In the volatile world of dairy markets, risk management has become key to many producers’ success, enabling them to gain stability and control over their margins. Although dairy producers are masters at balancing multiple aspects of their operations, many remain uncertain about how their milk turns into money once it leaves the farm. Yet, before implementing an effective risk management strategy, it is crucial to grasp the fundamentals of milk pricing and its impacts on the milk check. While milk pricing can seem daunting, confusing, and complex, understanding the basics is the first step on the road map to success.
End-product pricing
Milk is priced according to its end use, a method known as end-product pricing. Since milk can be made into many different products, it does not always have the same value from processor to processor. For example, a processor making cheese values milk differently than a processor making butter, as cheese and butter each have their own supply and demand variations. Thus, despite milk being a homogeneous product, the product it gets made into determines its value. To distinguish this, milk is broken down into four different classes, each having its own associated value:
• Class I: Milk made into fluid milk products, such as whole milk or eggnog.
• Class II: Milk made into soft manufactured products, including yogurt, sour cream, and ice cream.
• Class III: Milk made into hard cheeses.
• Class IV: Milk made into butter or powders.
Because of the differences in individual manufactured products, formulas translate dairy product prices into these class prices. These formulas were created for the Federal Milk Marketing Orders (FMMOs), which establish monthly milk prices based on market fundamentals. There are three key parts of the FMMO milk pricing formulas, known as the “Three C’s” of milk pricing: commodities, components, and classes. Understanding the basic flow of these formulas is key to understanding how milk is priced in producer milk checks.
Each week, USDA surveys dairy processors on sales prices and quantities for four major dairy products: Cheddar cheese in two forms (40-pound blocks and 500-pound barrels), butter, dry whey, and nonfat dry milk. USDA compiles the data and publishes a weekly report called the National Dairy Product Sales Report (NDPSR), releasing the weekly weighted average prices and sales figures by product. Subsequently, these weekly prices are aggregated into monthly weighted average prices that are used to calculate the monthly FMMO class and component prices.
FMMO formulas use these commodity prices as inputs, resulting in values for milk’s components, including butterfat, protein, other solids, and nonfat solids. These formulas generally subtract a make allowance (plant manufacturing cost) from the product price and multiply the difference by a yield factor (pounds of the product used to make one pound of the component).
The four components are then put into formulas that establish the value for each class of milk. Figure 1 details the path of the “Three C’s” of milk pricing, displaying the connections between the commodities, components, and classes. Important to note from the figure is that Class III milk is made up of butterfat, protein, and other solids, while Class IV milk is comprised of butterfat and nonfat solids.
Analyzing the milk check
A milk check is typically divided into two parts: the base price and adjustments. The base pricing portion drives most of the price that producers receive and often leads to the most volatility in the milk check. When creating risk management plans, advisers will often focus on this portion, as it is largely influenced by supply and demand trends of the dairy markets.
The base price portion depends on several factors, yet it typically follows a similar pattern. FMMO pricing influences most milk checks across the country, both inside and outside regulated areas.
The most common method of milk pricing is multiple-component pricing, which is utilized by seven of the 11 FMMOs. Multiple-component pricing pays producers on the major components in milk — butterfat, protein, and other solids — along with a producer price differential (PPD). This pricing method is used in the milk check example shown in Figure 2.
The remaining four orders utilize skim-fat pricing, where producer milk is priced on the value of skim and butterfat. Both pricing methods are determined using end-product pricing.
While multiple-component pricing and skim-fat pricing are the most common base pricing methods, they are not the only methods. The base portion can differ depending on several factors, including the plant’s location, the handler’s business type (cooperative versus independent), and the individual handler. Though unregulated handlers (those who choose to depool their milk or are located in an area without a state or federal order) may have more freedom over the base milk price they give producers, they often utilize FMMO pricing formulas in some capacity.
Adjustments typically are determined by the individual handler and are added or subtracted from the base price. These adjustments can take the form of premiums or bonuses as well as deductions for costs associated with marketing the milk that are passed along from the handler to the producer.
The milk check example in Figure 2 portrays various types of premiums and deductions commonly found in a milk check, including quality bonuses, hauling costs, promotion dues, laboratory or testing fees, and cooperative dues. While these milk check adjustments may change, they are often more stagnant on a per-unit basis compared to the volatility seen in the base price. On average, the annualized volatility of base milk prices is roughly 20%, whereas adjustments typically account for a smaller portion of the overall milk check.
Risk considerations
When developing a risk management plan, it is important to understand the connection between the FMMO class prices and the actual price a producer receives. Class III and IV milk prices settle to different values than a producer’s milk check price. These discrepancies can be attributed to factors such as component levels, a handler’s product mix, the PPD, and adjustments. It is essential to consider this translation between class prices and the actual average price received in the milk check when formulating risk management strategies.
Milk pricing may seem complex with many layers, but resources are available to help producers better understand the transformation of milk into money. For example, to learn more about milk pricing and its contributions to the milk check, check out HighGround Dairy’s Milk Check Guide available at on.hoards.com/milkcheckguide.
