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Chapter 4

Contracts and their specifications

This chapter reviews the legal framework of contracts, the basis for the agreement (the formula), the format or way the contract is presented, and the detailed specifications that must be included.

The legal framework

  • The contract should comply with the minimum legal requirements of the country
  • Local practice must be taken into account
  • Arrangements for arbitration must be addressed

The formula of contracts can be based on ...

  • Market specifications, where only quality standards are specified and input provision is often minimal
  • Resource specifications, where details of production, e.g. varieties, are specified. Input provision is often limited and income guarantees are minimal
  • Management and income specifications, which are the most intensive and may involve predetermined pricing structures, farm input advances, technical support and managerial control
  • Land ownership and land tenure specifications, which are a variation of the management and income model with additional clauses relating to land tenure. This formula is usually used when the sponsor leases land to the farmers

The format

  • Formal agreements are legally endorsed contracts which closely detail obligations of each party
  • Simple registrations are the most common format which the farmer signs to indicate that he/she has understood the terms of the agreement and wishes a contract to be reserved for him/her
  • Verbal agreements are frequently used under the informal model and sometimes by corporate sponsors

The specifications may include ...

  • The duration of the contract
  • The quality standards required by the buyer
  • The farmer's production quota
  • The cultivation practices required by the sponsor
  • The arrangements for delivery of the crop
  • The way in which the price is to be calculated using...
  • Prices fixed at the beginning of each season
  • Flexible prices based on world or local market prices
  • Spot-market prices
  • Consignment prices, when payment to the farmer is not known until the raw or processed product has been sold, or
  • Split pricing, when the farmer receives an agreed base price together with a final price when the sponsor has sold the product
  • Procedures for paying farmers and reclaiming credit advances
  • Arrangements covering insurance

Examples of contracts
are referred to in this Chapter
and given in the Annexes.


Agreements, in the form of a written contract or a verbal understanding, usually cover the responsibilities and obligations of each party, the manner in which the agreement can be enforced and the remedies to be taken if the contract breaks down. In most cases, agreements are made between the sponsor and the farmer, although in the case of multipartite arrangements and some others, the contracts are often between the sponsor and farmer associations or cooperatives. In the case of arrangements through intermediaries, the sponsor contracts directly with the intermediaries who make their own arrangements with farmers. Four aspects need to be considered when drafting contracts:

  1. The legal framework: The formal law of contract in a particular country, as well as the manner in which that law is used and applied in common practice.
  2. The formula: The clarification of the managerial responsibilities, the pricing structures and the set of technical specifications that directly regulate production.
  3. The format: The manner in which the contract is presented.
  4. The specifications: The details of the implementation of the contract.

The type of contract used depends on a number of factors such as the nature of the product, the primary processing required, if any, and the demands of the market in terms of supply reliability. The nature of the agreement is also influenced by quality incentives, payment arrangements, the level of control the sponsor wants to have over the production process, and the extent to which the parties have capital tied up in the contract. A contract covering, for example, oil palm, tea or sugar, where significant long-term investment is required from all parties, will be different from a contract covering annual crops such as fruits and vegetables. A contract covering the production of fruits and vegetables for local supermarkets may not be the same as one covering such produce destined for overseas markets, which may have more rigid controls on pesticide use and product quality as well as higher presentation and packaging standards.

Although corporate bodies, government agencies and individual developers are of necessity the catalysts of the contract, farmers and their representatives must be given the opportunity to contribute to the drafting of the agreement and assist in the wording of specifications in terms farmers can understand. Any contract, however brief or informal, should represent a mutual understanding between the contracting parties. Management must ensure that agreements are fully understood by all farmers. In many countries a high proportion of farmers may be illiterate and, therefore, it may be necessary to rely on oral rather than written contracts. However, the terms and conditions entered into must be written down for independent examination and copies given to the farmers' representatives. Copies should also be available to relevant government agencies.


All countries have basic laws that govern contracts. Farming contracts, whether written or oral, should comply with the minimum legal requirements that apply in a particular country. At the same time, however, it is important to take into account prevailing practices and societal attitudes towards contractual obligations, because in almost all societies these factors can produce an outcome that differs from the formal letter of the law. In some societies, for example, there may be an underlying assumption that contracts are intended to be respected only if certain factors remain constant. If climatic, political or personnel conditions should change, it may be considered socially acceptable for either party to disregard the contract, whatever the contract itself or the law may say on the subject.

