guest editorial/opinion
Perspective: Dairy Economics

Dr. Mark Stephenson is with the Cornell Program on Dairy Markets & Policy. He is a guest columnist for this week’s issue of Cheese Market News®.

What is it about make allowances?

Make allowances have been a topic of discussion since the adoption of product price formulas in the 2000 federal milk marketing order reform. We used to let the Grade B marketplace discover the value of manufacturing milk and use that price as the starting point for regulated milk prices. It wasn’t a perfect system but it worked for many decades. However, as Grade B milk supplies dwindled, a new mechanism was required.

All of the product price formula factors are important but perhaps the make allowance is the most controversial. If you happen to be a plant that sells product at the average National Agricultural Statistics Service (NASS) price, has product yields equal to the yield factor, and has costs of processing equal to the make allowance, it would seem as though making product was a zero profit venture for you. The testimony to determine make allowances, however, does allow for a return on investment in plant and equipment. So theoretically, the completely average plant will have some profit.

Not all plants are average. Most have production costs above or below the make allowance value. Most sell product for more or less than the NASS average, and yields will vary in all plants. Yet we can imagine that for several years after 2000 that most plants were making some kind of profit or else they didn’t stay in business.

One of the problems with make allowances is that if a plant is relatively profitable with the current formula values, then the plant will be relatively indifferent as to product and milk prices — the margin will remain about the same over time regardless of how high or low prices go. However, if the underlying components that make up the yield factors or the make allowances change, the margin also changes. Over time, components such as labor and certainly energy prices have increased, and plants have not been able to recover those costs in the marketplace. Passing those costs along upstream toward consumers doesn’t help because that gets captured in the NASS survey of prices and comes right back as a higher milk price. The margin, whether positive or negative, is locked in.

To state the obvious, a negative margin is a big deal for dairy plants. Unfortunately, the simple math of increasing the make allowance to recognize the increased costs of processing will decrease the regulated milk price for dairy producers — to quote Shakespeare, “ay, there’s the rub!”

The courts have recently rejected a legal challenge by producer groups to block the implementation of an increase in make allowances, but the real question is whether producers should feel that make allowances are an “us vs. them” issue at all.

It is easy to do the math looking at the change in make allowances and see that the Class III minimum prices will be reduced by about 25 cents per hundredweight. But let’s consider how these changes will take place over time. First, dairy farmers react to lower milk prices by reducing inputs such as concentrate feeding or rbST and milk per cow declines, or is off trend, nationally. Later, producers may cull a bit more heavily and reduce the number of cows. Together, the milk supply is less than it would otherwise have been.

Consumers are initially unaware that anything is different in the dairy case and choose to purchase what they have been purchasing at the same price. Dairy processors, however, react to lower milk prices and better margins by wanting to sell more dairy product. This isn’t possible without more milk and there is even less available so they must increase over-order premiums to producers. As the whole industry works its way back to an economic balance that economists call “equilibrium” the revenue lost to producers is eventually made up by an increase in product prices and thus milk prices. In fact, our dynamic modeling shows that producers are better off in the long run (about two years). And, this analysis does not account for the increased costs to producers for additional milk hauling if dairy plants went out of business if the make allowances were not changed.

In my opinion, as long as we have product price formulas, we need to have a mechanism for updating the parameters that doesn’t involve federal order hearings. We simply exhaust too many resources fighting changes that must be made. Producers and processors need to save their energy and political capital for more fundamental arguments. Dairy farmers need a healthy processing industry and processors need an uninterrupted supply of milk.

CMN

The views expressed by CMN’s guest columnists are their own opinions and do not necessarily reflect those of Cheese Market News®.