2. Helping producers to farm profitably

FACTORS AFFECTING PROFITABILITY

In the past, ministries of agriculture and even NGOs worked mainly on improving agricultural production and yields. This involved carrying out field trials, testing varieties and developing improved production techniques. The extension officer's primary role was to advise and encourage farmers to use improved production technologies.

Although farmers do, of course, benefit from improved yields, their primary concern must be to make a reasonable living from their farm. They need to generate sufficient profit from their sales to be able to cover their living costs. The key issue for them is how to do this.

The main role of the extension officers should therefore be to help farmers farm more profitably. To do this they must have a basic understanding of the factors that influence profits. These are farm gate or market prices, volumes sold and costs.

Table 1 shows how small changes in these three factors have an effect on a farmer's profit. Improving the price obtained and the quantity sold have a greater impact on profitability than does increasing production.

Table 1
The effect on profit of different levels of production, prices, sales and costs

Note: Costs for packaging, transport and commission are $2 per kg sold, except for column 7, where they are $1.80 per kg sold.

THE BASE SITUATION

(1) Summarizes costs and returns of a grower who produces 10 tonnes (10 000 kgs) of a product. Although 10 tonnes are produced, only 80% is sold. Sale price is $5 per kg. Production costs include cultivation, seed, fertilizer, any sprays and labour costs and are $10 000. Marketing costs (e.g. packaging, transport and commission) are $2 per kg sold. The farmer's total sales are $40 000, the costs are $26 000, leaving a margin of $14 000 to cover any fixed costs (rent, bank charges, salaries) and profit.

In the cases that follow (2 to 7) a single variable (in bold) has been altered, thus affecting the gross margin of each case

(2) Additional production inputs result in the yield being improved by 10%. Production costs are increased by $1 000 and marketing costs by $1 600 as additional production is marketed. Margin increases by $1 400 or 10%.

(3) Only half the production is sold (e.g. because of oversupply, a lack of buyers, poor demand). Margin falls dramatically to $5 000, or about a third of the typical profit in the Base Situation (down by 64%).

(4) Shows impact on profits when prices are 10% down. This will happen when there is low demand or oversupply. Profit margin falls by about a third (29%) to $10 000.

(5) Sets out the situation where prices are increased by 10%. This could happen when demand is high and/or supply is low. Profit increases by 29%, or by $4 000.

(6) All production is sold. This might be because the market linkages have been improved, because the farmer works harder at marketing or because of strong market demand. Profits improve by $6 000, or over 40%.

(7) Reflects the situation where 10% savings are made on marketing costs. Margin increases by 11%, or $1 600.

From Table 1 we can note several important points about profitability:

1. If farmers cannot sell all their production, potential profit goes down a lot. This highlights the danger of increasing production without being confident that the additional supply can be sold.

2. An increase in price has a significant effect on improving profit because production and marketing costs are generally fixed (unless a marketing commission is calculated as a percentage of the selling price). In the example in Table 1 a 10 percent increase in price lifted profit by nearly 30 percent. The opposite is true of low prices, where a small decline in price can lead to a large decline in profitability. This shows the importance of helping farmers to sell at high prices. Ways of doing this include growing crops that are in demand, producing better quality and negotiating more effectively with traders. The graph opposite shows the effect on profit of increased prices.

3. Marketing costs (e.g. marketing commissions, transport, packaging) can be greater than production costs, particularly in the case of horticultural crops. Marketing costs can often be reduced, leading to higher profitability.

Figure 1
The relationship between prices and farmer profit

PRICES AND PROFITS

Balancing risk and profit

High profits are closely linked to high risks. In agriculture, the enterprises that offer the possibility of the highest profit are usually the most risky. For example, if there is only a small demand for some products, such as flowers or some fruits, they can easily be oversupplied, leading to dramatic falls in price.

Some products may be technically difficult to produce or susceptible to pests and diseases. Farmers, and particularly poorer farmers, need to consider the importance of balancing production of potentially more profitable, but riskier, crops with those that provide a lower, but more stable and reliable income.

Enterprises that usually provide reliable incomes include staple crops (e.g. rice, potatoes, maize) and contract production for agricultural processors (e.g. cotton or sugar cane).

Farmer prices

The prices that farmers receive are mostly influenced by supply and demand. This is discussed in more detail in Chapter 3.

Other important factors affecting the price a farmer receives include:

· How much competition there is between buyers. When there is only one buyer, he or she will possibly offer a low "take it or leave it" price. Prices are likely to be higher and more profitable when there are many buyers competing with each other.

· The amount of information the farmer has. A farmer who is poorly informed of market prices and demand will be less able to negotiate with traders.

· The quality of the produce. Buyers will sometimes, but not always, offer higher prices to producers with better quality products. If most farmers produce low quality produce it is difficult for a trader to market high-quality produce separately.

· The transport costs. Lower prices are generally offered to producers whose product is costly to transport (e.g. from farms with small volumes; that are long distances from the market; or along poor roads).

Price increases along the marketing chain

As produce moves along the production-marketing chain, prices increase. Unit prices are lowest when farmers sell a standing crop. An example of this is when fruit growers sell their fruit on the tree to fruit contractors, who then harvest and pack it. This is common in Near East and South Asian countries. Harvested produce sold at the farm gate to rural buyers obtains a lower price than produce sold at a local assembly market which, in turn, is sold at a lower price than produce sold at a wholesale market. Retail sales achieve the highest price. The price the farmer gets depends on the point in the marketing chain at which he or she decides to sell. Although prices are higher, selling further along the marketing chain involves additional costs for transport, market fees, meals and accommodation. There are also costs in terms of farmers' time. Farmers who take produce to market and sell directly to consumers will usually get the highest price but they do need to decide whether this is the best use of their time, as it may be more usefully spent managing the farm.

