Executing a successful forward contract: Lessons from practical implementations

 Friday, 13 July 2018

Among many, maintaining quality and continuous supply are the two most important things to an exporter. Some exporters go the distance by themselves to make sure these two are in order. However, most rely on third parties. These third parties are basically “Field Agents” who make sure the supply is continuous and up to standard.

Regardless of how the value chain is set up, a larger transaction cost is associated with maintaining quality and continuity of supply. Therefore, different tools are in place to make sure these transaction costs are reduced. A forward contract is such a tool, designed to ensure the security of supply and adherences to quality specifications. Yet, there are many instances where forward contracts fail.




There is plenty of literature that suggests how a forward contract should be designed and implemented. Yet, we all know that the real-world implementation is different to theories and ideas. This write-up discusses some of the essential factors to be considered in implementing a successful forward contract. All points discussed herein are based on practical experiences.

Land characteristics

Land ownership varies. Farmers cultivate in their own land, rented or leased lands, collective cultivation (land is owned or leased by one farmers but cultivation is done by a group) and even on encroached lands. It is very important that the land under the forward contract has a clear ownership. Ideally, what you want is to tie a privately-owned land to a forward contract. This gives enough incentives for a farmer to commit to the forward agreement.

Leased or rented land will also have incentives to commit to the forward contract, but there can issues with the continuity. Forward contract for short-term crops can be renewed every season or for a year or two. This renewal process or commitment for a longer period such as a year or two is easily possible if the land is owned privately. Lands that are under forward contract will get developed as the cultivation moves on. For lands that are rented or leased, this gives incentives for the owners of the land to stop leasing or renting out when the next season comes.

One way to get around this is to ask the farmers to go for a longer-term agreement with the owner of the land; an ideal time would be five years. Forward contracts on collective farming might also not be ideal. In theory, collective action makes sense. However, unless proper agreements are in place (who will take care of what, how farmers invest on inputs and how the allocation of labour is determined), collective farming can fail easily. Encroached lands should never be used for forward contracts.

Soil type, fertility and soil health is important for a better harvest. However, this is hardly checked in implementing forward contracts. Most of the time, we tend to believe the farmer rather than examining these conditions of the soil. Farmers in the dry zone uses paddy lands for vegetable cultivation during the “Yala season”. These paddy lands have the potential to give farmers a good harvest, however at the same time, unless proper management practices are applied (using raised beds), these lands can produce undesirable conditions.

A small rainfall can flood these lands, and they can be under water for several days. In such a case, unless raised beds are used, the cultivation can be damaged. Determining soil fertility and heath is important for many things. Understanding these conditions of the soil will help determine the best use of fertiliser. Any crop will carry a fertiliser recommendation. But based on the soil fertility and health, these recommendations need to be adjusted. If already cultivated lands are used, there is a pretty good chance that the land is heavily exposed to agro-chemicals.

In such a situation, being vigilant about the Maximum Residual Limits (MRLs) is very important. Otherwise, the harvests can easily register some of these chemicals and this may result in rejections at the export and import points (at quarantine checking). In determining soil health, it might not be possible to check every land for MRLs, but there are widely accepted scientific sampling methods that can guarantee a sufficient understating of the situation. Therefore, before a forward contract is signed, it is important to evaluate these criteria of the lands in terms of soil type, fertility and health.

A Sri Lankan smallholder who grows paddy, fruits and vegetables will have on average 1-1.5 acres available for cultivation. However, there are many farmers who have less than that. In agriculture production, unless it is a high value crop (such as vanilla), profits are possible only if economics of scale are achieved. There are many factors to this aspect, e.g., managing inputs, crop management (land preparation, weeding, fertiliser application and pest and disease management, harvesting and managing quality), involvement of agents who manage the forward contracts (these can be field officer of the organisation that issues the forward contract) and logistics and transports.

