Factors impacting dairy profitability in 2007

Kevin C. Dhuyvetter and Terry L. Kastens, Department of Agricultural Economics, Kansas State University

A common saying in Kansas (and elsewhere) is: “If you don’t like the weather, just wait 10 minutes,” which points to the weather variability. While the unit of measurement might be months rather than minutes, these days it seems that saying fits the dairy industry regarding profitability just about as well. Profits for dairy producers tend to go from feast to famine in relatively short order, which obviously makes management decisions a never-ending challenge.

Unfortunately, 2006 has likely been more famine than feast for many dairy producers due to low milk prices and rising input prices.

How are things looking for 2007? This [article] provides a glance at some of the key profit drivers for 2007 based on information that was available in early December of 2006.

Many factors impact profitability on a dairy, such as milk production, replacement prices, milk price, input prices (e.g., feed, labor, utilities, supplies), facility and equipment costs. This [article] examines a few of these key factors, but it does not address all profit drivers. Furthermore, it is recognized that the various factors impact differently managed dairies (e.g., conventional, organic, pasture) in different ways, and thus comments here will not apply to all dairies in the same way. Also, it is recognized there might be interactions between several factors impacting profitability.

Producers can do little about overall milk prices from a management perspective, but price obviously impacts profit in a major way. Thus, producers need to consider prices when making management decisions. The variation in milk prices dairy producers have faced since 2000 is quite dramatic, ranging from a low of $8.57 per hundredweight (cwt) (November 2000) to a high of $20.58 per cwt (May 2004).

The average price in 2006 (11 months actual and one month forecasted) is $11.88, compared to a forecasted average for 2007 of $13.89 (an increase of 16.9 percent). While $13.89 is lower than the 2004 and 2005 averages ($15.39 and $14.05), this annual average price is higher than the annual average for five of the last seven years (and not much lower than the $14.05 received in 2005).

When thinking about costs, dairy producers need to consider if the cost is “fixed” or “variable” based on production (number of cows milked and milk production). While all costs are variable in the long run, for shorter time periods many costs are fixed. For example, the cost of facilities is basically the same whether they are being used or not or whether cows are producing 60 pounds of milk or 80 pounds of milk per day. Likewise, labor and utility costs likely do not vary much with milk production per cow, although they will vary based on the number of cows milked.

As a general rule, profits for the dairy are maximized by maximizing the returns to fixed costs (or in the case of unprofitable years, losses are minimized). This typically means milking as many cows through the facility as possible to maximize the returns to the fixed facility investment and maximizing the production per cow to maximize returns to the fixed cow investment.

Feed costs are the greatest cost for most dairies, but they can vary significantly from dairy to dairy because of many factors (e.g., type of ingredients used, milk production, geographical location). While many feed ingredients are used besides corn and soybean meal, these two commodities provide a reasonable proxy for dairy feed costs in general. Price forecasts for soybean meal in 2007 are 12.3 percent higher than 2006 prices; however, average prices for corn in 2007 are expected to be considerably higher than 2006 (+40.4 percent). The average price forecast for corn in 2007 of $3.67 per bushel is over $1 per bushel higher than the average prices in both 2004 and 2006 (the other “high corn price years”).

What should a producer do in response to potentially high feed costs in 2007? Rather than focusing on what should be done, it might be more useful to focus on what should not be done. Dairy producers should not attempt to minimize feed cost when measured on a per-cow basis, or for that matter, even on a per-cwt-of-milk basis. Rather, they should consider income-over-feed costs (IOFC) as the measure to focus on, or total cost per cwt of milk (as opposed to feed cost per cwt).

This is important because as producers consider alternative feed ingredients (e.g., increased use of distillers grains) it is possible to reduce feed cost per cwt, but if milk production decreases IOFC might also decrease, leading to reduced financial returns.

Once feed maintenance requirements are met, it typically takes 1 pound of feed (dry matter [DM] basis) for every 2 to 2.5 pounds of milk production. Given 2.25 pounds of milk per pound of feed and a net milk price of $14 per cwt, this implies the income from each additional pound of feed is $0.315 (2.25 x $0.14), which is significantly above projected feed costs ($0.09 to $0.11).

The important point to remember is that, even though feed costs likely will be considerably higher in 2007 compared to 2006, feeding for top production (i.e., maximizing milk per cow) probably will still be the most profitable management strategy. That is because maximizing returns-over-feed costs (IOFC) per cow generates the maximum dollars that can be used to cover fixed costs and, hence, increase profits.

As anybody that has been paying utility bills knows, energy prices generally have been increasing for the last five years or so. The good news for dairy managers is that price forecasts for 2007 are for energy prices to be similar to 2006 levels. Unfortunately, the bad news is that 2006 levels were the highest they have ever been. Thus, producers will continue to face high energy prices in 2007.

To the extent energy-related costs are fixed (i.e., not directly related to milk production), producers will minimize energy costs by maximizing milk production. Furthermore, even when milk production is directly related to energy use (e.g., use of fans for cooling cows), the value of the additional milk generally will offset the additional utility costs.

Another fixed cost most dairies face is the interest cost associated with the capital invested in the dairy. Interest rates have been steadily increasing since early 2004. While we do not have official forecasts of these interest rate series for the last quarter of 2006 and 2007, it is fairly safe to say that interest rates in 2007 will likely be at comparable or higher rates than recent years.

These relatively higher interest rates result in higher fixed costs. In response to these higher fixed costs, profit-driven producers should strive to maximize production so as to generate the maximum returns to contribute towards fixed costs.

After feed and replacement costs, labor is one of the largest costs of production for many dairies. From 1995 to 2005, the annual increases in wage rates have ranged from 2.8 percent for milkers to 4.5 percent for those in supervisory positions. Labor costs for 2007 likely will be higher than 2006, continuing the trends.

Another factor that likely will lead to higher labor costs in 2007 is immigration reform, which could increase direct (i.e., wage rate) and indirect (i.e., compliance) costs associated with hired labor. Similar to utilities and interest costs, labor has a huge “fixed” aspect, and thus managers should strive to maximize the returns to this fixed cost, which once again typically is accomplished by maximizing production.

Profit
What do these changes mean for dairy profits in 2007? Projected budgets were used to evaluate the effect of +$2 per cwt milk price, +30 percent feed cost, +5 percent labor cost, +0.5 percentage point in interest rate and all other factors held constant. The cumulative effect of these changes is that returns are approximately $3 to $30 per cow worse than 2006. However, if feed prices are 25 percent higher, rather than 30 percent, then returns are $50 to $70 better than in 2006. If management strategies are adopted to increase production per cow, further diluting fixed costs, profits would increase further.

Summary
This past year (2006) has been a tough year for many dairy producers because of low milk prices and high input costs. The outlook for 2007 is mixed – milk prices will be higher, but so will many costs (e.g., feed, interest, labor). From a management perspective, there are several things dairy producers should keep in mind for this upcoming year.

First, as they consider alternative feed ingredients that might impact both production and cost per ton, it is important to analyze the impact on IOFC or total cost per cwt rather than feed cost per day or feed cost per cwt. This will ensure appropriate conclusions are reached regarding the economic optimal feeding program.

Second, producers need to recognize that often the best management response to many of the high costs is to maximize production (number of cows through parlor and milk production per cow). This is because many of the costs on a dairy are “fixed” in nature in the short run and thus do not vary directly with production. Maximizing the returns to these fixed costs leads to maximum profits (or minimum losses in unprofitable years). PD

References omitted but are available upon request.

—From Kansas State University Ag Manager website