The principal motivation for contract swine production by those who employ it has been to allow the growth of the operation. The owner of the animals typically invests in the sow farm, animals, feed mill and related capital items and lets contracts for the facilities post-weaning. By inviting investment in the very capital intensive production process by others, added scale can be achieved.
I'm not sure anyone has ever thought that contract production was a low cost method of production but it allows additional scale to be achieved which offsets some of the added cost associated with it.
You might ask what is the real cost of contract production and what are the benefits? First of all, contracts typically offer the equivalent of a triple net lease on the facilities. In systems where the buildings required are modern, well-built structures, the typical pay-off period has been 10 years. By setting the payment in such a way that all of the costs of the facilities flow through to the grower, including principal and interest with a paydown of 10 years, the cost of contract production has generally exceeded the normal cost of obtaining such facilities. One of the biggest reasons is the rapid paydown (10 years) which exceeds the actual rate of expensing of the building dramatically. In fact, most swine production buildings which were constructed 10 years ago, are selling for the same nominal cost of construction today as the day they were built. Realizing that the time value of money comes into play here, still, accounting systems don't allow for that adjustment so for many growers, there has been no loss in value of the facilities over the last 10 years.
Paying down an asset dramatically faster than its actual decline in value raises the cost of using the facility. In addition, it requires more cash outflow (from a cash flow perspective) than would be otherwise required.
Lenders of course have always wanted the payments to amortize the loan faster than the actual decline in value of the asset, which is understandable. How much faster however is a question of risk. Paying down an asset with a reasonable life expectation of 25 years or more in only 10 years, raises the cost of production.
There are a lot more hidden costs of contract production as well as some added risks which are causing some larger systems to consider abandoning the concept. Some have already done so. We'll be taking a look at these issues over the next several days. As you might suspect, we will return to the concept of variation as we examine the costs and benefits of contract production systems.
