Wednesday, February 12, 2020

94. Cost of Production - the basis for understanding price

Feb. 12, 2020
Adele (L), a coffee farmer in Rwanda,
talks with researcher Ruth Ann (R).
Cost of production (CoP) is an accounting term. It refers to the "cost of production of any item or unit." Most definitions talk about three components of CoP:

  1. Raw material
  2. Direct labor costs
  3. Overhead costs (e.g. management salaries, office supplies)

CoP gives the accountant a value for the costs incurred to produce a product or service. Once CoP is known, then profitability of the product or service can be calculated more easily.

A long lamented issue in the coffee industry is the difficulty to get a measurement, a value, for CoP for 1 kg of green coffee. More and more, the discussions about the "price crisis" and "fair trade" are focusing on how problematic and core this issue is. Say Roaster X just paid $2.75/lb FOB, about $6.05/kg FOB for green coffee. Is it a good price? It might be. The correct answer depends completely on the producers' costs.

At Artisan Coffee Imports, we have a perspective on this problem that goes back to our automotive roots. I grew up in southeastern Michigan and in an earlier part of my career I was a non-profit adviser to small manufacturers supplying the big auto companies. The companies that did well were the ones that had a fairly good understanding of their CoP, which enabled them to have productive discussions with their buyers about price.

After getting started in coffee around 2007 and seeing the parallels in coffee's long supply chain, I was eager to work with those who could help me understand costs and prices. Fortunately, I had the opportunity to be part of an amazing research project, the Feed the Future Africa Great Lakes Coffee support program in Rwanda and Burundi, from 2015 - 2018. My participation on this project enabled me to live in Rwanda for a year, and to utilize a large, new dataset to define and analyze cost of production of coffee in Rwanda.

In short, I wrote my masters thesis for an M.S. in Community Sustainability degree from Michigan State University on this topic. "Estimating Farmer Cost of Production: Implications for Sustainable Growth in Rwanda’s Coffee Sector" is the title of this 65 page labor-of-love, completed in August 2017. I've recently been able to format at least the executive summary to be more reader friendly, and therefore would like to share a link to the entire document HERE.

Summary of a Masters' Thesis
In case readers of this blog do not have time to read a 65 page thesis, I'd like to share a few highlights here. Tables and graphs are often the most interesting parts of any research paper, so let's focus on a few of those. In the literature review, I share Table 2: a summary of the results of 10 different coffee cost of production studies from around the world.

Table 2:  Ten CoP studies with country and CoP result

Sorted by country, then highest to lowest CoP

Study #
Study (Author – year)
CoP Result
US$ per lb. green coffee
USAID – AGLC – 2016
Technoserve, 2011-2013
NAEB – 1990s
TMEA – Integrity – 2014
COSA – 2015b
Costa Rica
COSA – 2015c
COSA – 2015e
COSA – 2015f
COSA – 2015g
COSA – 2015a
Nyoro, Wanzla & Awuor 2001
CIAT/CRS – 2015
Colombia – Narino – Off-farm
IDH – Technoserve 2014
CIAT/CRS – 2015
Colombia – Narino – Specialist
CIAT/CRS – 2015
Colombia – Narino Diversified
COSA – 2015d
CIAT/CRS - 2015
Colombia nat’l avg.
Committee on Coffee Competitiveness, 2015
Colombia – state A
Committee on Coffee Competitiveness, 2015
Colombia – state B
Committee on Coffee Competitiveness, 2015
Colombia – state C

Table 2 shows ten of the twenty or so papers reviewed for the study. The ten were selected because they give clear estimates of CoP. Using US$/lb green as a unit of measure to enable comparison, the range of values for Rwanda is $.05 to $.64. Integrity’s milestone study for Burundi estimated $.75/lb green for 2012. Estimates for Colombia range from $.68 - $2.38/lb green. This wide range of values can be attributed to both the underlying differences in costs across time and across regions and countries, as well as the variety of methodologies used in the estimation formulas.

After the literature review, we review the methodology of the research, especially the manner in which the survey was conducted in 2016. It was conducted with 1024 coffee farmer households randomly selected from farmer lists from 16 washing stations in 4 selected coffee-producing regions of Rwanda (Huye in the south, Rutsiro in the West, Kirehe in the East and Gakenke in the North.) So the calculation to understand the sample size of 1024 is 16 coffee washing stations x 64 farmers from each. This is a unique and extremely valuable database, providing the basis for establishing many new insights on Rwandan coffee, not just cost of production. Click here to see some of the publications that have already come out of this dataset!

CoP Punchline
To share the "punchline" first, we find the average CoP in Rwanda is 177/RWF/kg cherry (see Fig. 2 below). These costs for many farmer groups are higher than the average cherry prices being paid in Rwanda. This has serious implications for Rwanda’s long term production trend of specialty coffee. 177 RWF/KG cherry converts to $.64/lb. green, a more universally comparable metric, using Fx rate of 790 Rwf/$1 and cherry to green ratio of 6.4.

A key finding from the report is the confirmation that similar to other crops in many countries, cost of production in coffee in Rwanda tends to be lowest for the largest farms. The number of trees in on a coffee farm is significantly and inversely related to CoP (see Figure 1 below). It is recommended that this finding be used to guide both the design and the evaluation of farmer training programs. Programs should seek to target their resources to the size of farmer that will benefit most. 
Figure 1: CoP/Kg cherry is inversely related to number of trees in Rwanda.

CoP and Prices
More and more, the specialty coffee industry is realizing that programs and, importantly, pricing may need to be tailored by farm size to achieve sustainable margins in all size groups, (Trewick, 2015). For example, as shown in Figure 2 below, the floor price for cherry in Rwanda was set at 150 RWF at the beginning of the 2016 season (see line A in figure 2). On the left side of the graph, one can see how the smaller farmers will lose money when the cherry price is 150 RWF/kg cherry, whereas large farmers with 1001+ trees (20% of the sample in this research) make a slim margin, because their cost of production is below the average and below the floor price.
Figure 2: CoP/KG Cherry by Number of Trees with the 2016 cherry floor price
Based on these findings, stakeholders in Rwanda might look at other aspects of those with very few coffee trees, such as the inability to join cooperatives due to the fact that membership usually requires a minimum number of trees. A minimum tree requirement of 200 – 300 trees is common.  On average, cooperative membership has been shown to significantly correlate with lower cost of production in Rwanda (see section 6.2 of the report). With a holistic look at the situation of the “smallest of the small” farms, appropriate and specific interventions that would help create profitable scenarios for these farmers could be designed. 

Hopefully, these few highlights give a glimpse as to why understanding cost of production can be valuable. I know it has helped me as an importer to have confidence in my contracting methods and ways in which I interact with the producer organizations from which I buy. I tend to have a lot more emphasis on the cherry price paid to the farmer than other buying groups. Since I understand average cost of production is around 177 RWF/kg cherry (in some areas I have more numbers more specific for that exact geographic area), I push hard to get at least 300 Rwf/kg cherry to the farmer, roughly $1.50/lb green (using foreign exchange rate of 790, as used in the year the thesis was written). 300 Rwf/Kg cherry is the value the farmers told us in the survey was the value that they need to be profitable. As a buyer, I can see 300 Rwf/kg offers a reasonable gross margin to the farmer (30-40%), even those who are small farmers with CoP much higher than 177/Rwf/kg. We believe in the benefits that come to everyone in the supply chain when farmers are compensated for all the risk and effort required to grow great, specialty grade coffee, year after year.

Have questions about cost of production? Please contact us at .