All this becomes easy and efficient if the land is big enough. Therefore, issuing forward contracts to very small lands is not advantageous. If okra is your crop, then on average it will produce 200 kg per acre. Harvesting can be carried out every other day (or sometimes daily). There are 15 harvests in a single cropping cycle. For an order of 1500 Kg, packed in crates, a small ‘Dimo Batta’ lorry is sufficient. We can manage this by getting in to forward contacts for 7 acres, or 7 farmers with one acre or 14 farmers with 0.5 acres or 28 farmers with 0.25 acres (we may suggest a mix of sizes as well, but having a uniform size across all farmers is again easy to manage). Managing a small number of farmers with larger lands parcels is comparatively more efficient.

Farmers commit to a forward contract in terms of land size. However, through practices it is shown that farmers hardly commit to that promised and size. This will impact the harvest greatly and can impact the logistics as well. A crop comes with a recommendation for planting. For example, an okra seed packet will have 3,500 seeds. One hole in the ground needs two seeds, and with a spacing of 2*2, on average the seed packet requirement for an acre is 6. Since we know the average yield for an acre if 6 seed packets are used, it is easy to forecast the yield for the total area cultivated. But if farmers do not follow the seed recommendation then this will fall apart. Therefore, when farmers commit to a land size, it is always important to get them agree on the seed requirement as well.

Let’s assume that you want to establish a collection centre in order to manage these forward contracts. Otherwise a door-to-door collection must be set up and that is an uncontrollable cost for anyone who manages the forward contracts. Therefore, it makes good sense to establish a collection centre. Then it also makes perfect sense to establish forward contracts close to the collection centre, so that logistic operations are optimised.

What is ideal is to have a “cluster” approach. For a particular value chain it is important to establish forward contracts as a cluster closer to the collection centre. For a given value chain, there can be several clusters, cultivated at the same time, or several with time gaps (for example 15 days apart) so that a continuous harvest is guaranteed.

Managing cultivation

It is important that all farmers cultivate at the same time. With respect to short-term crops, this has to be the same day. We project the harvest attached to forward contracts based on the cultivation day and the number of plants. Hybrid seeds will give harvest on an exact day (given that the cultivation happens with proper crop management). This makes it easy to implement a logistics plan. Logistic costs can be minimised only if they are done with economies of scale. To plan a successful logistic operation, we need harvests at the correct time in correct amounts.

Having plantations on different dates will increase the logistic costs. Moreover, it will decrease the chance of fulfilling quotas for buyer forward contracts, in this case it could be the exporters or ultimate buyers overseas. Therefore, it is really essential that all the farmers in the program cultivate on the same day.

For any crop, the Department of Agriculture (DOA) provides a fertiliser recommendation. However, their recommendations are not for hybrid seed varieties. Almost all the export-oriented short-term vegetables and fruits are based on hybrid varieties. With the seed act, seed importers are responsible for managing a supply chain for these hybrid seeds.

Before introducing a seed variety, seed importers must do field trails and determine the yields, spacing requirements, fertiliser recommendations, pest and disease management and harvesting. However, unless you directly engage with these seed suppliers, this information is not publicly available.

For example, if a particular value chain adopts a particular seed variety, the organisation that manages the value chain and forward contracts can partner with the seed suppliers in order to engage in training and information sharing. This is very important, since these short-term value chains can easily fail with the wrong information.

Now, the fertiliser recommendations at the DOA is not wrong. They might not be sufficient for a hybrid variety. Therefore, a proper fertiliser recommendation has to be attached to the forward contract, so that farmers know what to follow. But again, these recommendations have to be revised with the soil conditions explained before.

There are chemical pesticides as well as bio-pesticides. Both these pesticides are available at the pesticides store for purchase. In addition, farmers usually come up with different experimental bio-pesticides that sometimes can be effective, at least in the short run. Issue with these bio-pesticides is that they are not proven by scientific experiments and there can be side effects.

