Saturday, November 25, 2017

78. Perspectives on Recent Reports on Farm Profitability

Nov. 27, 2017
An undercurrent of discussions and meetings related to cost of production and farm investments has been on-going in the specialty industry for at least two years, maybe longer. It was 2015 when I first read Chad Trewick's elegant article about cost of production in Specialty Coffee magazine. By 2016 he had organized conference calls for the SCAA's Sustainability Council to learn about cost of production from a consultant, Christophe Montagnon, president of RD2 Vision. I felt fortunate to participate as a guest on one of those calls. Chad understood my curiosity as a grad student writing a masters thesis on this exact topic. Later in 2016 Montagnon's report was available, and just last month a revised and finalized version of the "Farm Profitability" report was introduced to the world by the SCA at the Avance conference in Guatemala. Now comments are reverberating such as the recent "Perspectives" blog post by Kraig Kraft, technical advisor for CRS, which was re-published in Daily Coffee News.

I would like to add to these comments. First, I'll share 3 key points to consider when reading the SCA/RD2 Vision report. Then I'll share 3 points as comments to Mr. Kraft's article review. For both sections, the following three equations are important to keep in mind:
  1. Profit (or net income) = (KGs x Price) - Costs
  2. Cost of Production = All Costs/Total KGs produced
  3. Farm Investments = All Costs/Total productive asset (such as land, ha; or # of trees) 
Comments on Key Findings of the SCA/RD2 Vision "Farm Profitability Report"

  • Key Finding 1 (of the SCA report): Yields increase with higher costs per hectare, especially in the short term, and hence may decrease a farm’s profitability. In other words, production yields are not necessarily correlated with farm profitability.
    • Africa Great Lakes Coffee (AGLC) data also shows that increased investments per asset (measured in ha or tree) leads to increased productivity (or yield). (Note: “investment” is more accurate than “cost” in this case, because we are talking about an asset, namely hectares.)
    • The SCA report seems to be saying that farms with the highest yields (most productivity per asset) are not the most profitable. AGLC data shows this correlation also, by stratifying the farms by size. Large farms have the lowest productivity (KG/tree) and the highest operating profit.
    • When I think about it in terms of factories it makes total sense. “Land and trees” are assets, like machines are assets in a factory. Just because your machine is producing widgets 2x as fast as my machine, doesn’t mean you have a more profitable business.
    • The SCA report is disappointing because it doesn't point out how the metric, cost of production, can be a very useful one, to manage investments and ensure they are increasing profitability.
    • It is also disappointing that key findings like this one fail to mention the critical role of price in determining whether farmers have profits. I would suggest re-writing this "finding" this way: Farmers must be careful to increase investments only as long as those investments lead to lower cost of production per KG, which, assuming price is constant, will mean increased profit.

  • Key Finding 2: Good Agricultural Practices (GAPs) are effective tools for increasing yields but do not automatically translate into more profit for the farming system.
    • This is why it is important to understand cost of production (CoP). The objective of GAPs is to lower cost of production per KG. By lowering cost of production of a product, you are increasing its profitability for the farmer, as long as the price is constant. By definition this is true, no research needed. These are principles of Econ 101.
    • Our research is looking for the “other factors”, that are enabling GAP to lower costs in ways that increase productivity, thus lowering CoP/KG and increasing profits. For example, we find that cooperative members:
      • Adopt best practices at a higher rate than non-coop members
      • Are 14% more productive per tree
      • Receive 52% more income from coffee than non-coop members
      • Have 22% lower cost of production than non-coop members
o    We’re not saying “every farmer will be more profitable in a cooperative”, but in Rwanda, something is happening in cooperatives that helps farmers. Because of the data that shows this, we can do a better job of discovering why.
  • Key Finding 3: There is wide variability of situations in coffee production. When production costs and profitability figures are given as an average at a country, or even regional level, this high degree of variation is not being accounted for. 
    • Couldn't agree more! The most important disaggregation to look for or insist on is farm size. What is cost of production on small, medium and large farms in the area of focus?
Kraig Kraft writes in "Perspectives on the New SCA Report on Farm Profitability."
  • Key Finding 1: Calculate net income using: Net Income = (yield x price) - (cost of production)
    • We prefer to use the term 'production' or 'KGs' instead of yield in this equation. So Net Income = (KGs x price) - Costs.
  • Key Finding 2: Producing more coffee is expensive, costly and cuts into a farmer's margins....the law of diminishing returns.
    • Kraft correctly describes the law of diminishing returns, but falls short of describing how cost of production/KG plays a critical role in helping farmers determine "how far to go" with their investments. Farmers are still optimizing their profits if they continue to invest up until the point where the next investment pushes the farmer into increased cost of production per KG instead of decreasing CoP.
  • Key Finding 3: MACERCAFE... the key to their profitability is to maximize efficiency, not yield.
    • I would clarify the term "efficiency" further and state that MACERCAFE is maximizing profit by investing in coffee only up until the point where their net income is protected, given the price. Looking at the equation above, if price is low, the farmer needs to keep the costs low, to protect his/her profit. We show in AGLC data from Rwanda that large farmers (perhaps similar to MACERCAFE in Nicaragua) reduce their investments in coffee when price goes down. They are protecting their gross margin, even if it means investing nearly nothing - i.e. neglecting the trees completely. Large farmers will do this until the price improves.
    • Contrary to the comments of the supply chain manager for MACERCAFE, small farmers in Rwanda do not have the luxury of doing the same. Their coffee trees are sometimes their only source of cash the entire year, so they invest everything they can into them, no matter what the price is. Maybe "small" has a different meaning in Rwanda than Nicaragua? For Rwandan standards, a small farmer has less than 400 trees. 500 - 1000 trees is a medium sized farm, and 1000+ trees is large (1000 trees still being less than half a hectare).
The AGLC program produced a helpful typology for understanding the spectrum of small to large farmers. See figure below. This typology highlights an important aspect driving whether farms are profitable or not - farmer motivation.  The SCA's report doesn't mention it and neither does Mr. Kraft. Yet a farmer's motivation for growing coffee cannot be assumed to always be profit maximization. In Rwanda, at least, some farmers are growing coffee out of necessity - it is their only source of cash. The typology also highlights the other factor that greatly impacts profitability, that is capacity. Capacity includes things like whether the farmer has an education, other adults in the household, a large farm and access to credit.

[Typology diagram credit: Dan Clay, 2016]

The punchline of the typology is that large farmers in Rwanda own over half of Rwanda's trees. Seems like they are similar to MACERCAFE in Nicaragua. They have capacity and their motivation is commercial - profit maximization. So price is a key driver. If the price they receive for their cherry does not cover costs, with a margin that matches their opportunities elsewhere, you can train them and talk to them all day, but do not expect their coffee trees to be well-attended. Their focus will remain on the crops and businesses that are paying the highest return on their investment.

The fact is, it is helpful to be having these discussions so that the gaps in our knowledge are recognized, which allows researchers to focus and fill the gaps. There is a lot of new research since the time that the SCA's report was written in 2015, especially from the AGLC project. Click here for the project description and scroll down to see the list of publications and resources.