Risk Sharing and Transactions Costs in Producer-Processor Supply Chains

In addition to efficiency, inter-firm synergy, and responsiveness, supply chain participants often express a desire to manage risks as a reason for forming supply chains. The risks may be input/output price risk, quantity/quality risks, and/or safety/health risks. The recent interest in food safety and traceability are often cited as reasons for forming tighter vertical alliances. Agricultural producers often state that reductions in price and volume variability are key influencers in their decision to join a supply chain (Hennessey & Lawrence, 1999; Rhoades, 1995).

Supply chains have been a dominant focus of both academic research and business strategy in the food and agribusiness industries for the past decade. Much discussion, analysis, and experimentation with various forms of vertical alignment using governance structures such as strategic alliances, joint ventures, contracts, and vertical integration has occurred. Much of the recent debate and discussion, as well as the controversy concerning the development of these arrangements has focused on the production sector, and in particular, the linkages between producers and processors.

The effectiveness and long-term viability of a supply chain is determined in no small part by how well the coordination governance structure manages the sharing of the risks and rewards of the supply chain among its participants. The different types of risks encountered in alternative supply chain business structures, the incidence of risk on the part of individual supply chain partners and the sharing of risk and reward among supply chain participants has important implications for who will be the most likely participants in a supply chain, as well as the benefits the various players will receive.

Risk Sharing and Costs of Vertical Alignment

For some firms, the risk sharing transactions cost of monitoring channel partners exceeds the willingness of the marketplace to compensate them. In these cases, the firm may choose to acquire the chain (vertically integrate), thereby avoiding the transactions costs associated with moral hazard and adverse selection. These firms have decided that the internal transactions costs associated with owning both stages of the chain (agency costs, influence costs, increased production risks, employee risks, etc.) are less than the external transactions costs (moral hazard, adverse selection, and risk premia). Smithfield Foods and Tyson Foods offer examples where vertical ownership has been the preferred choice in an industry where other governance structures continue to be employed. These two firms, with their international brand identity and diverse product bases, may be in a position where the transactions costs of open-market, contract, or joint venture agreements exceed their internal transactions costs of owning the chain.

Figure 1 depicts the conceptual framework of external transactions costs of risk sharing in comparison to internal transactions costs of ownership. The vertical axis measures the total cost of the transactions of products, services, information, and compensation between stages of the chain. The horizontal axis represents the risk aversion and/or ability to manage risk for producers from whom the processor may choose to acquire products. The processor is assumed to have a lower relative risk aversion than producers. Thus, as channel captain, if the processor wants to source products from more risk averse producers, they must design vertical arrangements to either take on more of the risk, or compensate the risk averse producers more for accepting the same share of the risk.

Two separate lines are displayed in Figure 1. The external transactions costs line reflects the additional risk-sharing cost borne by the processor when the exchange is between the processor and producers in a vertical arrangement. This line increases at an increasing rate as producer risk aversion increases. Increasing external transactions costs reflect the additional costs that must be borne by the processor in the form of either increased risk taking or increased compensation to the more risk averse producer for taking on more risk.

The internal transactions costs line reflects the cost of ownership to a processor that owns both stages of the chain where separate firms are replaced with employees. Internal transactions costs of ownership are initially assumed to be higher than external transactions costs. That is, we assume that the efficiencies of an open-market transaction in the absence of risk aversion by the producer result in lower transactions costs than vertical ownership.

As producer risk aversion increases, the internal transactions costs of ownership do not change -- only the risk sharing transactions costs of a market-based exchange increase. There is a point where the additional transactions costs of risk sharing cause the transactions costs of the market exchange to exceed the internal transactions costs of ownership.

The delineations across the top of the figure illustrate the different governance structures likely to be employed. When producers have risk management capabilities or have low enough risk aversion that risk sharing transactions costs are low, channel partners are likely to align in an arms-length exchange such as open markets, strategic alliances, or joint ventures. As producer risk aversion rises or management ability declines, the external transactions costs rise for the processor due to increased risk sharing costs. The increase in external transactions costs lead to more formal vertical arrangements such as contracts, where the risks and returns are dictated by the channel captain (processor). There is a point along the producers' risk aversion/management scale where the risk sharing transactions cost of the market exchange are higher than the internal transactions costs of owning the chain. It is at or just beyond this point where ownership of the channel (vertical integration) becomes an option because the transactions costs of risk sharing exceed the internal transactions costs of ownership. Producers at this level of risk aversion would likely choose to become a grower for a vertically integrated firm, receiving a flat fee for their services much like an employee of the company.

