Including Smallholders with Vertical Coordination

*Linda Bitsch, Silva Atoyan, Barbara Richter, Jon Hanf and Taras Gagalyuk*

## **Abstract**

The current chapter demonstrates an application of the theoretical framework of vertical coordination, more specifically the application of contracting in productive partnerships, to integrate smallholders into the value chain of a specialised crop. The aim of the chapter is to derive implications for industry participants on how to integrate smallholders with vertical coordination. Therefore, we take a closer look on vertical coordination and contracting in productive partnerships. We have taken the value chain of brandy production in Armenia and used the Yerevan Brandy Company (YBC) to perform our case study, with which we can analyse vertical coordination mechanisms used by the company. Further, we want to identify factors that drive processors and smallholders to enter into contracts. Qualitative interviews were conducted with the YBC, their grape suppliers, as well as experts from related fields. We analysed the data with a qualitative content approach. Results show that the YBC uses different measures of vertical coordination, i.e., contracts and farm assistance in the form of consultancy and input supply. The company tends to use production contracts rather than pure marketing contracts, as it is actively engaged in the production process. The use of contract farming is beneficial for both the processing company and the smallholders.

**Keywords:** value chain, vertical coordination, contracting, smallholders, brandy, Armenia

## **1. Introduction**

After the collapse of the Soviet Union in 1991, the whole food chains in Armenia and other Eastern European countries experienced an economic breakdown due to the beginning of the transition process. Problems occurred at the beginning of the transformation process. After land privatisation, and the liberalisation of prices and trades, the prevailing structures did not fit to the open market [1].

Disruption and instability in the supply chain from farmers to retailers had a negative impact on qualities and quantities. At the same time, changing consumer demands forced retailers and processors to adjust and improve the structure of the food chains to meet consumer demands and to overcome the supply problems. The agricultural policy could not provide frameworks and institutions fast enough to restructure the food commodity chains to guarantee stable and higher qualities as well as quantities. As a consequence, retailers and processors were engaged mainly in the approach of private-driven vertical coordination with partners along the supply

chain to overcome the problems of supply disruption and minor quality [2, 3]. These structural changes and their consequences are still present today.

To adapt to the new environment, the Yerevan Brandy Company (YBC), the producer of Ararat brandies, was acquired by the international Pernod Ricard Group with French origin in 1998, shortly after the collapse of the Soviet Union.

Investments of foreign companies can cause structural changes in the agri-food sector. The requirements of the newly established procurement systems demand that suppliers can guarantee both disruption-free product flows and delivery of products of a certain quality, thus forcing domestic producers to keep up with quantity and quality demands to prevent the import of products [4].

Literature on the influence of foreign direct investment (FDI) on transition economies mentions several positive effects of FDI such as follows: (1) it facilitates economic growth [5, 6], (2) it reduces poverty [7, 8], and (3) it can induce technology transfer, technical innovation as well as enterprise restructuring [7]. Dyker points out that those investing companies have to impose their corporate organisational structures on subsidiaries or partners [9]. Those organisational structures are based on the disposition of hierarchies, lines of responsibility, the use of intra-firm e-mail systems, etc. Hanf et al. show the influence that foreign investors have taken in the development of the Armenian wine and brandy business. They use different Armenian companies, among others, the YBC [10].

This is why we take the YBC as a case study to show exemplarily how an international company manages to integrate local smallholders (grape growers) into their national and international value chains by successfully installing a procurement system by using different measures of vertical coordination.

The case of the YBC in the Armenian brandy industry can be seen as a benchmark example for other countries and their agricultural sectors where the structure of smallholders is still prevailing, too. Based on the case study, we derive implications for the participants.

The chapter is structured as follows. To show the theoretical background on integration of smallholders into value chains, the next chapter gives an overview about vertical coordination, and vertical coordination mechanisms, i.e., contracting in productive partnerships.1 In the third chapter, background information on the Armenian wine industry is provided. The fourth chapter presents the case study results from the Yerevan Brandy Company. Finally, concluding remarks are offered.

## **2. Integration of smallholders into the value chain: vertical coordination and contracting**

#### **2.1 Vertical coordination**

In everyday business, companies face decisions about the synchronisation of successive stages in the marketing channel from producers to consumers. Traditionally either spot market transactions or integrated processes in companies have been used. The spot market and vertical integration can be considered as classical modes, which continue to be applied in nowadays businesses.

