December 1965 No. 3 ECONOMIC OUTLOOK FOR ONE GRADE OF tlilk By TRut-1AN F. GRAF
ECONONIC OUTLOOK FOR ONE GRADE OF rlilk Presented at the Thirteenth Annual Dairy Manufacturing Conference, University of Kentucky, Lexington, Kentucky, December 1, 1965 By Truman F. Graf Department of Agricultural Economics University of Wisconsin Madison, Wisconsin I will make my position clear at the outset. Some time in the fair~y near future, probably in our lifetime, all milk coming to market will be subj ect to the same quality standards, and 't!e will have only one grade of milk-.,,-grade A. There will be no ~'Ianu.facturing Grade milk as we know it today. Approximately 61% of the milk in this country is noid Grade A, and 39% is Manufacturing Grade. In 1950, only 39% of the country's milk was Grade A. The 21 percentage point increase 1n Grade A in the past 14 years 1S a good indicator of continued future conversion to Grade A. Some of the factors which will bring this situation about are: (a) Consumer Pressure: Because of improved knowledge by consumers, and development of new and improved dairy substitutes and competitive products, the consumer of the future \,i11 insist on the highest quality dairy products for all purposes from fluid to manufactured products. As a result, profitable outlets for Nanufacturing Grace milk Hill be scarce. Recent promulgations or Grade A standards for skim milk, and increasir:.g production of this product is an example of this trend. (b) Producer Pressure: Even noh, in many areas, quality standards for Manufacturing Grade milk are not far from those for Grade i\ milk. Als.,?-, producers of Manufacturing Grade milk are converting to bulk tanks and
-2- expanding operations in the process. The combination of increasing quality standards for Manufacturing Grade milk, and the general change to bulk tank occurring, means that even fairly small price incentives will result in many producers converting to Grade A milk. In Wisconsin, the Grade A-IVlanufacturing Grade price differentials have been aver'aging approximately 35 per hundredweight. This is lower than in many other areas of the country, but even these differ~ntials will be too large to keep producers on the Manufacturing Grade side in the future. Approximately 15% of Wisconsin's Hanufacturing Gr'ade producers novl have bulk tanks. This is more than double the number 3 years ago... In excess of 90% of Wisconsin's Grade A producers and 70% of all U.S. Federal Milk Order producers have bulk tanks. l\l though the change to bulk tanks by producers of Manufacturing Grade miu: will not: be as rapid or initially as complete as by Grade A produ~ers, a substantial continuing converslon is inevitable. Thus, the pressure will be on for one grade of milk, because of increasing s~:andards on ~1anufacturing Grade milk and the conversion frem ~1anufacturing Grade can to Grade A bulk and from ~'lanufacturing Grade can to bulk, the latter which is already not much different fr.om Grade A milk. (c) Milk Sanitation Regulations: Regulations that cost: producers money but that aren!t essential from a sanitation and health standpoint o will be less prominent in the future. The artificially high Grade A quality standards existing in some areas will be gradually t hittled away by court decisions and the legislative process, and as a result, greater uniformity and less stringent quality standards will exist in
-3- the future. This will make it easier fer. dairymen to meet the single Grade A quality standard, and add to the growing trend for one grade of milk. (d) Procurement and Plant Economies: Although not automatically forthcoming, procurement and plant economies can result from conversion from two grades to one grade of milk. Possible resulting reorganization of procurement routes so as to reduce overlapping and duplication, and internal plant reorganization, as well as increased volume, can reduce costs and increase both pay prices to producers and profits to plants. These possible economies will create additional strong continuing pressures for only one grade of milk---grade A. The possible magnitude of these economies is discussed in following sections of this report. POSSIBLE PLANT SAVINGS RESULTING FROM THE CHANGE TO ONE GRADE OF MILK Substantial decreases in unit costs in dairy plants could occur as Manufacturing Grade milk is converted to Grade A, and this milk is transferred to Grade A plants, resulting in an increase in their volume and capacity. It's true that a strong trend toward larger plants is already taking place, but the switch to one grade of milk would make for even larger plants. Also, the elimination of Manufacturing Grade milk would result in the elimination of many of our present Manufacturing Grade milk facilities, which are generally considerably smaller than Grade A plants. Thus, most of the facilities eliminated as a result of the change to one Grade of milk, would be the smaller plants; therefore, remaining plants would be considerably larger on the average than plants now are, and unit costs would be lower. Research we have done in Wis. indicates the following cost-volume relationships:
