basic milk pricing concepts for dairy farmers (a3379) · pdf...

A3379

Milk pricing is complicated.Historically,most dairy farmershave understandably been

quite content to worry about makingmilk and to let their dairy plant worryabout marketing their milk.

This was a sound strategy until the1990s. Until then,milk prices werequite stable and predictable, seldommoving more than a few cents perhundredweight (cwt) from theannounced support price under thefederal dairy price support program.Stability meant little need for dairyfarmers to worry about pricing milkbeyond selecting a plant that offeredthe best price and other incentives.Moreover, even if dairy farmerswanted to be more actively involved

in pricing their milk, there were nopractical risk management tools toallow them to do so.

But marketing milk at the farm levelhas fundamentally changed. First,milkprices have become much morevolatile.Month-to-month pricechanges of $2–$3 per hundredweightand year-to-year average pricechanges of $5–$6 have becomecommon (figure 1).These extremeprice movements provide producers astrong incentive to practice price riskmanagement.

Second, dairy farm managers nowhave the opportunity to protect priceand profit objectives through the useof futures, options, and forward pricecontracts — something their grainand livestock compatriots have beenable to do for many years.1

So matters that were previouslyunderstood by only a few people,such as product formula makeallowances, advanced higher-of Class Ipricing, and producer price differen-tials, now make a difference to indi-vidual farmers who can use this infor-mation in futures-based price riskmanagement strategies.

In this publication, we explain milkpricing concepts for dairy farmers andothers who don’t need to know all ofthe intricate details but seek a basicunderstanding of how milk is priced— in particular, how federal milk mar-keting order prices are derived andhow orders and other federal milkpricing rules affect dairy farmers’farm-level milk prices.

We begin by discussing how marketsfor manufactured dairy productsoperate, since minimum federal orderprices have been based exclusively onthese markets since 2000.That discus-sion includes a brief review of thefederal Dairy Product Price SupportProgram.Next, we describe thefederal order system.We cover basicprincipals of classified pricing andpooling, show how milk componentand class prices are derived, anddemonstrate the calculation of poolvalues and producer pay prices.Finally, we discuss some controversialissues surrounding milk pricing —issues that have occupied economistsand politicians for several decades.

Basic Milk Pricing Conceptsfor Dairy FarmersEd Jesse and Bob Cropp

Market price

Market price is Federal Orderminimum price for milk used to manufacture cheese

Support price

Source: Agricultural Marketing Service, USDA

Figure 1.Market and supportprices for milk

1For details regarding dairy price risk management options and strategies, see E.V. Jesse and R.A. Cropp, Futures and Options Trading in Milk andDairy Products: A Guidebook for Dairy Producers, Cooperative Extension, University of Wisconsin-Extension, Bulletin A3732.

2 University of Wisconsin Extension • Cooperative Extension

Markets fordairy productsUtilization of milkFarm milk prices are the outcome ofthe interaction of supply and demandfor hundreds of dairy products.Theseproducts vary according to how theyare ultimately consumed. Some, suchas homogenized 2% (reduced fat) milkin gallon plastic jugs and yogurt in six-ounce plastic containers, are pur-chased in grocery stores and otheroutlets for at-home family consump-tion. Some, such as wheels of Swisscheese and bulk containers of icecream, are distributed to consumersafter some preparation through delis,restaurants, and cafeterias.

Other dairy products, including mostof the mozzarella cheese produced inthe United States, reach consumers asprimary or secondary ingredients inother foods such as pizza. And otherproducts, such as nonfat dry milk,whey products, and dried cheeses, areall but hidden in the long list of ingre-dients for bakery items, snack foods,and other processed food products.

For the purpose of discussing marketsand prices, it is useful to separate dairyproducts into fluid and manufacturedcategories because prices for theseproducts are determined in differentways. Prices for storable manufactureddairy products such as butter, cheese,whey, and nonfat dry milk are marketdetermined.That is, these prices areestablished by product supply anddemand conditions except when thedairy product price support programis active.These market-determinedmanufactured product prices then setthe minimum prices for milk used tomake the products through federaland state milk marketing order pricingformulas, which are discussed later inthis report. In other words, competitiveconditions in these manufactureddairy product markets determine theminimum amount that manufacturersare required to pay for their rawproduct.