The spot market represents the classic *buy* (on the market) decision, where the company organises the transaction directly on the market. That means, the company buys, for example, an input on the market place. In this case, individual

<sup>1</sup> The theoretical frame is mainly based on the published chapter "Integration of Small Farmers into Value Chains: Evidence from Eastern Europe and Central Asia" [11]. For a detailed review on vertical coordination, look into Hanf and Gagalyuk [11].

economic actors follow their self-interest and focus on short-term, opportunistic exchange relationships, in which the individual actors can preserve their independence and high flexibility [12].

Vertical integration is considered to be the *make* (inside the company) decision, which means that a company integrates a successive stage, which can be an upstream or a downstream process. Hence, vertical integration combines different levels of the value chain within one firm [11]. Internal, intra-firm transactions replace various market transactions. This can be achieved either by forming a subsidiary or by a merger or acquisition. In vertically integrated firms, management directives dictate the transfer of resources across stages [2].

The classic *make* vs. *buy* decision has been researched quite well. Based on Coase's work about boundaries of a firm that make the difference whether companies choose to *make* or *buy* the product [13], Williamson [14] was one of the first to speak about hybrid governance structures. Based on the previous research made on the topic of hybrid coordination strategies and hybrid governance structures, Peterson et al. have highlighted the hybrid strategies and the nature of the so-called vertical coordination continuum. Depending on the type of vertical transaction, firms decide between the spot market, vertical coordination (productive partnerships) and vertical integration [12, 15]. Vertical integration combines different levels of the value chain within one firm [11]. Internal, intra-firm transactions replace various market transactions. This can be achieved either by forming a subsidiary or by a merger or acquisition. In vertically integrated firms, management directives dictate the transfer of resources across stages [2].

Vertical coordination can be described as the synchronisation of successive stages in the marketing channel from producers to consumers, leaving out spot market transactions, where the commodity exchange is only based on pricing. Productive partnerships, a kind of vertical integration, are characterised by collaborations of independent firms, in which the partners share interests as well as knowledge and resources to improve the outcomes of the supply chain activity. Productive partnerships can be based on specification contracts (production and marketing contracts2 ), relational-based alliances and equity-based alliances [12]. It can take different organisational forms possible: from loose or tacit agreements to stable, long-term and trust-based cooperation contracts [14, 17].

One can assume that the higher the priority to secure quality and/or quantity of raw materials, the stronger is the shift from spot market transactions towards advanced vertical coordination mechanisms [18]. This is closely related to the intensity of control, which increases along the continuum (**Figure 1**). With spot markets, the intensity of control is low, as exchange partners decide on whether to realise the transaction or not. With specification contracts, the control increases from that related to spot markets. As in relation-based alliances, involved firms share risks and benefits; coordination control arises from mutual interests and decisionmaking. In equity-based alliances, the intensity of control is even higher, because partners are key stakeholders and control and decision-making are decentralised among the ownership parties. Examples for equity-based alliances are cooperatives and joint ventures [12, 15].

### **2.2 Contracting in productive partnerships**

The key for all types of vertical coordination is contracting. Vertical coordination aims to overcome the disruptions in supply and inferior-quality products. However, the key actors (retailers and processors) find themselves constrained not

<sup>2</sup> For an overview on different classifications of agricultural contracts, see Drescher [16].

#### **Figure 1.**

*Framework vertical coordination (based upon [12]).*

by their capital capacity but by that of other participants along the chains on which they depend for critical inputs. This is because traditional lending institutions such as banks do not give credit to enhance the inter-firm product flow. Contract farming can be defined as an agreement between legally independent firms for the production of a commodity or product for a future market [16]. Götz et al. state: "An essential element of contract farming is the provision of some degree of assistance to the farmers, with the aim of increasing supply quantity or quality, or reducing seasonality" ([19], p. 364). Overall, farm assistance can include input supply programmes, investment assistance, trade credits, bank loan guarantees, extension and management advisory services, etc [4]. Thus, farm assistance programmes must be accompanied by appropriate governance mechanisms.

