Federal milk marketing orders began using product price formulas to set minimum prices for milk back in January, 2000. Product price formulas determine the value of milk by looking at the market prices of a few major dairy products and calculating the value of the milk that was used to make them. (The process of determining the milk value is sometimes called “price discovery.”)
For example, we use Grade A butter prices collected by the National Agricultural Statistics Service (NASS) every week to calculate a value for butterfat in producer’s milk. The current formula for Butterfat = (Butter Price – 0.1202) times 1.20. The 1.20 value is the yield factor, which is an estimate of the pounds of butter you could make from one pound of butterfat. The 0.1202 is the make allowance. This is an estimate of what it costs a processor in energy, labor, salt, packaging, etc. to make a pound of butter. These make allowances were based on surveys of processors’ costs at the time the new pricing rules came into effect. The butter price surveyed by NASS reflects both the value of the butterfat in milk and the costs of processing it into butter, because butter manufacturers must receive a price that covers both the butterfat in the milk they buy and processing costs. Subtracting the make allowance from the NASS price and adjusting for the yield (because butter contains about 80 percent butterfat) provides an estimate of what the butterfat in milk is worth.
Federal milk marketing orders set the minimum prices that processors must pay for milk and its components. They are welcome to pay more, but they must pay at least the federal minimum prices. If processors try to recoup higher processing costs, such as increased energy prices, by raising their butter prices, the higher butter prices are captured in the NASS survey and result in a higher milk price. This can prevent manufacturers from cost recovery. Thus, if manufacturing costs increase markedly but the make allowance used in the milk pricing formula remains the same, this can have substantial negative financial consequences for processors.
Dairy farmers have the possibility of receiving over-order premiums for their milk. This mechanism can provide higher prices if market conditions allow, and in virtually all parts of the country processors do pay some level of over-order premiums. However, processors do not have any such voluntary mechanism for this kind of adjustment. When their costs of manufacturing increase, as they have since 2000, changing the make allowance is their only option.
Mark Stephenson, Cornell Program on Dairy Markets and Policy