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Coaponent Pric-fng - New

Robert E. Jacobson1 _.

I was asked to speak about component pricing and its relationship to

products. I do not see any particular causal or functional relationships

between these two topics, so I'll $pend most of these few minutes talking

strictly about component pricing. However, a couple of points on the

relationship are worth noting. First, the advent of component pricing should

not be any kind of a factor in either slowing o~ hastening the introduction of

new products. There is not any kind of a significant cost/price change

incorporated in component pricing plans that would act as incentives or

disincentives to the introduction of new products. Second, the continuing

price question for new products is the matter of which price class the product

will be assigned to in classified use price plans. Component pricing enters

the picture at this point because products designated as Class II or Class III

are much more relevant to component pricing than are Class I products. I'll

try to come back to this point later.

My purposes this afternoon are (1) to make some probably obvious

observations about component pricing; (2) to bring us up to date on the

iaplementation of component pricing in Federal order milk markets; and (3) to

consider the next steps in the full adoption of component pricing.

First, some of the obvious observations:

1. The average composition of the 145.4 billion pounds of producer

in the United States in 1988 was as follows:

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1Robert E. Jacobson, Professor, Agricultural Economics, The Ohio State University, for presentation at 14th Southern Dairy Conference, Atlanta, Geqrgia, February 14, 1989.

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Milkfat 3.67 lbs. • I

Protein 3.20 II

Lactose 4.75 I I

Minerals 0.65 Water 87.73 I

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Total 100.00 lbs ...

Jn the jargon of component pricing, we are usually talking about the ..

testing and pricing of either the protein OR solids-not-fat (SNF) in milk in

ADDITION to testing and pricing for the milkfat.

Among the components in milk, the milkfat and the protein have been found

to vary in test (cow, herd, breed, season, etc.) while the lactose and the

minerals or ash stay fairly constant. This means that any changes in the SNF

•. test of milk are principally driven by changes in the test of one of the key --a!.

components of SNF - the protein. Much debate revolves around whether it is the

protein .Q!:. SNF that should be tested and priced in the milk. I'd like to

dismiss that debate by simply saying that either one of these component

measures can act as the proxy for the other. • I

While the average annual milkfat test in the United States approximates

3.67 percent, it moves in a better than 3 point range, from 3.48 percent in

July to 3.81 percent in December. Similarly, protein tests, reflecting the

historic relation that has 4/10 of a point in SNF moving directly with each 1

point of milkfat, move in a range of approximately 3.16 percent protein in July

to 3.33 percent in December. 2

2. Let us agree upon a definition of component pricing. Too often,

producer pay plans that incorporate a protein, SNF, or even a quality

adjustment are erroneously called component pricing plans. Some people say ,.

2Halverson, Victor and Kybury, H. Paul, Analysis of Component Levels in Individual Herd Milk, Staff Paper 86-01, Federal Order No. 68, March, 1986, page 4.

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that component pricing is ... any payment plan that prices milk on a basis

other than volume alone." My point is that a component pricing plan is ~

than a producer pay plan; a component pricing plan is one in which both the

buyers (processors) are charged and the sellers (producers) are paid on the

basis of specified measures of components and volume. Both sides of the pool

of money - the pay-in side and the pay-out side - are affected. Component

pricing that only pays producers, e.g., protein differentials, and does not

charge the market is not component pricing. Such plans are only competitive

procurement devices. And there are a lot of those around - recognize them for

what they are.

3. Under our present pricing procedures, which I usually refer to as

butterfat - cwt. pricing, in fluid milk markets, the skim milk portion is not

subject to any pricing adjustments, regardless of the protein of SNF tests of

that skim milk. Most of us know that. Let me just document it in relation to

current prices from a producer payment point of view. In December, using the

Georgia Federal order market as our example, the blend price was $14.38 per

cwt. and the butterfat differential was 15.1 cents. Given these two factors,

the 96.5 pounds of skim milk was worth $8.77, or 61 percent of the producer

price; the 3.5 pounds of milkfat was worth $5.61 or 39 percent of the producer

price. Yet, it is only the milkfat that is tested and priced. Skim milk,

regardless of protein test, is only handled as a residual value. The

continuing trend toward higher proportionate values on the skim milk side of

milk argues ever more strongly for testing and pricing of the skim milk.

4. The last "obvious" observation I would advance has to do with the

variations in yields of manufactured dairy products of differing solids tests.

This fact has always been obvious with respect to butterfat (milk testing 3.5

yields 4 1/4 pounds of butter; milk testing 4.2 yields 5.1 pounds of butter).

