AMS Advises Farmers on Contracts

February 7, 2001

USDA's Agricultural Marketing Service has developed a report on farmers' contracts, designed to make producers aware of the advantages and disadvantages of contracting. Most farmers consider signing a contract either to reduce their exposure to risk or to make more money, says AMS. And "indeed, some contracts can lead to higher returns and serve as a form of risk sharing."

AMS says contracts can reduce financial risks by providing a guaranteed source of cash flow while reducing the need for capital. For example, by raising hogs on contract, the producer will not need to purchase the animals but instead can use his or her own labor and facilities to care for the contractor's animals. The contract will provide regular payments, and by not owning animals you are somewhat insulated from market price fluctuations.

If the producer needs to borrow, contracts may make the producer a more attractive borrower. "In fact, some lenders may require contracts as a condition for a loan. By providing a steady source of income and reducing marketing risks, a contract may make banks more willing to lend you money to construct facilities. Some contractors even offer direct financing for producers if new buildings are required," according to the agency's report.

Contracts also can provide the producer with access to new technologies such as biotech grain. Entering into a contract may be the only way to acquire some technologies. By contracting the producer may get not only the technology but also support and advice from the company.

Access to new markets and higher prices can be another advantage, says AMS. "Contracts can provide an opportunity to sell for higher prices or to receive price premiums for raising new crops or using certain production methods. It may be easier to raise a specialty crop by contracting with a processor."

The report also cautions that every business decision has pros and cons associated with it, and the decision to enter into an agricultural contract is no different. "While contracts may be a way to reduce your risk, in some cases contracts may create new risks. In addition, you may lose some of the independence you have as the sole decision-maker in your business," says AMS.

A good rule of thumb, says this reeport, is that if a producer expects higher returns or more benefits under a contract, it will come in exchange for something the producer must do. In contract law this is known as the "consideration." Depending on the commodity involved and the contract terms, the required action – the producer's "consideration" – can take several forms.

The producer may have higher production costs in order to comply with contract terms, for example, because higher priced inputs or special equipment must be used; the producer may invest large amounts of money in special-purpose buildings or equipment of little use without the contract; the producer may wind up with less flexibility on how the farm is operated, and may have less control over pricing and market decisions.

In addition, the crop under contract may have lower yields than the producer's traditional crop. "Although your contract may state a higher potential price per unit (e.g. bushel) your overall yield may result in lower total revenue for the contract crop," says AMS. Also, the producer may receive less for the product if it does not meet quality standards specified by the contract.

The entire report is available on the Internet at http://www.ams.usda.gov/contracting/contracting.htm.