Production contracts (resource-providing contracts) are predominantly used to address quality concerns [20]. Developed markets have various consumer segments with differentiated demands. In production contracts, the contractor provides, on the one hand, a market for the goods and, on the other hand, engages in many of the producer's decisions and retains ownership of essential production inputs to secure higher-quality products to attend to the differentiated demands of the consumer segments [21]. However, when the higher-quality products become standardised (e.g. IFS or GlobalGAP certified) and there are no supply difficulties and/or the overall product quality is not complex, mainly marketing contracts will be used.

Marketing contracts address only the issue of supply disruptions by private contractual initiatives [22, 23]. The contractor usually provides a market for the goods but—on the contrary to production contracts—engages in few or none of the producer's decisions. In marketing contracts, the contractor and producer may negotiate the delivery schedule, pricing method and product characteristics.

For both types of contracts, Swinnen states that "these private contract initiatives can be quite substantial" ([2], p. 1). Empirical evidence indicates that they include farm management assistance, extension services, quality controls, farm input assistance programmes, trade credits and even bank loan guarantees. The programmes generate essential improvements in the credit situation of the farms, as they contribute directly to improved access to finance (e.g. through trade credit) and indirectly as they improve contracting farms' access to loans from banks or external financial institutions (through loan guarantees, enhanced farm profitability and improved future cash flows). Summing up, there are different factors influencing participants towards contract arrangements.

The main reason why processors enter into contracts includes the control over input supply. Further, processors use contracts to achieve uniformity and predictability to suit consumers, but they also benefit from lower costs in processing, packing and grading [24–27].

The main motivating factors for farmers to enter into contracts are the following, as reported by the USDA (1996): (I) income stability (to reduce risk compared

#### *Including Smallholders with Vertical Coordination DOI: http://dx.doi.org/10.5772/intechopen.92395*

to other ways of selling on traditional marketing channels); (II) improved efficiency (management decisions are transferred to the farmers); (III) market security (entering the contract provides a certain security in that the product will be sold if it meets with the requirements); and (IV) access to capital (contractor often provides inputs for farmers, which reduces the usage of credits) [28].

However, two reasons for the breaching of contracts have been detected. First, a lack of trust in business relations between producers and their buyers, as in transition countries, many buyers experienced that businesses were not able to pay. According to Ring and Van de Ven, trust is not built based on contracts; it rather emerges over time due to the commitment of assets or satisfactory performance [29].

Second, they may not be able to fulfil a contract because they cannot access basic production factors [23]. Contract enforcement is still an important problem. In the World Bank study, the enforcement problem was regarded as one of the most important barriers for successful vertical coordination [4]. However, in some cases, public enforcement institutions are not fully functioning. Furthermore, since transition countries are often described as having limited social capital, there is also an absence of societal enforcement mechanisms (e.g. peer or community pressure, a sense of mutual obligation and an overall sense of distrust). Thus, to improve the farmer's access to basic production factors (capital and specific inputs) and knowhow/information (knowledge and experience), means have to be worked out and put down in writing, i.e., contracts have to be signed [4].

The change to modern procurement systems is one reason for initiating vertical coordination and, therefore, chain-based financing. The requirements set by these systems favour large-scale farm production for two purposes: (1) significantly fewer large suppliers are needed, and hence the complexity of the system is lowered, which decreases transaction costs, and (2) it is more costly to assist small farms than larger farms [4]. As a result, many retailers and processors would like to see growth in farm size.

However, retailers and processors are (still) forced to include smallholders. Smallholders are essential for ensuring the required quantities in some countries. Particularly in labour-intensive sectors, small-scale farming has significant cost

### **Figure 2.**

*Contracting in productive partnerships.*

advantages. If the (farm) suppliers get too large, they begin to recapture some power. Since larger farms have the feeling that they can survive just by themselves, it may be more likely that smaller farmers join horizontal collaborations and ultimately create much larger units. The degree of market development is essential for the degree of vertical coordination. The less a market and its institutional environment are developed, the less likely it is that a complex system of vertical coordination will emerge (where marketing contracts are dominant). The more developed a market (i.e. the greater the demand for higher-quality products), the higher the degree of vertical coordination will be, and production contracts are favoured. These contracts vary in control allocation and risk transformation across stages.

**Figure 2** sums up the elements of contracting in productive partnerships.
