MARKETING PIH-6
PURDUE UNIVERSITY. COOPERATIVE EXTENSION SERVICE.
WEST LAFAYETTE, INDIANA
Producing and Marketing Hogs Under Contract
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 financ-
ing. 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%
to 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.
Marketing Contracts
Market Hogs. 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:
o The quantity to be delivered, with the minimum amount vary-
ing anywhere from 5,000 lb to 40,000 lb (40,000 lb equals
one live hog futures contract).
o The date and location of delivery. The delivery date may
normally be changed by mutual agreement. The seller may have
the option of selecting the delivery date within a specified
time interval.
o Acceptable weights and grades, including provisions for
premiums and discounts.
o A description of the pricing mechanism, either fixed base
price or formula price. Some contracts now price the hogs on
a grade and yield basis to reward better producers who would
otherwise be less inclined to contract.
o Provisions for non-deliverable hogs and unacceptable car-
casses. The buyer normally deducts from the seller's
receipts for unacceptable hogs and carcasses.
o Provisions outlining the credit requirements of the seller
and inspection of the hogs by the buyer. The buyer may
request to inspect the hogs while on the seller's premises.
o A provision dealing with breach of contract. Typically, the
seller is liable for all losses incurred by the buyer when
the seller is in breach of contract.
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 con-
tract 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 follow-
ing reasons.
o Marketing contracts can typically be written for smaller
sizes than the 40,000 pound Chicago Mercantile Exchange con-
tract.
o A fixed price marketing contract locks in the delivered
price. A futures contract hedge locks in the futures price,
but the local price differential (basis) may still vary.
o A marketing contract does not require an initial margin or
additional margin calls be paid should the price increase
after the contract is signed.
o The marketing contract is typically made with a local mark-
eting agent or packer rather than dealing with the Chicago
Mercantile Exchange. However, unlike a futures contract, the
producer is required to deliver the hogs to fulfill a mark-
eting contract.
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.
Feeder Pigs. Typically, feeder pig marketing contracts are
between a marketing agency, often a cooperative, and a pig pro-
ducer, 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:
o The producer agrees to market all pigs through the marketing
agency.
o The marketing agency prescribes specific management prac-
tices to be followed by the producer. These may relate to
the weight at which the pigs are to be marketed, health of
the animals, and immunization against diseases.
o Many larger marketing agencies will pool feeder pigs into
homogeneous groups to increase their marketability and will
provide technical assistance to the producer.
Producers are essentially hiring marketing expertise to
enhance their market prices and minimize the time and effort of
locating buyers for their pigs.
Production Contracts
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 pro-
vide 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 pro-
fits. The resulting contracts, between owner and producer, vary
considerably in form and responsibility of each party involved.
These contracting arrangements are attractive to young or finan-
cially strapped producers and would-be producers who do not have
the capital to invest in a herd, and for producers with underu-
tilized facilities.
Feeder Pig Finishing Contracts
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 transpor-
tation. 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 30 lb
pig and $4 for a 40 lb pig. The remainder of the producer's pay-
ment 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 exam-
ple, the right of refusal on obviously unhealthy pigs, or to
negotiate a more lenient bonus schedule for multiple-source 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 con-
tract is to increase feed sales and secure a reliable feed
outlet.
The contractor provides the feed and some management assis-
tance 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 mark-
eting expenses. Over the duration of the contract, the
contractor's costs are charged to an account. This account bal-
ance is then subtracted from the sale proceeds to determine the
profit. The contracting firm often will use its own feed and pro-
vide management assistance. The producer is normally guaranteed a
minimum amount per head as long as death loss is below a set per-
centage. 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 regard-
less 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
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 percen-
tage would go to the breeding stock supplier and the management
firm that supplies computerized records, and consultations. Nego-
tiated percentage shares should be based upon inputs provided and
risks borne by each participant.
Farrow-to-Finish Contracts
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, veteri-
nary 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 pro-
duction 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 facili-
ties, 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.
Breeding Stock Leasing
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 some-
times 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.
Characteristics of a Good Contract
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 produc-
tion, 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. Sim-
ply 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 facili-
ties 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 pro-
fit 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 com-
pany 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 con-
tracts?
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 docu-
ment 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:
o Except for the right to remove the hogs, the hog owner is an
unsecured creditor of the feeder. The owner has little
chance in recovering losses resulting from excessive death
loss.
o The feeder has a statutory lien on the hogs, but this lien
is subject to all prior liens of record. This means that the
owner's secured creditors can remove the hogs without paying
the grower. Once the hogs are removed, the grower has an
unsecured claim for his contract damages which is probably
uncollectible.
o It is possible for the grower to receive first lien on the
hogs if the owner and his/her creditors are willing to give
the grower a lien subordination.
At a minimum:
o The contract must be in written form and must be clear and
concise.
o The contract should clearly define the rights and responsi-
bilities of both parties involved.
o The contract also should contain the following: number of
pigs involved, names of both parties, duration of the con-
tract, method and timing of payment, and definition of who
shall supply certain inputs.
o A contract should be thoroughly read and understood before
it is signed. Enlisting the advice of a lawyer, farm
management specialist, or business consultant is helpful and
often essential when evaluating contracts.
o The contract should contain an arbitration clause. Such a
clause removes any disputes from the court system. The con-
tract also should define how the arbitrators are chosen.
o Complete records of inventories, deaths, purchases, and
sales should be maintained and open to both parties.
Other possible contract provisions would include:
o The right of the owner to inspect pigs at any time.
o Designation of responsibility for purchasing and marketing.
o A procedure for refusing delivery of unhealthy or poor qual-
ity pigs.
o The basis for compensation of feed and non-feed costs.
o Acceptable weight ranges for incoming feeder pigs and outgo-
ing market hogs.
o A procedure to use if failure of payment arises.
o The means and timing of communication by producer to owner
when a death loss occurs.
o Who assumes the risk of death loss.
o The extent of the producer's responsibility for care of the
pigs and record keeping.
o Designation of who will provide insurance and how much cov-
erage.
o The brand and quality of feed and supplement that is
required if any, and who is responsible for ration formula-
tion.
o How and when the contract may be terminated by either party.
The key to feeding or producing hogs under contract is find-
ing the type of contract that will allow each individual to pro-
fit most from his/her skills, resources, and ability to bear risk
associated with hog production. This strength may be record keep-
ing, producing with a low mortality rate, or an ability to maxim-
ize 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 con-
tract itself should be carefully read and understood. The respon-
sibilities 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 success-
ful 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.
REV 12/92 (7M)
______________________________________________
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