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Strategic Alliances:  Contracts, Business Co-ownership and Supply Chain Management

One decision managers need to consider is who they will work with and how they want to structure those arrangements. One extreme in answering this question is to envision a business where the owner/manager owns all the assets, invests the capital, provides most of the labor, buys the inputs as needed and sells the output after it is produced.

Perhaps not quite as extreme, is entering into arrangements to rent some of the land or facilities, hiring employees, borrowing some capital, pre-purchasing inputs, and contracting to sell output even though it is not yet produced. Each of these arrangements involves a contract whereby assets are transferred.

But these agreements also impact the owner/manager's risk exposure. For example, consider the contract to sell output before it is even produced? What happens if the production process fails? Without the contract, the owner merely would have nothing to sell, but with the contract, the owner has to compensate the buyer for not fulfilling the contract by delivering the agreed upon product. These contracts are more than an agreement to buy or sell an asset; they also influence risk exposure.

Review the case study of the California strawberry farm. What contracts is the business involved in and how do these contracts impact the owner's risk exposure?

The remainder of this page addresses arrangements that business owners and managers may have an opportunity to consider. How should these opportunities be analyzed in deciding whether to select the alternative of entering into the arrangement or deciding not to enter into the arrangement.

Strategy of collaboration

• Benefits of collaboration -- commentators suggest that business should collaborate; that businesses can benefit by collaborating with other businesses.
  • Is collaboration a necessity?  Why? Is the answer to this question influenced by whether our business has access to the consumer?   How does this question relate to the comment about independence?
    •  The State and the Farmer by Liberty Hyde Bailey, May 1908.  Note the reference (and challenge) to individualism in The Argument.  Has the trend in agriculture changed in 100 years?
  • What does collaboration mean? Working with another business?
    • There can be vertical collaboration and horizontal collaboration.
    • Collaboration is different than vertical integration within one business.
    • Collaboration is different than selling to the next business in the industry -- more on this later.
  • Why would businesses collaborate? Gain efficiency of size (lower cost), access information, allow specialization of labor, manage risk, ???
    • How does specialization relate to the economic concept of comparative advantage?
    • How does "access to information" relate to the concept of perfect and imperfect competition?
    • We do not want to merely alter each person's "share of the pie;" we want to increase "the size of the pie." Restated, can we better serve consumers by collaborating with one another?
  • Who are the business' competitors and who are potential collaborators?
  • What is the role of contracts and the role of negotiations in collaboration as a business strategy?

Business Co-ownership

• One form of collaboration would be co-owning a business.

• One Farm, One Operator? Not on the Largest Farms. ERS USDA Amber Waves Feb. 2005.
• Why would a person want to co-own a business? What would a person want to accomplish by co-owning a business?

• Do we "co-own" or just have a relationship?  What role do goals and risk have to do with answering this question?
  • How do we know whether we own a business? Does owning the assets mean owning the business? What is the difference between co-owning a business and co-owning assets?  Restated, what is the difference between owning a business and owning a business asset?
    • Does owning farm land make the landowner the owner of the farm business that is operating the land?  Does owning equipment make the equipment owner the owner of the farm business?  Can you offer other examples of making your assets available to a business even though you do not own the business?
    • If owning assets and owning a business are distinct, what is the distinction?  How does one know if they own a business?
      • One thought is "the business owner is entitled to the profit (should the business generate a profit)." The business owner also is entitled to ultimately control the business, for example, to decide whether to continue operating the business.
      • To continue this thought, consider the economic resources used in a business, e.g., land, labor, capital, etc. Owning land entitles the owner to rent; providing labor (including managerial activities) entitles the worker to wages; providing capital to a business entitles the owner of the capital to interest. We can confirm these ideas by considering how a business pays for land, labor and capital provided by someone else; that is, rent is paid to the landowner, wages are paid to the workers (including the hired manager), and interest is paid to the lender. This idea also is consistent with the concept of imposing an opportunity cost if these resources are owned/provided by the business owner.
      • If the business owner does not own any of these assets but instead pays others for them, what entitles the business owner to the profit? What has the business owner contributed? What does the business owner need to contribute to be entitled to the profit and control?
      • To answer these questions, consider which economic resources have not been accounted for? I would suggest (contrary to most economic texts) that information and risk have not yet been accounted for. I would further suggest that the person with information is entitled to a royalty payment and the person who bears the risk of the business is entitled to the profit (should there be any) and authority to control.
      • The risk in this situation is the risk that the business will incur a net operating loss, which is different than the risk borne by the landowner, for example, that the rent may not be paid, or the risk that the business will not earn enough profit to pay the laborer a bonus.
      • The risk of a net operating loss is having to pay creditors with assets from outside the business if the business does not generate enough cash to pay all of its obligations.
      • Bottom line -- the business owner is the individual who has assumed responsibility for the risk that the business may incur a net operating loss. The rewards for being the business owner are 1) ultimately controlling the business and 2) being entitled to the profit the business generates. Owning the other assets entitles the person to a payment of rent, wage, interest or royalty (whether it is a cash payment or an opportunity cost). Assuming the risk of a net operating loss defines business ownership; in exchange for assuming this risk, the business owner is entitled to control the business and receive any profit.
• Various forms of co-owned businesses.  Kay et al, Chapter 14, pp. 219 - 236.

