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January – June 2019

Taking a closer look at the efficiency and profitability of 19 agricultural cooperatives in Mpumalanga

By Thembi Xaba, Dr Nyankomo Marwa and Dr Babita Mathur-Helm

  • June 2019
  • Tags Features, Finance
17 minutes to read

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Why measure the performance of agricultural cooperatives?

Cooperatives serve as vehicles of economic development as members or small producers combine to benefit from economies of scale and to increase their collective bargaining power. In South Africa, agricultural cooperatives also play a key role in promoting economic inclusion. To better understand the significance and economic role of cooperatives, the researchers conducted a performance evaluation to establish if the cooperatives are fulfilling their economic role.

…It has been noted that cooperatives behave differently in terms of profitability as they are user-owned and user-controlled, and serve the interests of their members.

 

Performance evaluation can enable a firm to identify underlying problems and to establish benchmarks, which in turn assists with decision making. Also, performance analysis helps to drive the survival of a firm. This study analysed the efficiency and profitability of 19 agricultural cooperatives to establish whether efficient cooperatives were equally profitable, can withstand economic shocks, and can achieve economic gains for its members.

What does the literature say about agricultural cooperatives?The cooperative as a firm: Studies on the cooperative behaviour of firms agree that agricultural cooperatives seek to minimise costs or inputs in order to maximise profits. Various theories have been put forward, taking into account the effect of cost structure and product demand constraints on profits. Some researchers see cooperatives as aggregate economic units, with a vertical integration model, where each independent enterprise seeks to maximise profits. This means agricultural cooperatives operate as a single integrated firm that maximises profits through inputs from different firms, performing different functions, and yet are brought under single managerial control. However, this does not take into account the agency problem where the objectives of the agent are not the same as that of the principal. The challenges are horizon problems, as cooperatives are seen to focus on short-term earnings rather than long-term earnings and sustainability. In addition, cooperatives need to balance social needs with economic fairness. Suffice it to say, as much as members are entitled to the net income generated by the cooperative, they are equally residual risk bearers of the firm’s net cash flow. This study acknowledges the opposing views. However, it has adopted the classical theory of a firm – that of minimising cost and maximising output for profit optimisation.

In South Africa, agricultural cooperatives also play a key role in promoting economic inclusion..

 

Agricultural cooperatives and efficiency evaluation: Performance evaluation through efficiency measurement takes a look at the ability of a firm to produce the maximum output possible given input constraints. This study employs technical efficiency (TE) which measures the performance of a firm using the extent to which it deviates from the best practice frontier given a specific dimension: cost, inputs, output or profit. Two frontier estimations are usually employed when measuring efficiency, namely Stochastic Frontier Analysis (SFA) and Data Envelopment Analysis (DEA).

  • Stochastic Frontier Analysis: SFA is a parametric approach used to estimate the productivity and efficiency of a decision-making unit (DMU). SFA creates a framework that can analyse firms that do not succeed in optimisation, or are not fully efficient, by comparing firms to ‘best practice’.

Various studies have compared the performance of cooperatives with investor-owned firms, with results signifying that cooperatives were less efficient and profitable than investor-owned firms.

 

Data Envelopment Analysis: DEA as a non-parametric method introduced the efficiency measurement which generalised the single output and single input ratio to multiple inputs and outputs without requiring pre-assigned weights. The methodology emerged as an alternative to the traditional regression method analysis. The units that lie on the ‘surface’ are defined as ‘efficient’ decision-making units.

Agricultural cooperatives and profitability evaluation: Profitability can be measured as the net income over total expenses or the excess revenue over total expenses, or as return on assets (ROA) which is income before interest and taxes divided by total assets. Within the theory of the firm, optimal prices and quantities are determined by setting the cooperative’s marginal cost equal to the marginal revenue, which means that profit becomes the cooperative’s performance indicator. It has been noted that cooperatives behave differently in terms of profitability as they are user-owned and user-controlled, and serve the interests of their members. The economic benefit of members remains the core foundation for income generation and sustainability as members are entitled to the net income generated by the firm. Empirical studies have always employed the traditional financial ratio method to measure the performance and profitability of a cooperative.