Local practice may also influence the decision as to how detailed a contract should be, or whether it should be a formal contract or a more simple registration. Although there are examples of formal legal contracts that cover every eventuality, many contract farming arrangements, particularly in the developing world, are based on informal registrations. The Fiji Sugar Corporation, for example, has agreements with over 20 000 sugar-cane growers that are based on a comprehensive, legally binding document. Conversely, large tobacco schemes on the islands of Lombok and Java in Indonesia, involving tens of thousands of farmers, rely only on verbal understandings between farmers and their sponsors. In Thailand's sugar industry farmers and government personnel report never having seen a formal sugar-cane contract.

In the majority of cases, it is highly unlikely that a sponsor will take legal action against a smallholder for a breach of contract. The costs involved are inclined to be far in excess of the amount claimed, and legal action threatens the relationship between the sponsor and all farmers, not just those against whom action is being taken. Action by a farmer against a sponsor is similarly improbable. However, the improbability that a contract or agreement will be used as the basis for legal action does not mean that contracts or formal agreements should not be used. They can benefit both parties by clearly spelling out the rules of the relationship.

As neither side is likely to seek a legal remedy through the courts, it is important that ways of resolving disputes are identified in the agreement. A body representing the sponsor, farmers and other interested parties could be established in some cases, while in others a government agency might be the most appropriate forum. It is preferable that the contract farming industry regulates itself in order to offer a measure of protection for all participants. Participation of political nominees in such bodies should generally be avoided. Agreements between sponsors and contracted farmers are essentially voluntary undertakings and, in most cases, the two parties should control their own contract formulas and specifications. In some cases, however, there are advantages in having a single body managed by the industry to regulate a number of contract farming arrangements for the same commodity. The Fijian ginger and Tongan squash industry associations were established for that very purpose.22


Each of the contract farming models discussed in Chapter 3 can operate under a variety of arrangements. Each contract is designed for a specific situation, the formula of which may be based on one, or a combination, of the following:

Market specifications

Under a market specification contract only quality standards are specified. The sponsors normally provide only minimal material and technological inputs. This is the most elementary type of contract formula and is commonly used by individual developers under the informal model.

Resource specifications

In this type of contract key components are stipulated, such as varieties and, perhaps, fertilizer rates, crop husbandry practices and the conditions under which the crop is purchased. Normally few financial or material advances are provided under resource specification formulas. Product prices tend to be based on the open market and income guarantees are minimal. Many well-established individual developers operate under the informal model and some centralized processors use this type of formula.

Box 8
"Acts of God" clauses in contracts

In formal contracts it is sometimes necessary to include "Acts of God" clauses. Even when making verbal agreements sponsors must consider the possibilities of abnormal situations occurring that are beyond control, such as droughts, floods, cyclones, plant diseases or civil unrest.

In one instance a tobacco company included an "Act of God" clause to the effect that it would purchase farmers' tobacco leaf "while it was in a position to do so." When fire destroyed the company's curing operations an ad hoc pricing structure was negotiated with the farmers' representatives until alternative curing arrangements could be made. In this manner the farmers received partial payment for tobacco that they could not sell and the sponsor could not process.

Another company inserted a force majeure provision in its contract by allowing farmers to fill their quota through other sources. Any difference in price between that paid by the farmers to obtain the produce and that stipulated in the contract was to be shared equally between the sponsor and the farmer. Force majeure (the term used in the contract) was defined as very low crop production caused by the serious outbreak of disease or by abnormal weather conditions.

Management and income specifications

Contracts that focus on management and income specifications usually strictly regulate product standards. They are basically a combination of the market and resource specification formulas but, in addition, sponsors may establish predetermined pricing structures and make heavy commitments in the form of farm input advances, technical inputs and managerial control. This formula is the most commonly used by the multipartite, centralized and nucleus estate models.

Table 3
Characteristics of contract formulas




Market specifications

Individual developers State marketing authorities Farmer cooperatives Subcontractors

Basic controls for quality standards. Minimal inputs and conditions. Payments to farmers generally based on the open market.

Resource specifications

Individual developers Private corporate sector State agencies Farmer cooperatives

Important crop husbandry requirements in contract. Payments to farmers sometimes based on open market, sometimes fixed. Limited material inputs to farmers.