In contrast,minimum prices for milkused to produce beverage milkproducts (and some perishable manu-factured products) are not based onsupply conditions for these products.Instead, federal and state milk market-ing orders administratively setminimum fluid milk prices by linking

them directly to the prices for milkused for manufacturing. In otherwords, prices for fluid milk are notbased on supply and demand condi-tions for fluid milk; they are based onsupply and demand conditions formanufactured dairy products.This isan important distinction that we willrevisit later.

Over the last 50 years,milk use in theUnited States has shifted graduallyfrom fluid forms to manufacturedproducts (figure 2). In 1950, fluid milkand cream took about half of the milksupply, compared to 30% in 2007.2

Note that fluid milk took an increasingshare of the milk supply from the1920s until the mid-1970s.This trendwas due to two factors — the increas-ing use of home refrigeration, whichmade bottled milk a mainstay in theAmerican diet, and the rapid displace-ment of butter by margarine, whichreduced the amount of milk used formanufacturing.

Since the mid-1970s, total use of milkfor fluid milk and cream has increasedslowly while growth in manufacturinguse has accelerated.Most of thisgrowth has been in cheese. On a percapita basis, fluid milk consumptiondecreased 20% between 1975 and2006 (table 1).3 Per capita cheese con-sumption more than doubled overthat period, with the largest growth in“other” varieties — mostly mozzarellaand other Italian cheeses. Per capitabutter consumption was stable andother categories showed a decline inper capita usage.

0

20

40

60

80

100

120

140

160

180

200

1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

Fluid milk and cream

Manufactured dairy products

Source: Economic Research Service, USDA

Bill

ion

lbs

Figure 2. Utilization of U.S.milk for fluid and manufacturing purposes

2Milk utilization noted here is based on receiptsof fluid milk handlers and manufacturers asreported by the Economic Research Service,USDA; that is, the volume of raw milk used forfluid and manufacturing. As demonstratedlater, utilization based on the butterfat andnonfat solids contained in milk yields a differ-ent utilization pattern since beverage milk isstandardized to achieve a fat content less thanthe content of milk as it comes from the cow.

3Population growth slightly offset lower fluidmilk use per capita, yielding larger totalconsumption.