Figure 2
Price increases along the marketing chain

Identifying new products

Products sold in larger volumes, such as grains, may make low prices, but these prices are usually more stable. Such crops offer greater security but lower potential profits.

Products with an increasing demand offer good opportunities. The market is less likely to be oversupplied. Such products provide the opportunity for producers to expand their business as the market grows. The market for food in developing countries very often follows the same patterns of growth as have been experienced by developed countries. Examples are:

• urban consumers increasingly buy semi-prepared food (e.g. pre-packed salads or pre-cut vegetables) and processed food products;

• eating at fast-food restaurants becomes more popular and such restaurants become an important market for horticultural produce;

• snack products are increasingly eaten;

• retailing becomes more sophisticated and supermarkets start to take a larger share of sales.

New products and new markets provide opportunities for more rapid growth and more profitable production. For example, processors and supermarkets sometimes like to secure supply of crops by contracting farmers or intermediaries to supply them. These changes in the market for food lead to the development of new marketing channels, new buyers and a move away from more traditional assembly and wholesale markets.

Farmers' marketing costs

Marketing costs can be reduced, especially by achieving economies of scale. The larger the volume of product marketed, the greater the scope for lowering unit costs, for example through using larger vehicles or bulk-buying of packaging. Sometimes, traders operating on a commission basic will accept lower percentage commissions for large quantities. Small farmers working on their own are naturally at a disadvantage. Cost savings have sometimes been achieved by farmers working as a goup to jointly purchase inputs and hire transport.

Marketing costs and the trader

Traders also have costs. Because these are not always visible, traders are often accused of making unreasonable profits. Although traders can sometimes exploit a situation and make exceptional profits, there are also occasions when they are unable to sell products that they have purchased and therefore make losses. High profits on some occasions compensate for risks of losing money on others.

Product losses

Losses of products will inevitably occur during marketing and are one example of a marketing cost that is often invisible. Ways of handling horticultural produce to minimize losses are discussed in Chapter 8. Types of loss are:

Loss of weight. Produce can lose weight, mainly through water loss in storage, transport and marketing. A trader may buy a tonne of products, but as a result of water loss may only sell 975 kilos.

Loss of value over time. The fresher the product, the higher the price. Fresh produce will last longer, will probably taste better and may be more nutritious. Over time, bruises and pest damage become more apparent and water loss leads to many products starting to shrivel, all leading to losses in quality and in price. The most obvious loss occurs when produce has to be thrown away.

Physical losses. Fresh produce losses in developing countries can be exceptionally high. Losses of ten to thirty percent are often quoted. In practice, only on rare occasions is this volume of produce thrown away. These figures more accurately reflect the loss in value that occurs from the combination of moisture loss, damage, disease and loss of freshness, as well as the proportion of the harvest that is thrown away.

For a trader, minimizing losses is very important. Part of the difference between the consumer price and the price paid to the farmer is because the trader needs to make a large margin, to cover wasted or damaged produce. By only looking at the selling price it is easy to think that the trader is making an unfair profit. However, when losses are taken into account the picture changes (see Figure 3).

Figure 3
The impact of product losses

A trader buys 100 kg of tomatoes at $5 per kg, and has to throw 20 kg away, and sell another 20 kg at cost price because of loss of quality. Therefore the trader will have to make a profit on the sales of the remaining 60 kg.

The apparent profit margin is 66% [(sales price - buying price) ÷ buying price] × 100

[(8.33 - 5) ÷ 5] × 100 = 66%

The actual profit margin is 20% [(sales income - buying cost) ÷ buying cost] × 100

[(600 - 500) ÷ 500] × 100 = 20%

THE IMPORTANCE OF TRADERS

If traders consistently made "super profits", others would be attracted into buying and selling the same products. The competition between them would reduce their profits to more normal levels. But it is important to understand that traders do have to make a profit.

Traders. It is often not understood how important traders are. Unless there were people who were prepared to buy farmers' produce, organize its distribution and find markets, farmers would not be able to make a living and consumers would not be fed. The more dynamic the trading sector and the greater the competition between traders, the greater will be the volume of produce taken out of rural areas and incomes returned to the farming community. Traders are therefore to be encouraged and supported, not criticised.

Sustainability and long-term profit. The most beneficial business relationships are long-term. Traders often conduct business with other traders with whom they have worked for years, or even generations. However, farmers are often tempted to neglect a long-term buyer because a new buyer offers slightly higher prices. This can be a risky policy. New buyers, as a tactic, will generally offer excellent prices initially in order to secure supply and market share. There is no guarantee that they will continue to pay more. New business relationships are much more likely to experience disputes.

Long-term business relationships have the advantage of the trust and understanding that develops over the years. Business transactions are more likely to proceed smoothly. Such relationships can continue to provide long-term, profitable opportunities to producers from season to season and provide benefits to both parties.

For agricultural marketing arrangements to continue for a long time they need to be financially sustainable. Although there are likely to be periods when products are sold at a loss, a sustainable production-marketing chain is one in which all the businesses involved make a profit. They must all benefit from the trade. The long-term success of such an arrangement depends on how well all those involved work with one another.

Selling directly to consumers can mean higher prices
... but also greater risks