Management and income specifications

Private corporate sectorNational development agencies

Directed contract farming. Intense contract formulas; high degree of material and management inputs. Prices to farmers are fixed and adjusted on a seasonal basis. Common under centralized and nucleus estate models.

Land tenure specifications

Private corporate sector National development agencies

Clauses relating to land tenure and land use conditions part of the formula. Normally directed contract farming. Intense contract formulas, high degree of material and management inputs. Common under centralized and nucleus estate models.

Land ownership and land tenure specifications

This type of contract is an extension of the management and income model, with additional clauses relating to land tenure. Wherever private companies or government agencies lease land to farmers for contract farming, formal crop-land tenancy contracts on a long-term basis are necessary. These contracts should be legally binding and can contain clauses relating to both crop and land husbandry. Land tenure specifications may stipulate the other crops that farmers are allowed to cultivate in proximity to the contracted crop. This is in order to avoid the risk of disease.

Box 9
Land tenure for contract farming

Contract farming ventures involving leased land can be complex. During the 1960s a Malaysian parastatal organization, the Federal Land Development Company, leased 715 000 hectares of state land to more than 100 000 farming families who, in turn, grew crops under contract. Over the first decade serious problems developed regarding absenteeism, illegal subcontracting and crop quality. In order to control these problems the company introduced stricter clauses, raising the possibility that land leases could be cancelled. By 1987 the contracted tenants had improved their production performance and were producing 10 percent of the nation's rubber and 25 percent of its palm oil. The project had become a flourishing model of an integrated approach to rural development.23

One early example of a land tenure contract was the Gezira cotton venture in the Sudan referred to in the Introduction. In spite of its "colonial" nature the Gezira project helped introduce an innovative concept of agricultural development. The venture established control over the use of the land, insisted on terms of tenancy related to an economically viable unit and developed sound agricultural rotation. Such measures led to production efficiencies previously only attainable by large-scale estate management.24

One land tenancy agreement for a cotton contract scheme in Zimbabwe stipulated that there was an "explicit restriction on non-farm activities." The restriction centred on the objective of the sponsors to confine farmers to growing only cotton.25 Formal tenancies of this nature should at least allow for subsistence production for farmers and their families.

Many contract farming ventures are in areas where customary land usage arrangements are negotiated between landless farmers and traditional landowners. While this allows the poorest cultivator to be included, sensitive measures must be applied to ensure that contracted farmers are not exploited as a result of landowners charging excessive rents.


The various formats that a contract may take are:

Formal agreements

Explicit, legally endorsed contract formats, which closely detail the conditions and obligations of each party, are particularly common in projects that involve heavy investment in capital infrastructure or where sponsors lease land to farmers specifically to grow crops under contract. However, such contracts can also be used when land tenure is not a factor.

Simple registrations

These are a common contract format used by most centralized operations and, to a lesser degree, under the informal model. The term "registration" usually refers to a signed confirmation from the farmer that he/she wishes the sponsor to reserve a contract for him/her. Simple registrations are based on so-called "informal associations of trust and patronage that bypass formal legalities."26 With a flexible and sensitive managerial approach, a simple registration is a proven and practical way to sustain contractual arrangements. Annex 2 shows a seasonal maize contract in the form of a one-page registration sheet. The contract is divided into technical and financial sections. The technical aspects of the agreement are drafted in short, simple terms, clarifying the responsibilities of both sponsor and farmer. Pricing formulas in the financial section are designed to encourage farmers to produce maximum yields, while Clause 9 is included in order to control the possibility of extra-contractual marketing.

Normally, the registration of farmers for the following season commences immediately after the last harvest. In well-established projects, registration for many farmers is only a formality or, perhaps, involves just a change of name of a family member. Following registration, field staff approve the land on which the crop is to be cultivated and decide on production quotas based on potential performance.

Verbal agreements

Unwritten or verbal agreements are commonly used by informal individual developers and sometimes by corporate sponsors. A major problem of verbal agreements is the interpretation of responsibilities and specifications. Confusion and misunderstanding can easily occur if the agreements are not clearly explained by management to the farmers and their representatives. In turn, the managers' field extension staff must also have a clear understanding of the terms of the agreement.


Contracts will need to specify some or all of the following aspects of the sponsor-farmer agreement:

These are discussed in this chapter. In addition contracts will normally specify technical support and inputs to be provided by the sponsor, as reviewed in Chapter 5.