• Choosing a form of business ownership. Should business owners think about "advantages and disadvantages," or should they consider what goals can be achieved with the various forms of ownership? 
  • For example, which form of ownership allows the group members to share ownership of the business? 
  • Which form of ownership allows the group members to direct risk of net operating loss to some of the business participants, but not to others? 
  • Which form of business ownership allows the group members to direct profit to all owners but management responsibility to only some of the owners?
  • Is the owners' goal to share ownership of assets, ownership of the business, or both?
  • Is the goal to provide opportunity for several individuals to invest their labor in the business?
  • To what extent will a goal of minimizing taxes impact achieving other goals?  To what extent will maximizing eligibility for government subsidies impact other goals?
  • To what extent does the form of business ownership need to be complemented with other arrangements, such as loans, leases, employment agreements, to reach the group's collective and individual goals?
  • How much does each member of the group want to invest in the business in terms of their land, labor, expertise, capital, and risk?  How much of each input does each member have to invest in the business?
  • See University for Minnesota Extension Service Farm Transfer and Estate Planning.
  • Developing a business structure is similar to designing and building a house -- the owners have the opportunity and responsibility to customize it, within limits, to meet their needs and goals.  Developing a business structure is NOT like buying a bar of soap where the purchaser has no input into what is contained in the product and is limited to only selecting which brand or structure they want.
• When thinking about how co-owners may want to organize or structure their co-owned business, it may be helpful to consider the income statement (that is, revenue, explicit expenses, and accounting profit) and opportunity cost (or desired return) for assets owned by the co-owners. (You may want to review the sample enterprise analysis form.)
  • In a co-owned business, the accounting profit will be allocated among the co-ownersm but how the accounting profit is allocated impacts the risk borne by each co-owner, this is especially critical in a year when the business does not generate enough accounting profit to fully reimburse the co-owners for all their contributions to the business.
  • To illustrate this, let's assume a two-person co-owned business to keep the example simple; let's also assume that one co-owner has considerable tangible assets (perhaps land and capital accumulated over a lifetime of work, such as a parent) whereas the other co-owner has far fewer tangible assets but will provide much of the labor and energy now and into the future (perhaps a son or daughter who is interested in taking over the family business). The following table illustrates the portion of asset contributed by each co-owner.

  	Portion of assets contributed by owner 1	Portion or assets contributed by owner 2
  Land	most	little
  Labor	half	half
  Capital	most	little
  Information	???	???
  Risk	???	???

  The task is to allocate the "less than desired" accounting profit between the two co-owners; that is, the year when the business does not generate enough accounting profit to pay all opportunity costs of the co-owners.

  • Scenario 1 -- If the owners had agreed that the business would pay a return for the land and capital, and then equally divide any remaining accounting profit between the two owners (because they work about the same), owner 1 would receive a major portion of the accounting profit before owner 2 receives a payment for the labor. Owner 2 in this situation would have little income in a year of limited accounting profit while owner 1 would be paid a return for the land and capital. Owner 2 would be bearing more of the risk, relative to owner 1.

