Contract Production: Counting the Cost

     On the surface, most people think of contract production in swine as a low cost method of production.  In fact it is in most cases the opposite.  It has been employed primarily to allow added scale to achieve other cost reduction goals and to preserve limited capital.

     As costs of facilities have risen, the amortization options have been extended by lenders to 12 and 15 years from the traditional 10 year paydown on modern swine buildilngs.  As previously mentioned, a 10 year payoff of a 25+ year asset imposes cashflow strains that increase the opportunity cost and the actual cost of this method of production.  The grower expenses the asset based on its useful life while achieving a paydown in less than half of that time.  That's called a windfall gain. 

     Imagine you are in a capital intensive business and your cash flow is paying off your assets over twice as fast as they are being expensed.   

     The financial outcome of contract growers has been the source of a lot criticism but it is largely from those who do not know how to conduct financial analysis.  Most of these folks naively look at the return to labor as the primary if not only return for evaluation. 

     In general, the return to labor is the proper return for the time invested but it appears like a poor return to some who look at it compared to the cost of the facilities.  The return to labor has nothing whatsoever to do with the cost of the facilities.  It is a payment to labor not to capital.  They omit the fact (or overlook the fact) that the capital asset is being completely paid for in a short period of time (compared to its useful life).  Somehow, those monthly principal and interest payments (the return to capital) are ignored in the compensation evaluation. 

     In the upper midwest, most contract offerings do not place the net value of the manure nutrients in prospective cash flows but growers in the corn belt are a bit more savvy.  They understand the returns to capital, labor and reduced input costs (fertilizer) make contract swine production in many cases far more lucrative than the return outcome of the person offering the contract and owning the inventory.  This is especially true if you count the risk mitigation associated with the cash flow.

      There are exceptions to all of this with individual offerings and companies that have not specified high quality or industry standard buildings in their plan or followed through in honoring their commitments etc.  

     The question I would like to raise, which turns the tables, is how good of a deal are these relationships for the owners of the animals?  The short answer is they are very expensive.