Contract duration

The duration of agreements depends on the nature of the crop. Contracts for short-term crops such as table vegetables are normally issued and renegotiated on a seasonal basis, whereas crops such as tea, coffee, sugar cane, and cocoa require long-term contracts that can be amended periodically.

Box 10
Transient verbal contracts

Starting originally under a farmer cooperative project in northern Thailand, farmers produced fresh eggs for a single sponsor under verbal arrangements. They were paid a guaranteed price of 1.50 Baht per egg. In 1997 a number of farmers changed to another buyer. Although the price offered by the latter was higher, between 1.70 and 2.00 Baht per egg, it was not guaranteed. Nevertheless the farmers considered the risk worthwhile and forfeited the guaranteed price given by the original sponsor. In 1999 one farmer changed his sponsor yet again. He did this because the new buyer graded eggs at the farm and not at the factory. Prices and material inputs provided by the third sponsor were similar but the farmer preferred on-farm grading. Although farmers do have flexibility in choosing their preferred sponsor under such arrangements, such flexibility can have a negative effect when practised by sponsors. Actions to change farmers at random can cause serious dislocation and acrimony.

Quality standards

Product quality or, more precisely, the absence of quality, can have far-reaching consequences in terms of market acceptance and future expansion. Most contracts contain detailed quality specifications so that produce that does not conform to the agreed criteria can be rejected. It is important that farmers fully understand the reasons for standards and also understand that the acceptance of poor quality produce from some farmers will ultimately affect an entire project and thus there is no long-term advantage to individual farmers to try to cheat. In the case of most smallholder tea schemes, for example, all leaf purchased on one day is processed at the same time. Poor quality green tea delivered by a few farmers will reduce the overall quality of the processed tea, thereby reducing returns for all.

Quality specifications may specify the size and weight of the product, the degree of maturity and the manner in which it is packaged and presented. A major problem with quality standards is that they are frequently vague and not clearly understood. This uncertainty could cause corruption problems, for instance the sponsors' employees seeking bribes to upgrade produce, or unfair practices by management such as trying to downgrade produce in order to reduce purchases when market conditions are poor. The use of terms such as "grade one, grade two," or "first quality, second quality" without clear specifications as to what these mean is unacceptable. Box 11 gives an example of grading specifications for Virginia tobacco purchased as fresh, uncured leaf. The description of each grade is kept as simple as possible, yet distinctly highlights the grade parameters. Extension staff should demonstrate the grades to farmers at the beginning of each season and explain the rationale for the specifications. It may also be necessary to specify the maximum content of each delivery container as quality can suffer if containers (boxes, bags, slings, bales, etc.) are overpacked.

Annex 3 shows a contract offered to Greek tobacco farmers. Its coverage of quality issues is complex and indicates the perceptions of past and future litigation. In contrast, Annexes 2 and 4 present two examples of simple contracts for maize and export papaya respectively. Contracts require continual scrutiny and revision by managers to ensure that the arrangements are updated and to avoid flaws becoming permanent and, therefore, a risk to stability. Annex 5 is a very complex and confusing swine-raising contract. Such a detailed contract, based on the expectation of problems and the desire to cover every eventuality, may meet the legal requirements of the sponsor but will inevitably cause confusion among the farmers.

Wherever possible, the number of grades should be kept to a minimum and each grade's specifications should be presented in clear terms. Unfortunately some contracts have demanded a complex multiple-grade system. In one instance, for example, there were 41 different grading specifications in a single contract. This resulted in widespread confusion that led to misunderstandings and, ultimately, confrontation. In another case strike action by farmers on a project in the South Pacific continued for two seasons and ended only when management introduced a simplified grading system. The grades were reduced from twenty-nine to three, thus making things more practical for the farmers. There was no subsequent deterioration in crop quality because of the introduction of a new processing technique designed to accommodate the simplification of the grading system. Often, however, there may be a need for only one standard, with all produce delivered being required to fall within a particular specification range. For example, in the case of papaya for export from Fiji only a single price was offered. The grade specifications were based solely on the size and maturity of a single variety, these two components being critical for market acceptance (Annex 4).