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More recently, end product pricing or product yield pricing has swept through .

the cheese industry. Protein is~ fundamental component affecting cheese

yields and, as such, has projected the tests of skim milk into critical

consideration in establishing the price of milk at cheese factories.

I have lifted small selected portions of data from actual industry yield

tables for cheddar cheese and for mozzarella cheese. ,.:

CHEDDAR:

Fat Pct.

3.5

3.5

3.6

3.6

3.7

3.7

MOZZARELLA:

Fat Pct.

3.5

3.5

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3.7

·. In the case of end product pricing as reflected in these tables, producers

are paid on the basis of how many pounds of cheese their milk will make.

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Likewise, the market is charged because the market pays

cheese that higher test milk yields. This is component

of it. L ,

With respect to the new products dimension of this

helpful if product yield tables could be generated for most or

dairy products and new products as they come on. Presently, I believe that

product yield tables are only available for the major cheese varieties.

In 1988, the Federal milk order program across the United States ran in

only 43 percent Class I utilization. The other 57 percent was in manufactured

/ dairy products - - Class II soft and Class III hard. One half of the 42 Federal

order markets were less than 60 percent Class I utilization. In fluid milk

markets with substantial utilizations of producer milk in Class II and Class

III, there is not only the opportunity but finally the necessity for relating

price to yield. Equity may not always be achieved in pricing, but it cannot be

ignored in pricing.

What about fluid milk -- Class I milk? Two fundamental

made about Class I milk and component pricing.

A. Fluid milk is not subject to yield variations. The yield

milk from 100 pounds of milk is 11 5/8 gallons. It does not matter

protein test of the milk is -- the yield is still 11 5/8 gallons, or 23 1/4

half gallons, or . . . . It does not matter if the product is whole milk, or

lowfat, or skim - the yield does not change -- it is still 11 5/8 gallons.

B. A primary responsibility of a Federal milk order

impose equal raw product costs on competing handlers.

III products, testing and pricing for protein or SNF is feasible because

handlers receiving higher solids milk will pay for it, but will also generate

more product from it. Processors receiving lower solids milk will not pay as

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much, but they will not have as much product to market. The equal raw product

cost principle is observed.

On Class I milk, where yield differences do not exist, testing and pricing

for SNF or protein would mean that some handlers would have higher raw product

costs on fluid use milk as compared to other handlers. This is why the Federal

order program has seemingly dragged its feet on component pricing. This is

also why, now that the Federal order program has waded into the lake of

component pricing, it is treating Class I milk one way and is treating Class II

milk, Class III milk, and producer milk another way.

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Component Pricing in Federal Orders: Phase I >

On April 1, 1988, multiple component pricing was introduced

milk order -- the Great Basin Market, Order No. 136 - for the first time.

want to dwell on the plan in that market for four reasons: (1) I ·have been

impressed with how little understanding exists across the milk industry

regarding that plan; (2) the plan reflects a fundamental forward step in the

evolution of milk pricing; (3) multiple component pricing in other Federal

order markets will be close relatives of the plan; and (4) the plan reflects

the essential principles of component pricing noted earlier.

Let me make the following points about the Great Basin plan and then go

through some parts of an example. r !

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1. Class I, II, and III price levels remain unchanged.

2. Butterfat differentials don't exist . .,, ._ ...

3. Handlers are subject to four charges 'I

a. Pounds of butterfat in all 3 classes

b. Pounds of protein in Class II and Class III ·I

c. Skim value of Class I milk, computed at Class III price

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. ' d. Class I differential times cwt. of Class I milk plus Class II

differential times cwt. of Class II milk.

4. Producers are paid for three things -

a. Pounds of butterfat

b. A "producer protein price", computed by (1) taking the value of

the pounds of protein in Class II and Class III, (2) adding the

skim value of Class I milk computed at the Class III price, and

(3) dividing that sum by the total pounds of protein in Classes

I, II, and III.

c. The marketwide utilization value of the Class I and Class II

differentials, otherwise called the "weighted average

differential. "

5. The only money subject to equalization in the producer settlement

fund is the Class I differential and Class II differential money.

Some of these points may sound a little complicated, but an example should

help. The first step is to compute the fat and protein values (note that in

the Great Basin market, it is protein that is designated as the additional

component to milkfat).

For January, 1989 the M-W price was $11.90 and the butterfat differential

was 15.1 cents. Conventional fat-skim accounting indicates that one pound of

butterfat is worth $1.576. This is what handlers are charged for butterfat in

all three classes, and what producers are paid for butterfat.