Basic Milk Pricing Concepts for Dairy Farmers 3

Table 1. U.S. Per capita consumption of selected dairy products, in pounds

Evaporated Ice cream All products,American Other and and frozen Dry milk equiv.,

Year Fluid* Butter cheese cheese condensed desserts products fat basis

1975 261 4.7 8.4 6.1 8.9 28.7 5.8 539

1976 260 4.3 9.0 6.7 8.6 27.5 6.3 540

1977 258 4.3 9.3 6.8 8.2 27.4 6.2 540

1978 254 4.4 9.6 7.4 7.6 27.3 6.0 544

1979 251 4.5 9.6 7.6 7.4 26.3 6.5 548

1980 246 4.5 9.6 7.9 7.1 26.2 6.2 543

1981 242 4.2 10.2 8.0 7.3 26.3 5.4 541

1982 236 4.4 11.3 8.6 7.0 26.1 5.6 555

1983 236 4.9 11.6 8.9 7.0 26.9 5.9 573

1984 238 4.9 11.9 9.6 7.4 27.1 6.3 582

1985 241 4.9 12.2 10.4 7.4 27.6 6.4 594

1986 240 4.6 12.1 11.0 7.9 27.8 6.8 592

1987 237 4.7 12.4 11.7 7.9 28.1 6.8 601

1988 237 4.5 11.5 12.2 7.7 27.6 6.9 583

1989 237 4.4 11.0 12.8 7.8 28.6 6.3 564

1990 233 4.4 11.1 13.5 8.0 28.6 7.4 568

1991 232 4.3 11.0 13.9 8.1 29.3 6.8 564

1992 229 4.3 11.3 14.6 8.4 28.8 7.3 563

1993 224 4.6 11.3 14.7 8.1 29.1 6.8 569

1994 223 4.8 11.4 15.1 8.1 29.6 7.9 580

1995 221 4.4 11.7 15.2 6.8 29.0 7.3 576

1996 220 4.3 11.8 15.5 6.3 28.2 7.5 566

1997 216 4.1 11.8 15.7 6.4 28.3 7.1 567

1998 213 4.4 11.9 15.9 6.1 29.0 7.0 572

1999 213 4.7 12.6 16.4 6.5 28.6 6.5 584

2000 210 4.5 12.7 17.1 5.8 28.0 6.8 593

2001 208 4.4 12.8 17.2 5.5 27.0 7.3 587

2002 207 4.4 12.8 17.6 6.0 26.6 7.2 587

2003 208 4.5 12.5 18.0 5.9 27.2 7.3 595

2004 206 4.6 12.9 18.3 5.4 24.2 7.8 594

2005 205 4.6 12.6 18.9 5.9 24.4 6.3 597

2006** 208 4.7 13.0 19.4 6.4 24.3 5.2 606

% Change,1975–2006 -20.3% 0.6% 55.3% 218.6% -27.9% -15.4% -10.6% 12.4%

* Includes sour cream, eggnog, and yogurt, **Preliminary Source: USDA/ERS, Livestock,Dairy, and Poultry Situation & Outlook.

Determining how the U.S.milk supplyis allocated to various dairy productsis not a straightforward process. Fewdairy products are produced inde-pendently of others. For example,butter, nonfat dry milk, and buttermilkpowder are joint products in a butter-powder plant. So adding up thepounds of milk used to make butter,nonfat dry milk, and buttermilkpowder would involve triple countingof the milk used. Similarly, cheese,whey powder, and whey cream areproduced together. Cream skimmedfrom lower-fat fluid milk productsflows freely among several productssuch as whipping cream, ice cream,and butter.

It is easier and more instructive toshow how milk components are allo-cated among dairy products. Doing soalso emphasizes that milk is not ahomogeneous good — it is a bundleof physical components and othercharacteristics that have differentvalues in different dairy products.

USDA annually calculates total avail-ability of butterfat and nonfat milksolids and the use of these compo-nents across products.4 Utilization for2007 is shown in figure 3.

Note that 80% of the butterfatproduced in the United States in 2007was used in three products: butter,cheese, and fluid milk and cream.These same three products absorbed45% of nonfat solids production, withbutter accounting for only 0.1% ofnonfat solids use. Ice cream and otherfrozen products and cultured dairyproducts represented other significantoutlets for butterfat, while whey andnonfat dry milk accounted for about20% of nonfat solids usage.

Looking at how milk components areused within product categories helpsus understand how changes indemand for dairy products can bringabout relative shortages and surplusesof milk components. For example, areduction in demand for fluid milk,which uses about 32% of nonfat milksolids production but only 23% of but-terfat production, would mean rela-tively more nonfat solids than butter-fat would need to find a home in dif-ferent products. In a similar sense,expanded demand for cheese wouldincrease butterfat usage relative tononfat solids.

Aggregate utilization of milk compo-nents masks major differences acrossregions of the United States. Usingmilk utilization by product class asreported by federal milk marketingorders, figure 4 shows differences inutilization between the Northeastfederal order (primarily New York andPennsylvania) and the Upper Midwestorder (primarily Wisconsin andMinnesota).

Given its proximity to large East Coastpopulation centers, the Northeastorder supplies a relatively large pro-portion of its milk for fluid and softmanufactured products (67% in 2007).The use of milk for butter and nonfatdry milk in this order is also relativelyhigh because butter-powder plantsserve as an outlet for “balancing” fluidmilk bottlers’ needs with the availablemilk supply.

In contrast, the Upper Midwest order islocated further from dense populationcenters. Consequently, only 22% of itsmilk supply was allocated to Class Iand Class II in 2007, and three-quarterswas used to make cheese.