Raw materials for processing are often purchased on the basis of the likely extraction rate. For example, sugar-cane deliveries are often sampled to ensure that they meet the minimum juice purity specified in the contract. In France and Italy, among other countries, members of wine cooperatives are paid according to the sugar content of their grapes. Such individual calculations, however, are not usually possible with relatively small-scale farmers as their product is bulked up with that of several others for transport to the processing facility. Oil palm farmers, for example, are usually paid on the basis of the average "fresh fruit bunch" conversion rate achieved by the factory over a specified period.

Production quotas

Both insufficient and excessive production can have serious ramifications. Overproduction can mean unpopular quota reductions and costly stockpiles. Conversely, underproduction caused by poor farmer selection, disease or climatic factors could eventually result in a project becoming insolvent, as processing costs per tonne could rise to unacceptable levels. Moreover, if a processing plant is unable to meet pre-arranged marketing contracts, future orders could be decreased or cancelled. Quotas are employed in the majority of contracts in order to:

Utilize processing, storage and marketing capacities efficiently. Failure to purchase any part of a farmer's production that meets the specifications of the contract will cause serious discontent. This could occur through poor calculation of the sponsor's capacity to handle, process, store and market the production. Sponsors need to limit their contractual commitment to buy from farmers to only the quantities they can process (in total and, depending on the product, on any one working day) and market. Processing is also often restricted by the capacities of the sponsors' and farmers' warehouses.

Box 11
An example of grading specifications for fresh tobacco leaf

Grade I. Fully ripe, disease free, and of good thickness/body

Grade II. As above, but slightly diseased or blemished

Grade III. Bottom four leaves (lugs) and other curable leaf except unripe or overripe leaf, suckers, broken leaf, badly diseased leaf (more than one-third blemished) and leaf less than 30 cm in length

Note: In the interest of preserving quality no bag should weigh more than 40 kg. Slings in excess of that weight will be downgraded.

Source: Adapted from Southern Development Company (SDC), Fiji, pers. comm.

Quotas allocated on the basis of actual volume to be produced by each farmer or, alternatively, on a defined area to be planted should overcome some of these concerns. In Thailand, for example, cassava farmers are issued rootstock of a specific variety by their sponsor. The quantity of the stock issued is proportional to the area that the extension staff considers sufficient for the farmer to transplant, plant and cultivate. The advance of the rootstock material becomes, therefore, the production quota. All production from the allocated rootstock is purchased in accordance with the grading specifications that indicate the specific gravity and the degree of pest damage of the cassava.27

Guarantee markets for all farmers. Specific quotas allocated by managers in each individual contract should guarantee that all farmers would be able to sell all of their production that meets the agreement's conditions. Without quotas, sales by farmers would be on a "first-come-first-served" basis. Theoretically, deliveries by some farmers could exceed the requirements of the sponsors, resulting in some other farmers being unable to sell any or only part of their crop.

Ensure quality control. Quotas can sometimes be used to control the quality of the raw commodity. For some crops, increases in quantity may only be achieved as a result of reduced quality, for example, as measured by the extraction rate. Farmers may be tempted to manipulate weights through fraudulent methods such as wetting the crop before sale or by adding foreign matter. Sponsors can reduce the likelihood of such practices by setting quotas based on expected output for a given area.

Monitor farmers' performance. As a means of monitoring farmers' production, quotas are used as a benchmark by which to analyse crop yields. Through the efficient monitoring of crop development, extension officers can usually make realistic yield forecasts. If yields fluctuate widely then abnormalities can be investigated and remedial measures taken. The use of quotas also permits the sponsor to identify whether farmers are selling crops outside of the contract (i.e. extra-contractual marketing) or whether they are supplementing their sales to the sponsor with non-contracted production from other farmers. The management techniques used to estimate and scrutinize production yields are described in Chapter 6.

The allocation and distribution of production quotas will vary according to crop and circumstances. Where there is no alternative market for the crop and farmers have made significant long-term investments in production (tree crops) or processing facilities (e.g. tobacco curing barns), the sponsor must be committed to purchase the entire crop covered by the quota. This obligation, of course, is subject to the crop meeting the agreed quality specifications. The most common and practical method is to allocate quotas on an area basis, with managers calculating the total area to be cultivated in relation to the project's processing capacity and their knowledge of each farmer's expected yield.