-4- Receiving Rooms: Receiving room savings occur ~.,i th larger milk volumes, as well as with bulk rather than can intakes, both of which would result from the conversion to one grade of milk. Can receiving rooms fiji th 40 ~ 000 pounds of milk a day have average intake costs of over 15 per cwt. more than the 160,000 per day operation, and ll per cwt. more than the 75,000 pound per Gay intake. This illustrates why strong pressures for increased volume 'dill occur, which will include encouraging producers to switch from Manufacturing Grade to Grade A milk. Furthermore, the intake savings resulting from switching from can to bulk vary from about 7 at 160,000 pounds per day to 22 per C'tTt. at 40,000 pounds per day. These substantial savings will result in strong pressures for changing from t~anufacturing Grade can to Grade A bulk. It is tvue that some receiving room cost reductions could occur with a change from Manufactu:'ing Grade can to bulk, but the savings Hould be greater if only one bulk intake---the Grade A one---were maintained than if both a Manufacturing Grade bulk and a Grade A bulk intake were maintained in the receiving room. Receiving Stations: Can-bulk comparisons in receiving stations with 40,000 pounds of milk a day, with respect to procurement, shrinkage, and equipment costs as well as intake costs. Indications show that Receiving Station total savings associated Hith a c~ange fr'om can to every-other-day bulk procurement are about lo per cwt. Al though savings could also result from a change from t>1anufacturing Grade can to bulk, they would not be as great as changing from Manufacturing Grade can to only Grade A bulk, because only Grade A--rather than both Grade A' andt"lanu acturi,ng Grade--intakes and equipment would be needed in the
-5- latter case, which would make possible greater cost savings. The substantial savings indicated above will also encourage the change t o one grade of milk. Butter Operations: An increase from 500,000 pounds of butter a year up to 2 million pounds of butter a year, reduced butter processing costs by approximately 3.4 per pound of butter in Wisconsin cooperatives. He estimate that if all the butter made by Wisconsin cooperatives were made in plants with annual outputs of 2 million pounds of butter per year, the potential savings to the cooperatives involved would be about $750,000 per year, or from S to over 20 per cvrt. of milk handled. Butter-Powder Plants: Wisconsin cooperative butter powder plants that increased their volume from 20 million pounds of milk a year to 110 million 5. pounds could cut their intake costs by about ~ per cwt. In ~hsconsin, 21 of the 39 cooperative butter-powder plants have less than 75 million pounds of milk a year. If these 21 plants had also operated at volumes of 110 million pounds of milk a year, potential savings to the plants would have been around $600,000 annually. Expres sed in terms of milk Intake, this could mean a savings in manufacturing costs of up to 20 per cwt. American Cheese Plants: Economies of scale are not generally as pronounced in American cheese as in skim milk powder or butter, because of the difference in technology. However, substantial savings could also result from increased volume, associated with the change to one grade of milk. As American Cheese plants increase volume from 500,000 pounds to 1,500,000 pounds of cheese a year, manufacturing costs are reduced approximately 1.4 per pound. If all Cheddar cheese produced by Wisconsin cooperatives were made in plants producing about 1 1/2 million pounds of cheese a year,
