Virtual Integration Takes Hold in the Pork Industry

Published October 6, 2004

In livestock marketing 30 years ago, the only information sent by processors to producers was the market price obtained when the animals were sold for slaughter. By that time, there was nothing the producer could do to change the animals. The only effect of market prices was to signal that changes had to be made in breed selection, feeding rations, and production scheduling so a better price might be received a year or two later.

The relationship between pork producers and processors was viewed as adversarial, one gaining only at the expense of the other. They were not members of the same team trying to produce a superior product that could compete against other products such as beef and poultry. With the high cost of specialized equipment used by both producers and processors, neither group could afford to let facilities go unused due to miscommunication about supply and demand factors. Little wonder, then, that many processors looked to vertical integration to better guarantee their supplies.

Things are much different in the pork industry today. Small, tightly aligned supply networks for niche markets have specific daily or weekly production targets and price discounts and premiums for quality factors. In such supply networks, information must continuously flow among all parts of the network to keep everyone apprised of opportunities and threats to the network.

Larger supply chains built around the major pork processors with multiple plants have more flexibility than the smaller networks, but not much. Wal-Mart and similar large grocery chains want to keep their meat cases full with no excess inventory. The development of case-ready packages–meat delivered from the processor to the retailer in packages that do not require further cutting or preparation before sale–allows little margin for error in quantity and quality. Retailers have the market power to demand exacting schedules, and processors are learning to communicate those needs back to producers on a regular basis.

This exchange of information between producers and processors is accomplished through virtual integration. Virtual integration occurs when processors choose to use qualified suppliers who ensure the availability of at least a portion of their needs with known quality. It creates new opportunities for hog producers.

Hog producers with little capital and little ability to take risks are likely to focus on contract production, probably with a large contractor who seeks out new producers willing to follow specific procedures laid out by the contractor. Producers with more capital, experience, and risk tolerance are likely to work with smaller contractors who provide less supervision and desire more decision-making by producers.

Alternatively, the larger producer can align itself with a supply chain, negotiating a marketing contract with some type of risk protection. Producers with substantial capital and risk-bearing capabilities can choose to own hogs and have a marketing contract or operate entirely outside the supply chain and supply hogs on the spot cash market.

Contract producers are generally satisfied with the virtual integration arrangements. Glenn Grimes et al. reported that contract growers rated their contracts an average of 4.9 on a scale of 1 to 6, with 6 being very satisfied. Contractors (the owners of the hogs) rated the contracts at 4.6, even though many have suffered significant losses over the past five years. Producers who are not contractors or contract growers rated contracts at 3.7.

Most production contracts are for four to five years. When contract producers were asked what they would do when their current contract expires, 80 percent said they would attempt to renew their contract with the current company. Only 9 percent said they would attempt to go with a different company, and 4 percent said they would go independent.

There is little doubt that production contracts have made hog farming more efficient by allowing producers to focus on what they do best and giving them access to the capital they need to buy new, state-of-the-art facilities. A 2003 study by the USDA Economic Research Service found, “The rapid and widespread growth of contract hog production has substantially raised productivity in the industry. On average, contracting raises total productivity by 20-23 percent and by as much as 50 percent for some inputs.”

Virtual integration is changing the face of the pork industry. For those producers who understand it and are willing to change their business models, it is the source of substantial rewards. Not all farmers will make the transition, however, The 2003 USDA study also found, “Many of the highest cost hog operations are small, independent operations, operated by older producers who plan to soon exit the hog industry. The lowest cost operations are mostly large, produce under contract, and are operated by younger producers with newer facilities.”

Ross Korves ([email protected]), an agricultural economist, is the author of a Heartland Policy Study on integration in the pork industry. He has written extensively on economic trends affecting U.S. agriculture and the livestock industry. From 1980 to August 2004, he was an economist with the American Farm Bureau Federation.