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PD POLL: Should federal order reform change classified pricing to less than four classes?

Published on 29 October 2010

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The objectives of federal milk marketing orders (FMMOs) are to assure consumers of an adequate supply of wholesome milk for beverage purposes and to promote greater producer price stability and orderly marketing, says Bob Cropp, professor emeritus and dairy marketing specialist, University of Wisconsin – Madison. To achieve these objectives, FMMOs use classified pricing and pooling.

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Initially, FMMOs had two classes, one for beverage milk called Class I and another for all manufacturing use milk, called Class II. Later, a third class was added for milk used to make soft manufactured products. A fourth class, Class III-A was added in 1993 in some orders for milk used to make butter and nonfat dry milk.

Justification for this fourth class was that butter-powder plants could not afford to pay as much for milk as cheese plants. In addition, dairy cooperatives provided market-wide service of balancing the Class I milk supply by operating butter-powder plants at a benefit to all producers with the order but at a cost to its members.

Adding Class III-A was a way for all producers within the order to share in this balancing cost. Federal order reform effective Jan. 1, 2000, continued the four-class system with Class IV essentially replacing Class III-A.

With industry groups today calling for another round of federal order reform, this month’s poll looks into the number of classes needed. Should federal order classes be reduced to two classes or remain at four? If you have comments or points of view that you think need to be discussed, please vote and let us know. Producer comments will be shared in the next two issues of Progressive Dairyman .

No, keep four classes.
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Classified milk pricing was being done by dairy cooperatives in New England before federal orders existed. Cooperatives felt that a higher price was warranted because of the higher service that was required by processors of perishable products. For example, a Class I fluid plant might want an extra load of milk today and no milk on the weekends. This level of service generates an extra cost when milk is taken from other plants to satisfy fluid milk needs and justifies a higher price. At the other end, plants that are having milk taken away from them on some days or asked to process additional milk on the weekend need to be compensated for their extra cost of operation. They are compensated by obtaining milk at a lower cost.

Although it is sometimes suggested that classified pricing exists to exploit the willingness of consumers to pay more for some products, I personally don’t believe that price discrimination is the primary justification for classified milk pricing. We actually see some cheese products that are less price-sensitive than fluid milk, which would suggest that we price Class III as high or higher than Class I. My own belief is that the level of service required and the perishability of the products produced is the justification for the number of classes of milk.

We often balance weekly and seasonal milk supplies with cheese manufacturers. Because of that, they should receive a price break on their milk purchases for operating their plant at less-than-optimum capacity. This is even more true for butter/powder plants. The real question is whether yogurt makers have some intermediate level of service needs. It is also the case that many ice cream manufacturers will make product in the flush season of the year and hold it in freezers for sale later in the summer. That is providing a balancing function to the market.

I can’t be sure that four is the right number of classes, but I am sure that it is more than one and probably doesn’t need to be more than four. It seems easy to justify having more than two classes; so if the question is should it be three or four ... let’s just stick with what we have.

Mark Stephenson
Director of Dairy Policy Analysis
University of Wisconsin – Madison

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Yes, we only need two classes.
I will argue that it now makes sense to return to two classes, given the five following reasons:

First, with the current system of having Class IV for butter and milk powder and Class III for cheese, using product price formulas with fixed make-allowances and market-wide pooling of the four class milk values, there is not a strong incentive for manufacturing plants to allocate raw milk to its best and highest-use value – from butter and nonfat dry milk to cheese, if cheese returns a higher value to raw milk, or vice versa. With one manufacturing class, butter/powder plants and cheese plants would need to compete more aggressively for raw milk. With this competitiveness there is a greater assurance that milk will be allocated to its highest-use value. This allocation would not only enhance producer milk prices but could reduce price volatility.

Second, currently Class II is for milk used to make dairy products such as ice cream, cream products and yogurt. Class II plants compete with butter, milk powder and cheese plants for cream and raw milk. Therefore, it makes sense to move Class II into one manufacturing class. Class II is priced $0.40 higher than Class IV. But, on the average with only about 12 percent of federal order milk used as Class II, the loss in producer revenue would not be significant.

Third, it is argued that a separate class for butter and milk powder is needed to compensate milk plants, primarily dairy cooperatives, for balancing the Class I market. A better approach would be for the federal order pool to better compensate plants for the cost of balancing. Dairy cooperatives can also bargain for over-premiums to help offset the cost of balancing.

Fourth, modern technology allows for the separation and refinement of milk and its components for the best use for different dairy products and food ingredients. No longer are we just making butter and cheese. In order to price each use of milk and its components would require an expansion of classes. But that would create a nightmare in pricing. It makes more sense to have one manufacturing class and allow plant competition to determine the appropriate value for milk and its components.

Fifth, there is the issue as to how the minimum price for one manufacturing class would be established. Currently, there is much dissatisfaction with using product price formulas with fixed make-allowances for Class III and IV. It is doubtful that an acceptable single product price formula could be developed for one manufacturing class.

Returning to a competitive pay price series where butter, milk powder and cheese plants compete for milk deserves serious consideration. A two-class system using a competitive pay price as the manufacturing class price and as the mover of Class I would better allocate milk to its best and highest-use value, provide a greater incentive for product innovation, reduce milk price volatility and enhance producer pay prices. PD

Bob Cropp
Professor Emeritus and Dairy Marketing Specialist
University of Wisconsin – Madison

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