-6- potential cost-savings for the cooperatives affected, could amount to over $300,000 annually, or up to 15 per cwt. of milk. None of the largest-sized plants listed above for butter, butter powder, and cheese operations are really large facilities. They are fairly modest compared to the sizes of many operations in this countrya Therefore, even greater cost savings could result from the change to one grade of milk, and resulting increased scale of dairy plant operations. Management Costs: Management costs could be reduced from 10.7 per cwt. to 1.8 per cwt. at the annual milk volume is increased from 25 million pounds a year to 400 million pounds a year. This reduction of about ~ per cwt. would have made possible savings of $2 1/2 million a year for Wisconsin cooperatives, presently handling volumes of under 200 million pounds of milk a year. Again, the change to one grade of milk would re~ sult in more of these larger-sized operations. Fluid Milk Bottling Plants: An increase in packaged volume from 1000 quarts of milk to 20,000 quarts of milk a day in fluid bottling plants is associated with a decrease of about ~ per quart in processing and packaging costs. This is equivalent to almost $2 per Cl'lt. of milk. Increased size of fluid bottling plants can also result from the change to one grade of milk. PROCUREMENT SAVINGS RESULTING FROM THE SWITCH-OVER TO ONE GRADE OF MILK.. Today, most efficient-sized processing plants can afford to reach out over 25 miles for their raw milk supplies. However, taking Wisconsin as an example, fully 20% of all Wisconsin cooperative dairy plants have 20 or more coopera-tives operating within a 25-mile radius, about 23% have 15 to 19 operating within a 25-mile radius, and about 70%
-7- have 10 or more cooperatives operating within a 25-mile radius. Thus, there is considerable overlapping and duplication in the procurement of milk. This substantiall.y increases marketing costs. Conversion to one grade of milk would make possible reorganization and elimination of many procurement routes, permitting substantial cost savings. It is very difficult to reorganize existing Jvlanufacturing Grade milk routes because they represent given situations. If the change ~o Grade A is made, a new dimension is created, which will reduce the difficulty in the reo~ganization. It could also bring in different plants vrith Grade A milk, who could initiate routes on a more efficient basis than now exists. Also, elimination of procurement duplication between Grade A bulk and Manufacturing Grade bulk, by hauling both A and Manufacturing Grade milk in the same truck on the same route, is not likely because very few bulk tanks have the double compartments to receive Grade A and Manufacturing Grade milk. Thus, the bulk procurement systenl is likewise considerably more inefficient with tho grades of milk than it would be with only one grade of milk. Also, inta.ke costs are greater when both!-ianufacturing Grade and "A" bulk are received, since two separated vestibules a.re needed; whereas, if only one grade of milk is received, only one vestibule is neces sary_ Thus, one grade of bulk milk also reduces vestibule intake costs. POSSIBLE COST SAVINGS FROt'i ELHlINATING DUPLICATION IN PROCUREMENT To estimate potential savings from consolidated milk hauling, two model routes were budgeted in Wisconsin, one for canned milk and one for bulk milk. Patrons' locations \.ere plotted on county plant maps, and miles driven in farm driveways and yards were estimated and added to the
-8- route mileage to the nearest can and bulk plants. Two plants were selected to receive the milk on the basis of proximity to the procurement area. This analysis indicates that savings to be gained through route reorganization range from 9.8 to 12.6 per cwt. for canned milk hauling, and from 4.7 to 6.1 per cwt. for bulk hauling, depending on the per cent of capacity the truck was operating at. For canned milk, this represents a reduction in hauling costs of 4 L t-56%, and for bulk milk a reduction in hauling costs of 33-43%.~ These are possible savings which could result from the change from two grades to one grade of milk, providing current route duplication and overlapping were eliminated. Although not all of these savings could probably be achieved in actual operating conditions, they do suggest the magnitude of possible procurement savings, resulting from the change to one grade of milk. POSSIBLE DISADVANTAGES RESULTING FROM THE CHANGE TO ONE GRADE OF!'1ILK It should not be assumed that there will be only "pluses" for the dairy industry as the change to one grade of milk occurs. Some IIminuses" may also be involved. Unit costs could actually be increased in some standby plants as the change to one grade of milk occurs. If these plants receive two grades of milk, they always have some milk available 1/ Source: Groves, Frances, H. and Cook, Hugh L., "Hauling and Transportat ion Cost Functions for Hisconsin!'lilk, " Agricultural Series 31, April 1961, Department of Agricultural Economics, University of Wisconsin, Madison, Wisconsin.
