Farmer-Owned Cooperatives and Vertical Coordination
Jeffrey S. Royer
Recently, market forces have led to greater opportunities for product differentiation and added value at the farm level. These opportunities have stemmed from increased consumer demands regarding health and nutrition, concerns about production practices, efforts by food processors to improve their productivity, and technological advances that allow greater coordination of crop and livestock production with the product attributes desired by consumers and processors. Examples of farm-level value-added opportunities include the production of leaner pork, corn with high oil content, hard white wheat for bakery products, and soybeans developed for specific overseas markets, as well as the use of natural production processes.
Vertical coordination, either through ownership integration or contractual arrangements, is necessary to link product characteristics and production processes to consumer preferences. The inability of markets to efficiently communicate the appropriate signals to producers and the inconsistency of producer response have contributed to the increasing use of contracts to coordinate production, marketing, and processing in the broiler, turkey, egg, vegetable, and pork industries. Contract integration has also been increasing because of efficiency considerations and the reduced availability of producer credit.
Farmer cooperatives are typically involved in first-stage marketing and processing activities as a result of their role as vertical extensions of the farming operations of their members. Consequently, they would seem well-positioned to coordinate product differentiation at the farm level and to integrate forward into value-added processing activities. A recent report by the Iowa Business Council lists several important opportunities for cooperatives to serve producers in the context of current changes in the food production and marketing system. These include: (a) helping producers access capital and technology, (b) helping them achieve economies of scale in production and marketing activities, (c) coordinating production, marketing, and processing activities to meet final consumer demands, (d) providing competition in contract markets by setting contract payment rates and other terms, and (e) capturing profits from other stages in the market channel.
Contract integration by farmer-owned cooperatives may offer both advantages and disadvantages compared with integration by other firms. Under contract integration, the producer bears some production risks, but price risks for the contracted commodity and most variable inputs are transferred to the integrator. The reduction in price risk is replaced by other risks, including risks of contract renewal, terms, and negotiation. These risks include the risk that the integrator may default on agreements. Because many production decisions are transferred to the integrator, contract producers may be concerned about management quality and continuity.
These risks are probably less important to producers who deal with cooperative integrators. Because a cooperative is owned by its producer-members, it is less likely to default on agreements or behave in an exploitative manner. Risks involving management decisions, quality, and continuity are also less likely to be problems for producers contracting with cooperatives because the producers maintain a means of affecting management decisions through the board of directors and its selection of managers.
Contract integrators are also exposed to risks, particularly if they provide credit to producers. Contract cancellation or loan default by producers may adversely affect expansion by an integrator or the willingness of financial institutions to make loans involving the integrator. A cooperative may have an advantage in locating and selecting qualified producers because of its close working relationship with members. However, producer selection may still be a problem if the cooperative has an obligation to contract with any member who meets minimal business standards. Cooperatives may also face difficulties with producers who are terminated due to poor performance because they are members of the organization and may have substantial equity investments in it. Terminated members may press for an immediate redemption of their equities, which can cause member relations problems and increase the cooperative's financial risk.
To limit their financial risk, as well as producer market risk, some cooperatives have taken to dealing with producer-members on a basis similar to that of other firms. Producers do not receive patronage refunds, and the cooperative handles margins in the same manner other corporations handle profits. Thus, although contract integration by cooperatives may provide advantages, the way some cooperatives manage the redistribution of risks could significantly redefine the nature of cooperatives and their relationships with members.
From Cornhusker Economics, September 1, 1993.
For additional information on this topic, see Jeffrey S. Royer, "Potential for Cooperative Involvement in Vertical Coordination and Value-Added Activities," Agribusiness: An International Journal 11(1995): 473-81.