The entire remaining skim milk value of the M-W or Class III price is

imputed to the protein. The 96.5 pounds of skim milk is worth the residual

$6.38, or 6.6 cents per pound of skim milk. That $6.38 is divided by the

average producer protein test of milk for the previous month (December in this

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~ .. - 8 ... case). Assuming the December protein test was 3.32 percent, one pound

Iii protein is priced at $1.92. •

Handlers are charged $1.92 per pound for protein they use in Class II and

Class III products. However, the "producer protein price", using numbers in

this example, equals (1) pounds of Class I°I protein times $1.92, plus (2)

pounds of Class III protein times $1.92, plus (3) pounds of Class I skim milk

times 6.6 cents. This dollar sum is divided by the total pounds of . protein

(Class I, II, and III) in the market to establish the price that producers are

paid for each pound of protein they market (producer protein price).

The only money not described thus far is the differential money. Assume

that a Federal order has a $3.00 Class I differential and a 10 cent Class II

differential. Each handler would be charged $3.00 and 10 cents respectively

for their utilizations of Class I and Class II milk. The total amount of money

generated in the market from these differentials would be divided by the total

pounds of producer milk in the market. The resulting value is a blend

differential or weighted average differential per cwt. All producers in the

market receive this differential on the total pounds of milk they market. With

a $3.00 Class I differential and a 10 cent Class II differential, a 50 percent

Class I utilization market would generate a weighted average differential of •I

about $1.60 per cwt. I • l

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Higher utilization handlers (higher than the market average of $1.60 in

this example) would owe the producer-settlement fund. Lower utilization

handlers would draw from the producer settlement fund.

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Great Basin Experience To Date . .

What kind of lessons has the implementation of dual component pricing in a

Federal order market brought to the forefront? Three or four points are worth

mentioning.

1. In the ten plus months since component pricing came into the Great

Basin market, the Market Administrator has not received a single complaint from , industry -- neither processors nor producers -- about any aspect of the plan.

2. You may have noticed that I have not mentioned problems associated

with testing of the components. Testing has not been a problem. In fact, the

hearing record that preceded implementation of the Great Basin plan essentially

concluded that testing for protein was more accurate than testing for milkfat.

Of course, questions about testing will never leave us, whether we are talking

milkfat or protein or, more recently, non-protein nitrogen.

3. The ''weighted average differential" in the Great Basin plan continues

to make a direct compensation to producers for volume of milk. This contrasts

with California's component pricing plan where producers are paid only for

milkfat and SNF, and they do not receive a direct payment for volume. The

question arises as to why not put the total producer payment in Great Basin,

Federal orders in the future, on the milkfat and protein, not pay the weighted

average differential as such, but instead incorporate the value of the

differential into the milkfat and protein prices paid to producers. The

California system discourages any watering of milk at the farm. The Great

Basin approach, as well as our current pricing procedures, do not discourage

watering; in fact, additional water takes on a skim milk and differential

value. I L

4. In establishing the protein price in Great Basin, it might be more

appropriate to use the average protein test of producer skim milk rather than

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the average protein test of producer milk to get a more accurate protein price.

Also, it should be possible to use the protein test for the current month

rather than the preceding month in computing the protein price.

5. Some people refer to the Great Basin plan as a Quasi-component

pricing plan because Class I milk is effectively separated from component price

adjustments. The Class I price continues to effectively be the basic formula

price (M-W) plus the Class I differential. This procedure is essential in

order that equal raw product costs be extended to Class I products. I am

doubtful that FDA will ever change the Standards of Identity on fluid milk

drinks (8.25 percent minimum SNF). Whether membrane technology and reverse

osmoses will bring new pressures to the situation or not cannot be predicted .

.. Where to From Here

In the same way that one log can break a logjam, one order can start

rolling the snowball of component pricing in regulated markets. The current

issue (February, 1989) of Equity Newsletter of National All-Jersey, Inc. notes

component pricing initiatives in the Middle Atlantic order, Orders 33 and 36 in

greater Ohio, and provisions in the proposed North/South Carolina order.

Competition for milk supplies has intensified in recent years. In many

markets, cheese factories have pulled supplies away from traditional outlets

paying premiums of different kinds, largely on the basis of product yields.

The adoption of component pricing in Federal orders will not remove this

competition, but it should narrow the range of prices that some milk producers

can get relative to what the market order requires. This would be a step in

the direction of "orderly marketing". And Federal orders are supposed to give

as "orderly marketing".

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Where the Great Basin market is today and where many markets are similarly

headed is just one other step, albeit a significant step, in the evolution of

milk pricing. It is important that we understand this step so that we can come

close to doing it right, and so that we can get a better fix on where to go

next in pricing milk.

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