Research in supply chains in other industries shows that eventually external transactions costs decline below the internal transactions costs of chain ownership as firms become more accustomed to working together and better equipped to handle the risks in the exchange between segments of the chain (a learning supply chain as described by Sporleder & Peterson, 2003). If the goal is to reduce external transactions costs, then firms will favor partners that are less risk averse or better able to manage risk. As such, contracts and similar vertical arrangements would likely accrue to larger producers. However, for processors willing to absorb more risk, the preferred partner may be more risk averse producers in very tightly linked production contracts, where producer risks are transferred to the processor but rewards to the producer are lower. The framework presented here ignores any concept of market power among channel participants, and yet illustrates a logical economic reason for more tightly aligned vertical arrangements and industry consolidation to occur even in the absence of market power.

Risk Premiums and Contract Production

Contracts frequently spell out portions of both "fixed" payments and incentive payments from buyers to suppliers based on performance variables. The balance of fixed versus incentive payments depends, ultimately, on the relative risk aversion/management capability of the partners in the chain. If a processor seeks a governance structure that allows the risks to be shared between the parties, then they will seek a governance structure with more incentive payments. To entice risk averse producers to accept more incentive payments (share more of the risk), the fixed payment would have to be greater than for less risk averse producers (this is reflected in Figure 2 as the risk premium).¹ The risk sharing transactions cost of governance structures with more incentive payments will be less if the producers are relatively less risk averse or relatively more capable of managing risk. This again suggests that agribusinesses seeking production partners in a contract-coordinated supply chain that will share the risks and rewards will tend to favor larger producers with the ability to spread risk and/or producers that are less risk averse. For processors that are more willing and/or able to manage risk, a fixed payment contract may be the preferred arrangement to attract risk averse producers that are willing to take less return for lower risk.

Implications for Producer Financial Performance

Analysis of pork contracting illustrates the financial implications of using more debt in the capital structure of the contract production farm compared to an independent grower. Contract swine growers can in fact finance their operations with debt comprising a large portion of their capital structure (Lins, 1997; Roberts et al., 1997). Table 1 illustrates the implications of different capital structures for different business arrangements on the return on equity (ROE). Note that with no debt, independent business arrangements generate a higher ROE (and ROA since they are equal when no debt is used) than the typical contract business arrangements analyzed. As debt becomes a larger proportion of the capital structure of the business, the ROE increases for all business arrangements. But the independent grower who does not manage operating risk will likely not be able to use as much debt as part of his/her capital structure as the contract grower. Comparing the ROE of the independent grower at 40% debt (23.5%) with that of contract growers at 80% debt (23.1% and 27.6%), it is apparent that vertically aligned systems that transfer risk to the buyer (processor) have equal or superior financial performance. By accessing more external financing these firms also have increased capacity to expand their business.

Increased access to debt capital allows vertically aligned producers to generate competitive financial performance, grow at a more rapid pace, and adopt new technologies more quickly than those not vertically aligned — further separating these producers from those with less access to vertical markets and debt capital. This outcome may, again, lead to a more rapid consolidation as well as vertical coordination of the industry as has been witnessed in poultry, pork, and potato industries.

Risk of Vertical Alignment

The adoption of more tightly aligned supply chains in agriculture is likely to compound the risk and uncertainty related to the effectiveness of markets in providing accurate messages to consumers and suppliers in the food chain concerning prices, quantities, and qualities of products and attributes. With the formation of more tightly aligned food supply chains, it can be argued that messaging is much more precise, timely, and generally more accurate for participants in the chain than might be provided by market forms of coordination. But, what about the risk faced by those who are not part of the tightly aligned supply chain - are not qualified suppliers? Is there more volatility in the prices they receive because of thin markets? Do they have access to a market or are they closed out because only qualified suppliers can participate? Because of the thinness of these markets, are they not only subject to more volatility, but also more potential for manipulation? Do the prices and other information conveyed by these thin markets provide accurate messages to consumers and suppliers concerning quantities, qualities, cost, and value?

Conclusions

Notes

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