Forward contracts are usually attached to export-oriented value chains. These crops are short-term crops. Therefore, it does not provide much room for experiments and side effects of unproven bio-pesticides, which can harm the total cultivation. Therefore, it is really important that farmers do not apply un-proven bio-pesticides for these crops. They can apply any bio-pesticides that are proven and registered at the pesticide register. But these have to be approved by the organisation that manages the forward contract. These bio-pesticides might carry chemicals that are banned in some export destinations.

There are produce tests which check for MRLs in the harvests, and it is extremely costly to find unapproved chemicals which can cause a rejection of the whole supply. The same holds for chemical pesticides as well. They have to be approved by the organisation that manages the forward contracts. Pesticide retailers might suggest pesticides for marketing purposes, but farmers should not follow their advice without prior approval.

Whatever the pesticide is, farmers need to follow recommendations in applying. Excessive amounts should not be applied, and pesticide application during harvesting time has to be carefully planned. All this information needs to be explicitly explained in the forward contract.

There are mortalities at different stages. Seeds have close to 1-2% mortality rate. However, there can be exceptional cases, and this information needs to be followed through with the seed suppliers. If the seeds packets produce higher mortality rates, this information needs to be conveyed back to seed suppliers, and it is possible to ask for compensations (maybe replacing seed packets). In such a case, farmers need to replace plants.

This is not a serious issue for lower mortality rates – e.g. below 10% – but if higher, it will seriously affect the yield projections. Plants can die due to diseases/natural hazards as well. Again, these plants have to be replaced. If the mortality here is also greater than 10% then the plants needs to be replaced immediately. Ideally, we also want farmers to maintain a crop record book during the cropping cycle. For some farmers, this is a normal activity, but some hardly do this although it is very important. This will help to track whether farmers have followed fertiliser and pesticide recommendations, especially in a case of exceeding MRLs. All this information and instructions to follow must be a part of the forward contract.

Harvesting and

managing quality

Each and every crop will have quality parameters when it comes to harvest. This will be specified in the forward contract. Since these vary based on the crop, this can be something attached separately to the master contract. Studies show that farmers tend to deviate from maintaining these quality parameters. This will only increase the rejections.

There should be a warning process if farmers are not adhering to quality specifications. One can allow a three-strike process, then farmers needed to be taken out of the value chain. Having lower quality produce at the collection centre will only increase sorting times, and that can create many transaction costs to the organisation that manages forward contracts.

For all short-term crops, there is a recommended harvesting interval. For example, okra needs to be harvested every day or every other day. A different quality parameter (this is mainly about the size of the fruit) can be achieved by harvesting daily or every other day. If this is not done then the harvest will exceed the quality parameters (such as the colour, maturity and size). Then the rejections will be higher. Also, logistic plans are based on the harvesting campaigns. Hence harvest needs to be done on the correct day. The harvesting time is also important. In general harvesting has to be done in the early morning, before noon, so plants and the harvests will not get stressed.

Most short-term cash crops can be harvested multiple times during a crop cycle. The size of the harvest varies during these multiple harvesting times, but that is not significant for most seed varieties (there are varieties that will have a uniform harvest size during the cropping cycle, some will have a bumper harvest in the beginning and will drop down gradually).

However, the first couple of harvests might not provide an optimal harvest and this applies to the latter parts of the crop cycle as well. Therefore, for example, okra can be harvested up to 15 times every other day, but the first two harvests will be lower and the last two harvests will also can be lower. Most of the time, the last two harvests will not be the required quality, since both the plant and the land is losing its potential. This can be evident by off-colour and oddly-shaped harvests. This need to be specified in the forward contract.

If the organisation that manages the forward contracts realises the last few harvests are not up to quality, they may stop buying from that farmer. Usually farmers realise the potential of the crops and the land during the last phase of the crop cycle, and there are farmers that may inform that they will not be able to supply. But there are farmers who will try to push low quality supply through and try to blame the organisation for not buying. Therefore, the forward contract need to specify that if the produce is not of the required quality, it will be rejected, and if a farmer reaches three strikes (number of strikes depends on the organisation) then he will be taken off from the value chain.