  .	Revenue - expenses accounting profit
  .	allocation of accounting profit to owner 1	allocation of accounting profit to owner 2
  Land	paid first	.
  Labor	paid second	paid second
  Capital	paid first	.
  Information	.	.
  Risk	.	.

• Scenario 2 -- If the owners reverse their agreement, and pay the owners for their labor and then use the remaining accounting profit to pay for the use of the land and capital, owner 2 would be fully compensated before owner 1 receives a payment for the land and capital. Thus owner 1 bears more of the risk in this arrangement.

  .	Revenue - expenses accounting profit
  .	allocation of accounting profit to owner 1	allocation of accounting profit to owner 2
  Land	paid second	.
  Labor	paid first	paid first
  Capital	paid second	.
  Information	.	.
  Risk	.	.

• Scenario 3 -- Another approach would be to 1) place an annual value on the use of the land and capital (such as rent an interest), and on the labor, and 2) use those values to calculate the proportion of accounting profit each owner is entitled to. But how does one value the owner's annual contribution of assuming risk? This apporach also may leave owner 2 with an inadequate income.

  .	$1,000,000 - $900,000 $100,000
  .	desired returns for owner 1	desired returns for owner 2
  Land	$50,000	.
  Labor	$40,000	$40,000
  Capital	$30,000	.
  Information	.	.
  Risk	.	.

• In total, owner 1 and owner 2 desire $160,000 in return with 75% being paid to owner 1 and 25% being paid to owner 2. But the firm only generated $100,000 in accounting profit so owner 1 receives $75,000 and owner 2 receives $25,000. Would the co-owners deem this an acceptable outcome?

• Summary -- How the co-owners decide to allocate the accounting profit based on their relative contributions to the business directly and significantly impacts their relative risk in years when the accounting profit is not enough to pay all opportunity costs.

• However, owner 1 (with the tangible assets) bears the majority of risk should the business incur an operating loss (that is, a negative accounting profit).

• It may be helpful to review and apply the concept of willingness to assume risk v. ability to assume risk to this example of owner 1 and owner 2.

• Cash flow -- co-owners also need to negotiate how much cash they will draw from the business. These negotiations will require that the co-owners recognize the difference between profit and cash flow.

Supply Chain Management

• Another way to collaborate is to establish an ongoing relationship between businesses. This is different than a "spot" transaction (I sell you a product and you pay me for it); it is different than a series of spot transactions; it also is different than an informal preference to enter into a series of spot transactions.
  • Instead, this type of collaboration envisions an agreement (a legally binding agreement?) or arrangement to conduct ongoing business (a series of transactions) with each other for a specified period of time.
  • But can that arrangement be expanded to be more than one party is selling and the other party is buying? Can we exchange more than the product or service that is being sold? Can we find a way to work together so both benefit? Can we find a way to work together to "expand the size of the pie" rather than pushing on each other for a larger share of a "pie" that is not growing?

• Is a strategy of supply chain management an example of such "a relationship?"  What is required to implement a strategy of supply chain management?
  • How might a "supply chain" relationship differ from other business relationships such as borrowing capital or leasing land?  How might a "supply chain" relationship differ from a traditional sale of product?
    • Buying or selling a tangible product, not a service; single agreement envisions on-going or multiple transactions; sharing production information with buyer or seller; defining risks; a higher level of dependency than is associated with traditional sale or purchase of a product.
    • In supply chain management, a supplier is presumably willing to assume the risk of delivering the appropriate product in the quantity being purchased by consumers at the appropriate time in exchange for the buyer providing to the supplier, as quickly as possible, whatever information the buyer has that indicates what product the consumers are interested in buying. This may require the supplier to develop not only a capacity to alter the quantity of the product, but also alter the product itself. Having immediate information about consumption may motivate a supplier to assume the risk associated with building the capacity to alter production.
      • In the past, an iron ore mining company would not know how much ore to mine until a smelter had placed an order, and the smelter would not know how much to order until an appliance manufacturer ordered steel, and the appliance manufacturer would not know how much steel to order until a wholesaler ordered an appliance, etc. Would a managed supply chain provide a structure today wherein all businesses would know when a dishwasher was sold?
      • The challenge in production agriculture is that crop production does not occur year-round. Someone still holds an inventory of grain for a period of time. At this time, a totally managed supply chain may be difficult to develop for food products based on grain.

