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Cost plus a profit: The Holy Grail of dairy producer economics

Ben Yale Published on 27 December 2010

Quick quiz

1. True or False?
According to the USDA Economic Research Service, for the period of January through October 2010, the average total operating costs per hundredweight (cwt) for an average Wisconsin dairy farm were greater than that for California.

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2. Which of the following states had the lowest total operating costs for 2010?
A. Idaho
B. Georgia
C. Ohio b
D. Vermont

3. Put the following regions in order of lowest feed prices to highest for 2010:
A. West: CA, ID, NM, TX, OR, WA
B. Southeast: FL, GA, KY, TN, VA
C. Midwest: IA, IL, IN, MI, MN, MO, OH, WI
D. Northeast: ME, NY, PA, VT

4. According to the USDA, which of these states for the first 10 months of 2010 had an average cost of production, including all costs, higher than the national average?
A. Vermont
B. Wisconsin
C. Florida
D. Idaho

5. How did dairy producers in New Mexico have lower total costs in 2010 than the next-lowest by more than $2 per cwt?

Note: are at the end of the article.

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As a rule, milk prices over time must exceed dairy producers’ cost of production or there would be no milk. This statement is universally accepted. Producers understand it because they are in business to make a profit.

Dairy economists, any economist, would concur that without sustained profit, any enterprise will fail and systemic losses can result in systemic failure.

Buyers of milk also understand that without a supply of milk, they have no business and unless there is profit in making milk, there will be no milk. The government, through law and regulation, at least gives it reference.

It would seem that with such agreement, a statement like that should not create controversy. That is not the case. Depending on the audience, the mere mention of the phrase brings a strong argument, sometimes with deep and emotional feelings.

Even if only producers participate in the discussion, there is disagreement. Hardly a day goes by without some e-mail that demands “cost of production plus a profit.” Virtually every session of Congress has at least one bill submitted that calls for such a requirement.

Organizations at the local, state, and national level are formed with that goal. But not every producer has joined those groups, or supported those bills, or even joined in the call.

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How then can this be controversial? Even if the discussion is held only among producers? On a personal, on-the-farm, basis, all producers want profitable milk production – every one of them. When we move from the farm to a larger scale, then the debate begins.

The first issue embedded in the debate is the source of income creating the profit. Dairy farming is a business, and like any business, there is a risk of loss and a promise of profit.

The difference between the first and the second lies in treating it like a business and making the right business decisions. Such decisions include where to dairy, how small or big, what style of dairy and so forth. All of these are, or should be, business decisions.

Variations in milk prices and input costs are part of the environment in operating any business, and navigating them is the challenge.

Fundamentally, all producers believe this or want to. They come in every size of operation from the very small to the very large and can be found in every dairying area.

They hold that while forces outside their control can bring failure, only they can build success and building that success is the reason they are in the fight. Controlling the cost of that farm’s production is one of the battles in the fight.

Supporters of this view point to other businesses where products are sold. In the setting of those prices, the buyer and seller strike a balance between a price which is sustainable for the seller, while one that allows the buyer to compete itself. It is a never-ending tension between the two, but it is proven to work and does millions of times over many, many years.

The problem with this view is that producers and processors do not negotiate milk prices. The government sets them. Dairy producers have full control of everything that happens on the farm – the size of herd, the breed of cow, the feed ration, the barn style, the milk parlor configuration, the times of milking, who buys the milk – everything except price.

But for almost 80 years the government has maintained the major role in setting milk prices. The price of virtually all milk sold, even in “unregulated areas” is largely set by government regulations and formulas.

Though there are some premiums or “over- order” payments, they constitute a very small percent of the milk price, and even government models show that when “minimum prices” are reduced, producers lose.

If the government is going to set these minimum prices to protect producers, then it should follow that the cost to produce that milk should factor into the equation.

While economic models would show that producers will, over time, receive cost of production justifying minimum prices, the actual cost of producing milk is not even considered. In fact, in some federal orders, producers wanting to testify on what it costs to produce milk have been considered irrelevant and denied an opportunity to testify.

The government argues this position in two ways. First, it is regulating plants, not producers. Thus it must be concerned about whether or not it forces plants out of business by demanding too much for milk. Producers need plants; too high prices mean fewer plants, and fewer plants hurt producers.

The second argument is that the government is only setting minimum prices and producers are “free” to negotiate more. That is a theoretical but nonexistent state of affairs. Besides if, as this argument logically results, minimum prices do not deny producers the fair price for milk, then why have minimum prices at all? It is an argument in support of irrelevancy.

Third, and this is the historical and compelling argument, no matter how low milk prices go or stay, there is always enough milk, even too much at times. Someone must be making money at those prices.

Therein lays the crux of the debate. The question is not, “Should producers receive cost of production plus a profit?” (a point all seem to agree with), but rather, “Should government, by regulation, ensure producers receive cost of production plus a profit?” (a source of disagreement). So long as the government is in the role of setting prices, this discussion will not go away.

Government does not operate in the dairy business by applying general standards to individual dairies. That is, individual dairy producers do not periodically bring their financial statements to the local Farm Service Agency and get their losses covered by a government check.

Instead, government policies operate generally through price regulation, price support, direct payments, government purchases and other government policies. In other words, the profit equalizer is not for your farm, but for all dairy farms. Even then, the point of price involvement is at the plant level, not the farm.

The reason cost of production is an issue in dairy policy is because the government is the price setter of milk in a fundamentally uniform way. Use of cost of production as a factor has to be uniform as well.

Since it is done at the national level, then at what rate would the cost of production be? In the real world there is no “typical” or “average” dairy farmer, so any government program for the typical or average will ill-fit everyone.

Because the price producers receive is fundamentally uniform, the decision of whether milking is profitable is almost entirely based upon the individual costs of production.

So what is the average cost of production? What number should apply? That brings us to the answers to the quiz above.



According to USDA ERS analysis of feed costs ( www.ers.usda.gov/Data/CostsAndReturns/TestPick.htm#milkproduction ), the answers are:

1. False. The total operating costs in Wisconsin for 2010 were $12.33 and California was $12.71.

2. Vermont, D, at $12.82. It was ahead of Ohio at $13.10, Georgia at $14.83 and Idaho at $15.26.

3. C, A, D, B, or Midwest, West, Northeast and Southeast.. This shift in costs is a result of the corn-based ethanol factor in feed prices. Farmers who grow their own or grazed feedstuffs had lower costs. The ranking reflects the farmer-grown feed.

4. D. Idaho. Of the group, only Idaho at $26.27 was higher than the national average of $24.07 per cwt.

5. They didn’t. This is a trick question.

The USDA cost-of-production numbers are based on the USDA’s 2005 Agricultural Resource Management Survey of milk producers and updated using current USDA milk production per cow and production input indexes. The base number was incorrectly set too low. Independent financial analyses of New Mexico dairies show costs more consistent with producers in Texas.

Therein is the major stumbling block to using cost of production in setting prices. The range in operating costs is almost $5 per cwt between the highest and lowest.

For total allocated costs, the highest costs are nearly twice the lowest state averages. But the need for uniformity only comes into play as an offset to a national regulated pricing system. Without a uniform government price, the question is no longer relevant.

By restoring milk pricing to plant, producer or co-op, negotiation will allow producers’ costs to be part of the equation. Retaining the current system will keep it out.

So the question is not so much about cost of production, but more of how we price our milk. Having a system that allows you to price milk, factoring your own production costs rather than using a government price geared to plant yields and costs, would provide producers the solution most could agree on. PD

Ben Yale

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