… overall, cooperatives demonstrated low rates of asset efficiency

 

About agricultural cooperatives, efficiency and profitability

Agricultural cooperatives and efficiency: Various researchers have investigated the performance and technical efficiencies of agricultural cooperatives using an input-oriented DEA model to measure technical efficiency (TE) scores, and Tobit regression. The regression estimates showed TE was negatively influenced by the number of farmers, age, plot size and off-farm income. In South Africa, some researchers investigated the efficiency levels of grain cooperatives in competitive markets using DEA and financial ratios, and found that increased competition led to the increased efficiency.

Agricultural cooperatives and profitability: Various studies have compared the performance of cooperatives with investor-owned firms, with results signifying that cooperatives were less efficient and profitable than investor-owned firms. Some researchers used traditional financial ratios to measure the profitability of investor-owned firms against those of cooperatives. They found that, overall, cooperatives demonstrated low rates of asset efficiency. These studies show that measuring financial performance employing traditional ratios such as return on assets (ROA) and return on equity (ROE) has been tested on cooperatives. This study focuses on ROA as a measurement for profitability, as opposed to ROE. The argument is that with ROE, cooperatives have limited return on equity capital as the business pays strictly limited dividends on equity capital invested in the organisation. Another limitation is that the value of an enterprise may exceed the value of members’ patronage. In the South African context, since agricultural cooperatives are funded by the government, employing ROE will distort the performance results.

…The results demonstrate that technically efficient firms do not always translate into profitable firms.

 

Agricultural cooperatives’ efficiency and profitability: The debate on whether firm efficiency is directly related to profitability is ongoing. One study measured the branches of a Portuguese bank and found that their efficiency has a positive effect on profits, although high profitability did not necessarily directly relate to high efficiency. Another study looked at Tanzanian financial cooperatives, showing that the majority had low profitability and low efficiency levels. Hence, there is a need to explore both dimensions in empirical studies. This study used ROA as a measure, noting that all the financial statements provided by the agricultural cooperatives have total assets as a variable.

How was the research conducted?

In this study, Data Envelopment Analysis (DEA) was used to measure efficiency while Return on Assets (ROA) was used to measure profitability. The study also employed a profitability-efficiency matrix to determine the correlation between profitability and efficiency.

… management needs to investigate how best to allocate resources in order to remain relevant within an environment characterised by increased competition.

 

This study used data from the Department of Agriculture, Forestry and Fisheries’ 2015-2016 Annual Report on cooperatives, and selected cooperatives from Mpumalanga. The study selected the 19 agricultural cooperatives in Mpumalanga that complied with Annual Financial Statement reporting. These cooperatives’ efficiency scores were measured by using pure technical efficiency and scale efficiency based on DEA. A frontier function approach was also employed. The frontier methodology measures how a decision-making unit is performing relative to its peers. Frontiers are important for the prediction of technical inefficiencies in the industry. DEA is widely used in agriculture due to its consistency in production, profit and cost functions, with the notion of minimising input or output orientation, or maximising profit.

To measure technical efficiency, total assets and total expenses were used as input variables while revenue and profit were used as output variables.

Policy makers need to investigate other drivers of efficiency and profitability when measuring the performance of a firm to influence future policy directives.

 

 

This study also created an efficiency-profitability matrix, which provides management with an overview of areas that can be improved to achieve higher efficiency and profitability. The matrix divides a firm’s performance levels in four quadrants, where Quadrant I represents the sleepers (high profitability but low efficiency levels), Quadrant II represents the stars (high efficiency levels and high profitability ratios), Quadrant III represents the question marks (with low efficiency levels and low profitability ratios), and Quadrant IV represents the dogs (high efficiency levels with low profitability). The stars are therefore those decision-making units that convert their inputs into outputs efficiently while at the same time recording high profits.

What did the study find?