Additional Thoughts:

"Supply chain management (SCM) is the oversight of materials, information, and finances as they move in a process from supplier to manufacturer to wholesaler to retailer to consumer. Supply chain management involves coordinating and integrating these flows both within and among companies. It is said that the ultimate goal of any effective supply chain management system is to reduce inventory (with the assumption that products are available when needed). As a solution for successful supply chain management, sophisticated software systems with Web interfaces are competing with Web-based application service providers (ASP) who promise to provide part or all of the SCM service for companies who rent their service. [emphasis added]

"Supply chain management flows can be divided into three main flows:

The product flow

The information flow

The finances flow

"The product flow includes the movement of goods from a supplier to a customer, as well as any customer returns or service needs. The information flow involves transmitting orders and updating the status of delivery. The financial flow consists of credit terms, payment schedules, and consignment and title ownership arrangements." Excerpt from http://searchcio.techtarget.com/sDefinition/0,,sid19_gci214546,00.html:

"Wal-Mart was one of the first firms to implement supply chain management techniques to efficiently handle large product volumes targeted to consumer preferences. These cost-cutting and information managing techniques helped the chain lower its prices and grow into the Nation's largest general merchandise retailer."

From Supply Push to Demand Pull: Agribusiness Strategies for Today's Consumers. ERS USDA Amber Waves Nov. 2003.

Is the ultimate goal of supply chain management to reduce inventory? What does the following excerpt and article suggest might be another goal? Might this be the ultimate goal of supply chain management?

"Consumer preferences, shaped primarily by incomes, changing lifestyles, and evolving cultural preferences, largely determine the items available in grocery stores in different markets." Processed Food Trade Pressured by Evolving Global Supply Chains. ERS USDA Amber Waves Feb. 2005.

Is the purpose of supply chain management really as narrow as "reduce inventory?" How about thinking of supply chain management as a way to assure we (the entire group) are providing the products consumers want? How about thinking of supply chaim management as "increasing the size of the pie" rather than merely decreasing cost of producing the current-sized pie?

Some thought questions

How does supply chain management relate to the evolving ag industry wherein more entities are becoming involved in the chain of events between production and consumption?

How does supply chain management relate to the consumer expectation that food is safe?

How does supply chain managerment relate to the expectation of businesses that they will hold their supplier liable for providing an input that results in an unsafe food product? How does supply chain management relate to traceability?

• Traceability is mandated by federal law for some sectors of the food industry, but perhaps more important, food firms also are increasingly expecting or requiring that their suppliers be able to identify the source of the product the supplier is selling and any process that was used in the manufacture or preparation of the product.

The right product at the right place at the right time.

Not everything in agriculture will evolve to imperfect competition. Commodity agriculture (more aligned with perfect competition) will remain a major component of the food industry. For those businesses facing perfect competition, low production costs will remain a critical strategy to achieve profitability.

Some producers may find that for several enterprises, they are producing commodities for a competitive market, but also find themselves operating an enterprise that relies on supply chain management to pursue an opportunity in a market with imperfect competition. Managers will need to be able to operate in both perfect competition and imperfect competition.

For managers interested in exploring opportunities to participate in a "managed supply chain," strategic planning and information and risk management will remain critical issues. Of course, these also are critical issues for firms involved with commodities.

What can managers do to assure they have the communication and negotiating skills needed to establish co-owned businesses or contractual relationships?

Last Updated August 16, 2010

Email: David.Saxowsky@ndsu.edu

This material is intended for educational purposes only. It is not a substitute for competent professional advice. Seek appropriate advice for answers to your specific questions.

E-Mail:sswandal@ndsuext.nodak.edu
Published by Agricusiness and Applied Economics
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