Figure 3. Utilization of U.S. butterfat and nonfat milk solids by product, 2007

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

40.0%

45.0%

50.0%

55.0%

60.0%

65.0%

70.0%

75.0%

80.0%

85.0%

90.0%

95.0%

100.0%

Butterfat Nonfat solids

Source: USDA/NASS,Dairy Products,2007 annual summary

Evaporated and condensed

Evaporated and condensed

Dry milk products

Dry milk products

Other and residual

Other and residual

Whey products

Whey products

Frozen

Frozen

Cheese

CheeseButter

Yogurt and sour cream



Yogurt and sour cream

4National Agricultural Statistics Service, U.S. Department of Agriculture,Dairy Products, Annual Summary, 2007.

Wholesale dairyproduct marketsThe manner in which producer milk isutilized in various products empha-sizes the importance of markets forbutter, cheese, nonfat dry milk, andwhey in determining farm milk prices.Organized wholesale cheese andbutter markets, operated through theChicago Mercantile Exchange (CME),are especially important in milkpricing, since they serve as pricingbases for products that utilize the bulkof manufactured milk volume.

ButterBrokers representing butter buyersand sellers trade Grade AA butter onthe CME each non-holiday weekday ofthe year.The trading session usuallylasts only five minutes, but it may beextended if the market is active.Whilevery little butter changes hands on theCME butter market, the price estab-lished at the end of the trading daybecomes a reference price used forselling butter throughout the UnitedStates under various contractualarrangements.

The Exchange operates as an auctionmarket with offers to sell and bids tobuy butter. But unlike an auction, theremay or may not be any actual transac-tions during a particular tradingsession.The reported price at the endof a trading session can change fromthe previous session with a sale, anuncovered offer, or an unfilled bid. Anuncovered offer occurs when butter isoffered at a price lower than the lasttransaction price or offer and there isno buyer. Since nobody wants to buyat the lower price, the assumption isthat the market-clearing butter price isno higher than the offer. An unfilledbid is a bid that is higher than the lasttransaction price or bid that attractsno seller. An unfilled bid suggests thatthe market-clearing butter price is atleast as high as the bid.

In 2007, 630 carlots (40–43 thousandpounds/carlot) of Grade AA butterwere traded on the CME.This amountrepresented about 1.7% of total 2007butter production. Despite the limitedvolume of CME butter trading relativeto production, the reported price isviewed by butter industry participantsas an accurate price barometer.Theargument goes like this: The largerbutter traders participating on theCME through their brokers account formost of the butter production and usein the United States.These traders onlyoffer to sell butter on the Exchange ifthey are unable to sell butter on theregular commercial market at thegoing price, and they only bid to buybutter if they are unable to obtain suf-ficient quantities of butter elsewhere.This marginal selling and buyingactivity on the CME is perceived toreflect the overall commercial supplyand demand situation.

Because of this trade confidence,mostbutter manufacturers sell butter undercontracts that peg the price to theCME quote. Since the value of cream islargely in the butterfat it contains,cream prices are also tied to the CMEbutter price. And since cream is theprimary ingredient in ice cream andother frozen dairy products, wholesaleprices for these dairy products are alsotied closely to the CME butter price.Because of its extensive use as a refer-ence price, the CME butter market hasan influence on butterfat prices that ismuch larger than suggested by thetrading volume.


0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Source: USDA, AMS, DairyPrograms

Class IV (Butter & NDM) 9%

Class IV (Butter & NDM) 2%

Class III (Cheese)24%

Class III (Cheese)76%

Class II (Soft & frozen) 21%

Class II (Soft & frozen) 5%

Class I (Fluid milk)46%

Class I (Fluid milk)17%

Upper MidwestNortheast

Figure 4. Percent of milk utilized by class: Northeast and Upper Midwest federalorders, 2007

Cheddar cheeseThe CME operates a daily wholesalemarket for cheddar cheese in twostyles — 40-pound blocks and 500-pound barrels. The cheese marketoperates the same as the buttermarket and for the same five-minutelength of time unless trading isextended. Prices can change from theprevious trading session with anactual sale, an unfilled bid, or anuncovered offer.