From the results, the median score for efficiency was 68%, which means that the DMUs’ combined efficiency rate was at 68%, and that there was a resource wastage of 32%. However, looking at individual DMUs, only 21% of the DMUs are 100% technically efficient, operating at constant returns to scale (these DMUs demonstrated that the size of the cooperative has an impact on its efficiency levels). From the efficiency analysis, profitability was decomposed using the ROA methodology. Each DMU efficiency was then measured against profitability.

The median for profitability in this study was 10%, with 37% of the DMUs above the 10% average. The technical efficiency and profitability dimension was employed to test for a positive correlation between efficiency levels and profitability. The results showed that some DMUs were operating at above efficiency levels while some were operating at a loss. The results showed there was no positive correlation between efficiency and profitability.

Overall, it is important that agricultural cooperatives find a balance between their social role and economic development.

 

The median for profitability in this study was 10%, with 37% of the DMUs above the 10% average. The technical efficiency and profitability dimension was employed to test for a positive correlation between efficiency levels and profitability. The results showed that some DMUs were operating at above efficiency levels while some were operating at a loss. The results showed there was no positive correlation between efficiency and profitability.

The efficiency-profitability matrixThe matrix showed an even distribution between the stars and sleepers in the quadrants. In total, 26% of the firms have high efficiency and high profitability. These firms are best performers and considered as stars. What this means is that 5 out of 19 cooperatives have high efficiency levels with high profitability ratios (stars), while another 5 have high profitability and low efficiency levels (sleepers). The sleepers will have to improve their resource allocation, which may result in them moving to the stars quadrant.

The majority of the DMUs (8 out of 19) are in Quadrant 3, meaning they have low efficiency levels and low profitability. These firms need to reconsider their operations as they are wasting resources. They should also look at how they are impacted by competition and the economic downturn, and whether their service is still relevant. Only one DMU was in Quadrant 4, indicating it was high on efficiency and low on profitability, which means it is using its resources efficiently while operating at a loss.

… there is a need for a turnaround strategy that focuses more strongly on efficient resource allocation and on measures and systems to thrive in a highly competitive market.

 

What is the way forward for these cooperatives?

This study explored efficiency levels and profitability ratios of 19 agricultural cooperatives in Mpumalanga, linking efficiency levels with profitability to see if efficient firms are also profitable.

The results demonstrate that technically efficient firms do not always translate into profitable firms. In this regard, management needs to investigate how best to allocate resources in order to remain relevant in an environment characterised by increased competition. Policy makers need to investigate other drivers of efficiency and profitability when measuring the performance of a firm to influence future policy directives.

Policymakers should appreciate that agricultural cooperatives also have a socio-economic role to play and that members’ patronage is inherent as these cooperatives are user-owned and user-controlled. Future policy decisions should factor in empowering the agricultural cooperatives as firms, enabling them to manage resources efficiently while being profitable, resulting in sustainable organisations.

Overall, it is important that agricultural cooperatives find a balance between their social role and economic development. Cooperative members need to review their position on the cooperative as a business, rather than an entity that services users’ needs. Hence, there is a need for a turnaround strategy that focuses more strongly on efficient resource allocation and on measures and systems to thrive in a highly competitive market.

  • Find the original journal article here: Xaba, T., Marwa, N., & Mathur-Helm, B. (2018). Efficiency and Profitability Analysis of Agricultural Cooperatives in Mpumalanga, South Africa. Journal of Economics and Behavioral Studies, 10(6), 1-10.
  • Thembi Xaba is a PhD candidate in Business Management Administration. She is currently the Chief Executive Officer of the Deciduous Fruit Development Chamber (DFDC-SA).
  • Dr Nyankomo Marwa is a senior lecturer in Development Finance and Econometrics at the University of Stellenbosch Business School. He also teaches at academic institutions in Canada and Tanzania.
  • Dr Babita Mathur-Helm is a senior lecturer in Organisational Transformation and Development, Transformation Management and Gender Empowerment at USB.

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