Managers must also address the issue of how the quotas will be allocated between locations and between the farmers they select (Chapter 5). In Mozambique's Nampula province, for example, sponsors assign a similar land area to all farmers included in the schemes. While farmers can be rejected for failing to fulfil production targets or repay credit, land size allocations do not vary. Such an approach is seen as avoiding conflict within the community and avoiding corruption in quota allocations.28 On the other hand, allocating a quota that the farmer cannot cultivate, either by area or quantity, will cause serious problems. Reductions of quotas in subsequent years or cancellation of contracts on the grounds of failure to supply agreed quantities could cause demoralization and a loss of prestige for the farmer. The allocation of appropriate quotas that reflect the different levels of resources and skills of the farmers and, at the same time, permit a wide range of farmers to have contracts will add to the stability of contract farming ventures.

Where there are alternative markets for crops under contract, quite often farmers are tempted to sell outside the contract. Quotas deliberately set at levels lower than the farmers' actual production capacity may enable them to take advantage of high open market prices when they occur. Such an arrangement is likely to apply particularly when the pricing arrangement is for a fixed price rather than a market-based price. An example of this is found in passion fruit production in Colombia. Such an arrangement cannot be acceptable in all cases; for example, a company that supplies farmers with day-old chicks and their feed will obviously expect the farmers to deliver the same number of chickens minus, of course, deaths.

There are examples of contracts where quotas are superfluous. This particularly applies when the crop has several buyers in active competition, and when it is unlikely that the company will be able to purchase more than the throughput of its processing facilities and thus wants to maximize its purchases. It is most common under the informal model, an example being the cotton industries of Zambia and Zimbabwe where several gins are in active competition for the available crop. In other circumstances, however, the absence of quotas can work to the disadvantage of the farmer. For example, although farmers in the Punjab grow tomatoes under formal contracts, the sponsors do not issue fixed quotas. The sponsors purchase only the amount they require leaving farmers with no option but to sell surpluses on the open market at a reduced price. The buyer therefore has much greater bargaining power than the farmers.

The sale of quotas between farmers should be discouraged in that the new farmer may not meet the farmer-selection criteria and the practice could lead to corruption. In all ventures there is always a degree of attrition; some farmers die, others retire or sell their land and move to other districts. In such situations, management usually transfers the contract to family members or nominees of the previous contractor on the understanding that the newcomer meets the selection conditions.

Cultivation practices

When sponsors provide seeds, fertilizers and agrochemicals, they have the right to expect that those inputs will be used in the correct quantities. They also have the right to expect that farmers follow the recommended cultivation practices. Of particular concern is the possibility that farmers may apply unauthorized or illegal agrochemicals which can result in toxic residues, with dramatic repercussions for market sales. It is therefore essential that all contracted farmers adhere strictly to the project's input policies. Managers and their extension staff must make every effort to explain to farmers why the specifications and input recommendations must be followed.

Crop delivery arrangements

Arrangements for collection of products or delivery by the farmers vary widely. Some ventures stipulate that farmers should deliver their harvest to processing plants at given dates; others may include the use of the sponsor's transport to collect harvested crops at centrally located buying points. For contracted fresh vegetables a normal practice is farmgate collection. When the sponsor's transport is used there is normally no cost to the farmer. In the sugar industry, small railways are used extensively; farmers deliver their harvested cane to a central loading point from which it is then transported to the crushing mill, weighed and purchased. Many formal contracts have clauses that outline the obligations of both the farmer and the sponsor regarding delivery and collection respectively. As a routine practice, managers and their extension staff should confirm delivery or collection arrangements at the beginning of each season and reconfirm these prior to harvest.

Pricing arrangements

Pricing and payment arrangements are the most discussed and challenging components of all farming contracts. The choice of which crop pricing structure to use is influenced by whether the crop is for the local or export market, the seasonal nature of production and the degree of competition in the marketing system. The application of transparent pricing formulas is crucial and the drafting of a clear pricing structure and the organization of a practical method of payment encourage confidence and goodwill. There are several ways prices offered to farmers can be calculated, including:

Fixed prices. Fixed prices are the most common method. The practice is usually to offer farmers set prices at the beginning of each season. In almost all cases, fixed prices are related to grade specifications. In calculating prices there may be a tendency for sponsors to adopt a cautious approach because of the danger of market price fluctuations. Fixed price formulas are usually ideal for the sponsor; however, where alternative outlets exist, farmers may consider such arrangements to be disadvantageous if prices increase on the open market. For managers, the set price formulas are preferable for both budgeting and marketing purposes, although they are still obliged to purchase the crop at the prices stipulated in the contract if the open market prices decrease below the set prices. The fixed price structure is widely used by tobacco corporations and companies processing crops for canning. Table 4 shows a set price formula for cassava, based on specific gravity and pest damage.

