Farm finance: Contract farming

Contract farming agreements have grown in popularity in recent years as a vehicle for farmers to reduce overhead costs and still be involved in practical farming. But how have they been affected by serious rises in input costs and more volatile cereals prices? By Christopher Monk of Strutt & Parker

Contract farming agreements have definitely stood the test of time.

Originally conceived in the 1980s for smaller, uneconomic arable farms and later for dairy farms, CFAs have been modified and improved, and are still thriving. At one stage we thought that Farm Business Tenancies, introduced in 1995, would herald their demise, but interest in CFAs strengthened and by the early 2000s it was suggested that half the arable farmers in eastern England were involved in such an arrangement, either as farmer or contractor.

With the introduction of single farm payments in 2005, CFAs soon adapted to incorporate the annual payments and have also been adapted to incorporate Entry Level Stewardship payments. But widely fluctuating crop prices in recent months have led many farmers and contractors to review their arrangements.

How agreements work

What makes the contract farming agreement resilient, adaptable and popular with land owners, farmers and contractors?

In a standard agreement the parties are farmer and contractor. The farmer may be a land owner or a tenant. The contractor is usually a neighbouring farmer, but could be a large farming company or a traditional contractor.

The farmer provides the land and buildings, arranges for a dedicated bank account, pays the bills, receives the farm income in his business name and claims the SPS/ELS annually.

The contractor provides the labour, machinery and some day-to-day management (eg crop management) for which he receives a basic payment (usually quarterly or half-yearly), plus a performance-related additional payment.

Both parties meet the requirements of regulations, such as health and safety, farm assurance and cross compliance, and their respective duties are set out in a relatively straightforward document that also specifies the contractor’s basic charge, farmer’s first or “prior” charge, calculation of divisible surplus (eg what overheads are included) and how that surplus is shared.

Contract farming agreements have adapted to increases in farm inputs and more volatile grain prices.

Pros and cons: Farmer

Advantages:

• Creates economies of scale
• Uses specialists whose reward depends on their achievement
• No capital cost of machinery or depreciation charges
• Generally avoids employment costs/HR regulations
• Continue as a farmer for purposes of SPS/ELS
• Inheritance tax (Business Property Relief), income tax and VAT benefits (compared with Farm Business Tenancy)
• Inheritance Tax (Agricultural Property Relief) for farmhouse if used for business (needs care)
• Very flexible and adaptable
• Not governed by statute – virtually all the terms can be agreed between the parties
• Reduced involvement means less stress compared with in-hand farming
• Good return – should be more than an FBT but also more risk and less secure
• Allows absent farmers to carry on by using an agent to manage the CFA.

Disadvantages:

• Administration costs generally higher than FBTs
• TUPE (employment legislation) applies if changing from in-hand to CFA.

Pros and cons: Contractor

Advantages:

• Economies of scale – some contractors have five or more agreements using the same labour and machinery
• A relatively quick way to expand a business
• Entrepreneurial farmers can use skill to achieve excellent income without the high capital cost of land
• Receive a basic contractor’s payment even in a poor year when no divisible surplus.

Disadvantages:

• Relies on the parties getting on well together and sometimes with the agent representing the farmer
• If the parties fall out, there are usually termination clauses in the agreement, but no statutory procedures as provided under FBTs
• No long-term guarantees, so it can be difficult to match resources of labour and machinery (eg farmer decides to sell up and purchaser does not wish to use the same contractor).

How contracts have changed

There has been a relative amount of activity reviewing existing CFAs over the past 12 months. Before 2007, agreements tended to be reviewed every two or three years and some of the most fundamental changes were to incorporate the SPS/ELS payments and related obligations.

Sometimes annual payments are excluded from the CFA, but in other cases they are included in the pot, adding to the divisible surplus. Either works, so long as the terms are adjusted appropriately.

Strutt & Parker carried out an internal survey of the results of 52 CFAs we had reviewed for clients in 2007 (2008 harvest). The average contractor’s basic charge was £220/ha and the average farmer’s prior charge was £205/ha for those including SPS payments within the CFA.

It is clear from the survey that the most popular share of divisible surplus before 2007 had been 20% to the farmer and 80% to the contractor.

However, following the rapid increase in commodity prices in 2007, the most popular arrangement for sharing the surplus income in our reviews was to split it into two tranches the first tranche (up to £50-70/ha) was 20% to the farmer and 80% to the contractor, as before.

The second tranche (ie divisible surplus above £50-70/ha) would then be shared 50:50.

The advantage of this slightly more complicated arrangement is that it allows the contractor to top up his basic charge, which rarely covers his full costs, from the first tranche and then share any exceptional surplus with the farmer.

In some cases the review involves increasing the farmer’s prior charge, but it is important to have a robust arrangement that will stand the test of high and low prices.

This 50:50 share of the disposable surplus is a good incentive to both parties and seems to be an important ingredient of successful CFAs. The example (right) shows how it might work in a typical agreement and the effect on the total payments (per hectare) for the contractor and farmer for three years, which show different gross margin levels.

There are, of course, numerous complicated sharing arrangements that have been devised and many work very well. But, from our experience, the agreements seem to work best if the arrangements are as straightforward as possible.

Factors that form part of a successful arrangement are:

• Trust between parties and their representatives
• Good incentive for the contractor to share from his efforts and management skills
• Robust terms – carefully thought-out first charges and sharing arrangements allows the agreement to work in volatile times
• Flexibility and imaginative ideas to deal with longer term improvements, eg grain drying, reservoirs and maintaining phosphate/potash levels
• Concise agreement – clear documents setting down the basic terms and all those tricky, but important issues, such as cross compliance, health and safety, and insurance, so everybody knows where they stand
• Regular meetings to communicate and discuss.