-9- to process and hence can at least partially cover their fixed costs every day in the year. However~ if the shift to one grade of milk were consummated, they might very well find that the plant had no milk at all on particular days, because it all had to be shipped out for fluid purposes. Thus, unit plant costs could actually increase in certain situations if there were only one grade of milk. Also:! it is possible that in some combination Grade A-Manufacturing Grade multiproduct dairy plants, internal plant costs would not be reduced substantially, as a result of changing to only one grade of milk. Some plants indicate that both Grade A and Manufacturing Grade milk can be switched around fairly easily within the plant at the present time, and it is not a matter of running two internal operations, but rather doubling up on costs since both A and B milk can be mixed for manufacturing purposes. They~ therefore, contend that no great increase in plant efficiency would result from a change to only Grade A milk. Moreover, this switch-over to one grade will result in greater concentration in the dairy industry because of the elimination of many of the smaller Grade B dairy plants who have thus far survived on Manufacturing Grade milk. This increased concentration could have an adverse effect on producers, other dairy plants, and consumers, if it resulted in less bargaining power for them. An indication of the pronounced trend toward concentration in the dairy industry already occurring is indicated by the following data: (a) The number of U.S. fluid bottlers and distributors declined 13%, and the value of the sales for plant increased 52% between 1954 and 1960. (b) The eight largest dairies now account for over 43% of total fluid
-10- milk sales in the country as compared to 32% in 1940. (c) The four largest companies now handle approximately 16% of the country's creamery butter, 25% of the natural cheese, 71% of the processing cheese, 36% of the ice cream and ice milk, and 66% of the special dairy products. Technological, transportation and marketing developments will encourage continuation of this trend towards fewer and larger plants. In a situation of this type large dairy processors tend to be the price setters, and the bargaining strength of dairy farmers, other dairy plants, and consumers is reduced. Tbe Ghange to only one grade of milk. will probably encourage the growth of large national dairies and weaken the competitive position of small dairy plants who received some or much of t heir milk in Manufacturing Grade form. Another disadvantage in the complete change to Grade A will be with respect to Manufacturing Grade milk plants, and producers selling milk to them. If a complete change to Grade A occurs, but these manufacturing plants are unable to develop "bottling" or "fluid" outlets, they will be at a pay price disadvantage to other plants with these outlets. At present these "manufacturing'~ plants can compete by handling Manufacturing Gr ade milk and paying lower prices. However, if all milk 1'1ere Grade A these manufacturing planns would be using Grade A milk for manufactured products, and would therefore be at a severe disadvantage with Grade A bottling plants which used Grade A milk for Class I bottling purposes. Considerable market tt).rmoil would undoubtedly result, and "Grade All producers selling to these manufacturing plants would be very dissatisfied with lower prices than their "Grade A" neighbors selling to fluid bottling
-11- plants, or plants which sold milk to bottling plants were receiving. This could possibly result in a severe weakening in the financial stability of wholly manufacturing plants, and either literally force them to merge with either "fluid plants!! or national concerns, or vji th diversified outlets. Producers who had difficulty meeting Grade A standards would also be disadvantaged. Now they can sej.l on the Manufacturing Grade market, but if only Grade A milk were permitted, they would lose their markets. This change to Grade A 'Aould therefox'e create some severe problett,s for some producers---probably those with small herds who might lack finances to meet Gr'ade A requirements. Significantly,?l% of all dairy herds in the U.S. and 86% of Kentucky's dairy herds have less than 10 cows. In Wisconsin, only 17% of the herds have less than 10 cows. Therefore, the complete change to Grade A milk may also put the less "advanced ll dairy state at more of a competitive disadvantage with the more prominent dairy states, as many of the smaller dairy farmers would drop out of the business, rather than meet and finance the higher standards on their farms. In summary, there are advantages to be gained from having only one grade of milk, primarily in terms of procurement 2nd plai1"t costs. Hov:ever, there, will probably be disadvantages to smaller plants 2nd producers, some plants that now have both ['1anufacturing Grade and Grade A milk, and some of the plants that have only Manufacturing Grade milk now. However, whether He like it or not, the conversion to only one grade of milk is coming, and sooner and faster than most of us realize.