Table 4
Pricing and grading structure of cassava under contract in Thailand


Specific gravity (%)

Surface damage (%)

Pricing structure


Standard value




> 17.6 %




>16.6 - 17.6%















Source: Adapted from information provided by Frito-Lay, Thailand

Flexible prices. This structure applies to prices calculated on a formula related to changing global and local markets. This form of pricing is common in, for example, the sugar industry where the final price to the farmer is known only after the processed sugar has been sold. Farmers are paid on the basis of a formula which takes into account agreed processing and other costs of the sponsor as well as world market prices over a particular period. The prices of internationally traded commodities for which there are few, if any, grades are readily accessible and should also be made available to farmers. In Papua New Guinea, smallholder oil-palm producers on nucleus estates are paid on the basis of such a formula, which is monitored and approved by the Government. In Guyana, sugar-cane producers receive two-thirds of returns from sugar sales and the factory one-third, to cover costs and profit.

In some cases farmers and sponsors may share price increases and costs proportionately. In the Philippines, for example, a pig-rearing contract specifies that the farmers and the company shall divide proceeds equally, after deduction of the agreed expenses of the company. The expenses include stock feed, medication, a marketing fee and an allowance for shrinkage between delivery of the animal and eventual sale. Such a profit-sharing arrangement can be successful if the contractor is efficient and honest. However, in other circumstances this system can seriously prejudice farmers by putting them at the mercy of inefficient processing and marketing. Wherever payments are dependent on fluctuating markets an independent arbitration mechanism should be developed by the industry to safeguard the interests of both the farmers and the sponsors.

Prices calculated on spot-market values. Payments based on spot-market prices can be very complex and often lead to misunderstandings and disputes. Such an arrangement removes income guarantees for farmers but does enable them to take full advantage of high market prices. The main problem with this approach is that sponsors and farmers must arrive at a common understanding of what constitutes a market price that is relevant to the higher quality that contracted farmers could be expected to produce. This form of pricing is common in Thailand where individual small-scale developers act as brokers under informal contracts. The brokers make arrangements with farmer groups to sell fresh vegetables to wholesalers. They collect the crops at the farmgate, arrange transport to Bangkok and, after the produce has been sold, pay the farmers a percentage of the final sale price. In most cases the open market pricing system is unsatisfactory, as the farmers do not have control over the price they receive or knowledge of how it is calculated.

Prices on a consignment basis. Prices calculated after the produce has been marketed and sold may be considered another form of spot-market pricing. This form of payment is normally termed "on consignment" and is mainly used by informal small-scale developers. In another example from Thailand, individual developers arrange to supply crops to markets on consignment. They take a commission out of the farmers' revenue and, at the same time, deduct the costs of seed and fertilizer advanced to the farmers. Consignment pricing arrangements are rarely found in well-structured contract farming projects and are best avoided. The growing importance of supermarkets suggests that more and more fresh produce will be delivered at predetermined prices rather than on a consignment basis.

Split pricing. Under this system an agreed base price is paid out at the time of purchase or at the end of the harvesting season. The final price is calculated once the sponsor has on-sold the commodity, and depends on the prevailing market price. If the crop is sold in the fresh form the second price can usually be calculated within a month. When the product is processed it may take much longer.

Payment procedures

For all farmers the most convenient method of payment is usually cash-in-hand immediately following delivery of any part of their crops. However, this is not always possible, particularly if the sponsor has limited resources, where payment depends on the total production after processing, or where the payment is based on the price the sponsor obtains. Also, the company may have the obligation to repay loans advanced by banks to farmers using the contract as collateral. In the majority of cases payments are made periodically throughout a season, perhaps two to four times, with the final payment after the last harvest. Any material and cash advances given to farmers during the season are normally deducted from the final payment.