In 2007, 451 carlots (40–44 thousandpounds/carlot) of block cheddarcheese and 485 carlots of barrelcheddar cheese were traded on theCME.The combined volume of tradingrepresented about 1.3% of cheddarcheese production and 0.4% of theproduction of all cheese in 2007.

Like the CME butter price and for thesame reasons, the CME cheddarcheese prices serve as reference pricesfor other cheese trades.The pricesestablished at the end of the dailytrading session are used in formulapricing of most of the cheese made inthe United States, cheddar as well asother varieties.

The “thinness”of the central wholesalemarkets for butter and cheese haslong been a source of concern in thedairy industry. Unusually large session-to-session variability in cheese pricesin 2007 intensified concerns andraised questions about whethertrading legitimately reflects supplyand demand conditions. If the CMEprices applied only to the smallvolumes traded on the butter andcheese exchanges, these questionsmay not be relevant. But in light of thegreat extent to which formula pricingis tied to the exchange prices, whathappens on the exchanges gains con-siderable prominence — the smallvolume of trading influences anenormous volume of cheese andbutter sales.

Controversy over charges that cheddarcheese prices had been manipulatedon the National Cheese Exchange(NCE), the predecessor of the CME, ledto the shifting of the central cheesemarket to the CME in 1997.The NCEhad previously been the subject ofseveral investigations, none of whichyielded a legal finding of price fixing. A2007 report by the GovernmentAccounting Office acknowledgedindustry concerns that the CME spotcheese market was subject to manipu-lation. Yet the report went on to rec-ommend that USDA should use theCME prices directly in setting federalorder prices rather than using averagesales prices collected and reported bythe National Agricultural StatisticsService.5

For better or worse, the exchangescontinue to play a very large role inpricing butter and cheese, and,through federal order pricing formulasdiscussed later, farm-level milk.

Nonfat dry milk and dry wheyThe CME maintains wholesale cashmarkets for Extra Grade and Grade Anonfat dry milk, but there has beenlittle activity on these markets andthey do not play the same role inpricing as the CME butter and cheesemarkets.There were no trades in ExtraGrade and one trade in Grade Anonfat dry milk in 2007.

Until about 2004, prices for nonfat drymilk were heavily influenced by theCommodity Credit Corporation (CCC)as a major purchaser of nonfat drymilk under the Milk Price SupportProgram. Except for brief periods, theCCC purchase price for nonfat dry milkset the commercial market price.Starting in 2005, U.S. exports of nonfatdry milk grew rapidly as a result of aworldwide shortage of dry milkproteins.World market prices, which

were well above the CCC purchaseprice, became instrumental in settingthe value of nonfat dry milk.

Most U.S. nonfat dry milk is producedby cooperatives, and most of thesecooperatives are members of DairyAmerica, a federated cooperativecreated to collectively market nonfatdry milk exports.Through a jointventure, Fonterra, a large NewZealand-based dairy cooperative withextensive international sales, handlesDairy America’s exports.This consoli-dated marketing of nonfat dry milkoverseas is likely a major reason thatthe CME spot market is inactive — theuncommitted volume of nonfat drymilk may not be large enough tosupport a wholesale market.

There is no central spot market for drywhey products.There are few drywhey manufacturers relative to cheeseplants, as most cheese plants diverttheir liquid whey to specialized dryers.Prices are established through individ-ual negotiations between buyers andsellers, often through brokers andother middlemen firms. An increasingproportion of U.S. dry whey produc-tion has been sold in export markets,and as a result, world market priceshave a significant influence on U.S.prices for whey.


5U.S. Government Accountability Office, Spot Cheese Market: Market Oversight Has Increased, but Concerns Remain about Potential Manipulation,GAO-07-707, June 2007.

The dairy product pricesupport program6

From time to time, prices for butter,cheese, and nonfat dry milk — andconsequently milk prices — areaffected by federal price supports.TheDairy Product Price Support Programoperates through a standing offer bythe CCC to purchase unlimited quanti-ties of butter, nonfat dry milk, andcheddar cheese at specified purchaseprices.