Because of these things, when implementing a forward contract, it is important to anticipate a loss of harvest of a certain percentage and plan for that. For example, if all the forward contracts are tied to a supply of 1,000 kg, we need to plan cultivation aiming at 1,500 kg. This leaves enough room for rejections and non-compliances.

For every crop, there is a forecasted harvest. For example, as explained before, okra: if the proper seed, fertiliser and other chemical recommendations are followed, one acre will give 200 kg per harvest. Based on this information, we need to set a limit to the quantity we accept from the farmer.

For example, we can say: We will buy a maximum of 200 kg and minimum of 100 kg (this is assuming farmers face some

diseases and lose half of the

harvest). Otherwise, farmers expect the organisation to buy over-production and it is not economical for them to buy an under-production as well. Farmers always have the ability to sell the over-production to other parties and this needs to be specified in the forward

contract.

Accepting harvests

and rejection handling

In an ideal situation, supply that is managed by a forward contract needs to be associated with crates. This is the opportunity for an organisation to track the produce from farmer to consumer. Crates needs to be given QR codes. A permanent QR code has to be on the crates that identifies details regarding the crate batch. Then there needs to be another QR code added for every harvest delivery, which will highlight the details on that particular harvest.

For any given crop cycle, before the first harvest, farmers need to come to the collection centre and receive crates. They will then bring in the harvest to the collection centre on them after doing the first level grading. Collection centre will issue another set of crates on the same day for the next harvest, or the same crates with a new QR code. There are only a few organisations that implement traceability for agricultural value chains, but we need to understand the importance of this. If we want to implement forward contracts with export-oriented value chains, traceability must be a part and parcel of the whole operation.

Quality checking and grading needs to happen at multiple points so the final rejection is minimum. Ideally the first level grading needs to happen at the farm gate. There isn’t enough incentives for farmers to do a proper quality checking and grading at the farm gate level by themselves, unless there are proper incentives attached. The forward contract therefore must specify that they need to have a grading and quality checking done, and whatever is rejected can be sold outside.

A dis-incentive must come in to play here, saying that if the second level grading at the collection centre finds higher percentages of rejections, even after the first level rejection, then farmers will be penalised. This will motivate farmers to have a proper first level quality checking and grading. A final quality checking could happen at the factory as well. What is rejected at the collection centre can be given back to farmers. But if there are rejections at the export factory, it might not be possible for farmers to receive those rejections with enough time for them to resell at the local market. Therefore, forward contract must make sure the first level grading and the grading at the collection centre is maximised.

Price and payments

Forward contract will specify a forward price. This can be for a season (one cropping cycle) or multiple cropping cycles. For short-term vegetables forward contracts are usually for a one cropping cycle. The price is guaranteed for all the harvests in that particular cropping cycle. At the same time, the price is a signal of quality. Different grades will have different prices.

In general, once a forward price is agreed, there is little or no room for negotiation during the period of the forward contracts. All this information must be clearly specified in the forward contract. Payments usually happen a few days after collection. A forward contract need to specify when can farmers expect their payments, how they will receive payments (money, cheques or direct bank transfer) and whether there will be notifications on how much of their harvest was accepted and paid for. Unless these are specified clearly, forward contracts with farmers can run in to problems.

Summary

A forward contract is a tool that manages quality and continuity of supply in agricultural value chains. There are organisations that run successful forward contracts but the number of failed attempts is larger. Conditions for a successful execution of forward contracts can only be known through actual field attempts. A forward contract must make sure it covers the whole agriculture production cycle from land selection to final delivery.

(The writer is an agriculture and environment economist. He can be reached via chatura_rodrigo@yahoo.com or 94 763599243).