Insurance arrangements

Agricultural investments always involve risk. The five most likely reasons for investment failure are poor crop management, climatic calamities, pest epidemics, market collapse and price fluctuations. The standard agribusiness approach to indemnify against quantity shortfalls is crop insurance. Although government-run crop insurance schemes often prove to be unsatisfactory, success with insurance programmes offering named (i.e. limited) peril cover for certain crops has been reported in Mauritius, the Philippines and Cyprus. There is also a growing awareness by the private sector that crop insurance should be encouraged and promoted.29 As the farming involved in a contract arrangement becomes technologically more advanced, the range of risks to which it is subject generally becomes more limited. In many cases some of the remaining risks can be managed with the assistance of insurance.

For seasonal contracts that are based on a fixed price payable at harvest, it is unlikely that farmers will be affected by market collapse or price variations; however, they are vulnerable to production losses caused by climatic or human factors. Some authorities classify the four main categories of crop insurance in order of "their comprehensiveness in terms of coverage of risks" as follows30 :

"Acts of God". This category encompasses natural disasters such as drought, floods, hail, storms, cyclones, lightning, insect plagues and disease epidemics that are beyond management control. In India, for example, efforts have been made to introduce rain-insurance contracts based on rainfall duration, the precise rainfall shortfall and a prearranged schedule of indemnities.31 The degree of insurance compensation for damage by flood, storms or hail is difficult to assess when there is only partial loss. Field crops that have been damaged by a fractional flood or hail require an experienced and independent assessor who would not only have to evaluate quantity losses but also the quality of the crop at the time of the damage. Some contracts may have "Acts of God" clauses inserted, although such clauses are uncommon.

Destruction of specified assets. Many farmers insure their houses, garages, grading and storage sheds as a matter of routine. Tractors and farm implements can be insured against damage and theft. Insuring of curing kilns by farmers when growing tobacco under contract is essential. If a contract farming venture is well established, management can sometimes organize the insurance of non-contractual farm buildings and housing as part of the sponsor's total indemnity policies, reducing the cost of premiums to the grower.

Loan default. In almost all ventures, sponsors assume the liability of credits advanced by management to the farmer for the contracted crop. It is therefore important that advances do not accumulate into debts that the farmer cannot repay. Managers normally allow farmers who cannot repay advances because of climatic or other mitigating factors to extend their loans to the following seasons. Sponsors, of course, do have the option to indemnify their farmer loans against default through their own insurance brokers.

Production and income loss. Insurance against both production and income loss is expensive and complex. Production loss may be caused by a combination of factors that are difficult to insure against. To determine who is culpable when a crop is destroyed by insects is one example. Was it an "Act of God" or the failure of the farmer to take measures for pest control at the appropriate time, or was it the fault of management for not training and instructing the farmers in pesticide techniques?32 There are also social risks that could cause crop loss such as theft and animal damage. In the case of injury to crops by horses, goats or cattle, the project's management staff assess the value of the destroyed crop. If the owners of the animals are not contracted farmers, local community leaders can sometimes negotiate compensation. If the owners are also contracted farmers, compensation disputes can often be negotiated through farmer forums.

Where there are fixed price contracts there is no apparent risk to farmers with regard to payment for their crops. If a market collapses, the sponsor should automatically shoulder the loss. However, if the sponsor becomes bankrupt, farmers could be permanently affected. Where contracts are on a flexible or spot-price basis the stability of farmers' incomes is always at risk.

In theory, the proposal of crop and property insurance for farmers in contract farming ventures is appealing. However, before advising farmers to consider insurance, a qualified risk analysis should be made to determinate the economic advantages of insurance against the specific risks applicable to the particular crop.

23 Ghee, L.K. and Dorell, R., 1992: 103-106; Centre for Research and Communications, 1990: 20-22.

24 Jackson, J.C. and Cheater, A.P., 1994: 160-161; adapted from Gaitskill, A., 1959.

25 Jackson, J.C. and Cheater, A.P., 1994: 160-161.

26 Watts, M.J., 1994: 26.

27 Frito-Lay, Thailand, pers. comm.

28 C. Donovan, pers. comm.

29 Roberts, R.A.J. and Dick, W.J.A., eds., 1991: 4-5 and 30-32.

30 Mosely, P. and Krishnamurthy, R. in Mishra, P.K., 1996: 271.

31 Mishra, P.K., 1996: 274 (for such arrangements to work effectively, rainfall recording gauges must be secure and protected against interference).

32 Ray, P.K., 1981:10.

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