, as well as penalties for high death losses and unmarketable animals. Producers should have control over factors that impact their bonuses and penalties. For example, the right of refusal on obviously unhealthy pigs, or to negotiate a more lenient bonus schedule for multiplesource pigs. Contract payment methods typically range from a low base payment with high incentive bonuses to a high base with relatively low bonuses.
Option 2: Directed feeding by a cooperative or feed dealer that contracts with a producer to finish-out hogs. The contractor’s objective when entering into a directed feeding contract is to increase feed sales and secure a reliable feed outlet.
The contractor provides the feed and some management assistance and typically directs the feeding program. The contracting firm often will purchase the feeder pigs, in which case profits from the sale of the hogs are shared as discussed below; or it will help the producer obtain financing to purchase the pigs. The producer agrees to purchase all feed and related services from the contractor and is responsible for all costs of production. The producer receives all proceeds for the sale of the hogs minus any outstanding balance owed to the contractor.
Option 3: In a profit sharing contract, the producer and contracting firm divide the profit in proportion to the share of the inputs provided by each party.
Typically, the producer-provides the facilities, labor, utilities, and insurance for his/her portion of the profit. The contracting firm normally purchases the pigs and is responsible for all feed, the veterinary services, transportation, and marketing expenses. Over the duration of the contract, the contractor’s costs are charged to an account. This account balance is then subtracted from the sale proceeds to determine the profit. The contracting firm often will use its own feed and provide management assistance. The producer is normally guaranteed a minimum amount per head as long as death loss is below a set percentage. For instance, depending on contract terms, the producer may receive $5/head if death loss is 3% or less and $3/head if death loss is over 5%. The producer receives this payment regardless of whether a profit is made. The contractor’s return depends upon the profit made on the sale of the hogs and the gain received from the markup on feed, pigs, and supplies provided.
Through contracting, producers are able to achieve more stable returns, trading the possibility of large profits for the assurance of a more reliable return. Many producers enter into contracts because they either lack the capital or they do not wish to tie up a large amount of capital in hog production.
Feeder pig production contracts come in several forms.
Option 1: The producer provides everything but the breeding stock and bids what he is willing to produce a feeder pig for, based on production criteria such as pigs weaned per litter, etc., with discounts and bonuses based on a target level. Most of the production risk is retained by the producer.
Option 2: A contractor provides breeding stock, feed, management assistance, and supervision, and pays the feeder pig producer a flat fee for each pig. This fee varies according to pig weight and current production costs. In this example most of the risk falls on the person providing breeding stock, feed, and management.
Option 3: The contractor provides breeding stock, feed, facilities, and veterinary costs. The producer provides labor, utilities, maintenance, and manure handling. A fee for each pig produced and a monthly fee for each sow and boar maintained is paid to the manager. This option fits owners who no longer want to be actively involved in production, but have a good manager with limited cash willing to take over the operation.
Option 4: A shared revenue program with revenues divided in proportion to inputs provided. One example would be where the producer supplying facilities, veterinary care, utilities, labor, and insurance would receive a negotiated percentage of gross sales in return for his/her share of production costs for each pig sold. The feed dealer would receive a certain percentage based on his/her share of the total inputs. The remaining percentage would go to the breeding stock supplier and the management firm that supplies computerized records, and consultations. Negotiated percentage shares should be based upon inputs provided and risks borne by each participant.
While base-payment plus bonus contracts are offered in some regions, many farrow-to-finish contracts are on a percentage basis to reflect the relative inputs supplied by each person or firm.
Option 1: The producer supplies facilities, labor, veterinary care, utilities, and insurance for an appropriate percentage of gross sales based on input costs. The feed retailer supplies feed, standard feed medications, and receives a predetermined percentage of returns. The capital partner and breeding stock supplier get another percentage. The management firm receives a percentage for supplying computerized records services and management consultation.
Option 2: The current hog inventory is purchased outright by a limited partnership and it will supply sow replacements. The producer supplies facilities, labor, utilities, veterinary costs, repairs, and manure disposal. The feed retailer provides feed and standard feed medications. A management agency supplies production and marketing guidance. Each of the contract participants receives a percentage of the proceeds when hogs are marketed. The remaining percentage is split between the limited partnership and the general partner for managing the partnership.
Option 3: The contractor provides breeding stock, feed and a prescribed system of management. The producer provides facilities, labor, utilities, insurance and disposal of manure. The producer receives fees per head or per pound of hogs marketed plus possibly additional compensation for farrowing and feeding efficiency.
The popularity of breeding stock leases has declined in recent years and presently they are seldom used. Many contractors were dissatisfied with the care of the breeding herd and sometimes were unable to collect their payments from producers. One lease involves a payment-in-kind for the use of breeding stock. This lease is particularly attractive to producers with limited capital but ample feed, facilities and labor to produce hogs. The producer pays all production costs and pays the breeding stock owner, for example, one market weight hog per litter.
The relationship of producer and contractor are generally more complex and interdependent for production contracts than for marketing agreements. Hence, production contracts need to be evaluated with special care. When considering contract production, contractors and producers need to evaluate each contract on its own merit. Each party should look for a contract that best fits its operation and management capabilities.
Both parties must know their cost of production to make an informed decision. Simply signing a contract will not necessarily improve efficiency or insure a profit. It is doubtful that producers will receive a bonus for feed efficiency better than 2.9 if they have been only achieving 3.5 on their own, for example.
Also, carefully scrutinize the examples used to demonstrate cash flow or producer returns. Unless otherwise stated these are only examples and not guarantees. Producers should consider the impact on cash flow and debt repayment if payments are less than projected. Is there a guarantee of contract length if new facilities or other major capital expenditures are required to obtain the contract? Most contracts guarantee a stated number of turns (groups of hogs) or are in force for a stated length of time. Few, if any, guarantee the number of hogs that will be put through the facility in a set time, say one year. Facilities that sit idle during an unprofitable period in the hog cycle may profit the contractor, but disrupt the producer’s debt repayment schedule.
Before considering the details of a contract, one should first consider the reputation and financial stability of the company or individual with whom the contract is to be made. For instance: How long has the company been in business? What has been the company’s financial success? How long has the company offered contracts? Do other producers in the area have contracts with the company? Does the company fulfill the terms of its contracts?
Because little can be done after the fact to correct the problem, both parties should be encouraged to gather financial information about the other. This may be best handled on a document separate from the production contract. Problems and risks can arise for both the owner and the feeder due to financial failure of the other. Remember that:
The key to feeding or producing hogs under contract is finding the type of contract that will allow each individual to profit most from his/her skills, resources, and ability to bear risk associated with hog production. This strength may be record keeping, producing with a low mortality rate, or an ability to maximize herd feed efficiency. Whatever the case, producers should make certain that the contract will reward them appropriately for what they do best.
Once the best contract type has been found, the written contract itself should be carefully read and understood. The responsibilities of both parties should be clearly spelled out and understood as should procedures for dealing with possible disputes. While a well written contract is essential to successful contract production, it is also important that both parties are professional and willing to work out any problems that arise. A contract can never be so complete that every possible problem is anticipated. Individuals interested in contract production should check laws regarding contracting in their state.