The purchase prices are detailed in theFood, Conservation, and Energy Act of2008: butter–$1.05 per pound; blockcheddar cheese–$1.13 per pound;barrel cheddar cheese–$1.10 perpound; and nonfat dry milk–$0.80 perpound.These prices may be reduced ifCCC net removals of product exceedspecified levels for 12 consecutivemonths.7 These trigger inventorylevels are very large compared torecent net removals and are notexpected to alter purchase pricesduring the life of the Act.

Prior to passage of the 2008 Act,Congress specified the support pricefor milk used for manufacturingpurposes. Using product priceformulas, USDA then translated thesupport level for milk into associatedCCC purchase prices for the eligibledairy products.The product purchaseprices currently in place under the2008 Act are the same as those associ-ated with a $9.90 milk support priceunder previous legislation. So whilemilk price objectives are no longerdirectly relevant in setting productpurchase prices, plants sellingproducts at the CCC purchase priceswould be expected to earn sufficientrevenue to pay producers $9.90 perhundredweight of milk at average but-terfat test.

The Dairy Product Price SupportProgram operates in the backgroundof the commercial markets for thesupported dairy products. If milksupply and demand are in goodbalance or if milk supplies are tightrelative to demand, then production ofhard manufactured products will becorrespondingly low and productprices will be above the CCC levels.Products will move to commercialoutlets and the support program willbe inactive.

If milk supplies are large relative todemand, then the supply of milk notneeded for perishable products willincreasingly be diverted to the manu-facture of storable products. Prices forthese products will fall with increasedsupply. At some point, the CCC

purchase prices will represent a moreprofitable market for some plants thancommercial outlets.8 Because of inter-plant competition for the availablesupply of milk for manufacturing, theCCC prices will also buttress prices forother manufactured products that arenot purchased by the CCC. Forexample, if cheddar cheese plants areable to pay their patrons the supportprice because of their ability to sellcheddar cheese to the CCC,mozzarellaplants will need to pay at least asmuch in order to retain their milksupply.

The CCC may sell back to commercialmarkets products purchased underthe support program at not less than110% of the purchase price.9 Thesesales are referred to as unrestrictedsales. As surplus milk productioneases, prices for butter, cheese, andnonfat dry milk will increase, enablingthe CCC to reduce stocks throughcommercial market sales.

Besides making unrestricted sales, theCCC makes surplus dairy productsavailable for use in several domesticand foreign food programs.Most ofthese special programs only providedairy products on an “as available”basis; that is, donations are made onlyif there are stocks available to donate.The CCC has also held fire sales ofnonfat dry milk for cattle feed and formanufacturing milk protein concen-trate when stocks were especiallyburdensome.


6The Food, Conservation, and Energy Act of 2008 changed the name of the federal dairy price support program from the Milk Price Support Programto the Dairy Product Price Support Program.The Act also reauthorized and modified the Milk Income Loss Contract (MILC) program,which pays dairyproducers when milk prices fall below a specified level.MILC is an income support program, not a price support program. Consequently, we do notdiscuss MILC in this report, which focuses on milk pricing.

7Net removals under the 2008 Act are defined as purchases plus Dairy Export Incentive Program (DEIP) removals minus unrestricted sales.

8The market price for commodities purchased by the CCC may fall below the CCC purchase price because selling to the CCC involves additional costsrelative to selling to commercial buyers.These costs include special packaging requirements,mandatory inspections and grading, and delayedpayment. In early 2003, the CME price for block and barrel cheese fell as much as 12 cents per pound below the CCC purchase prices.

9The percentage markup over CCC cost for unrestricted sales is occasionally altered.

The effect of the federal dairy pricesupport program on milk prices hasbeen substantially reduced over theyears. Once tied to parity,10 theannounced support price reached$13.10 per hundredweight in the early1980s.Milk production increasedrapidly in response to rapidly increas-ing prices, and surpluses mounted(figure 5). High government costsinduced Congress to decouple thesupport price from parity and gradu-ally lower it from $13.10 per hundred-weight in 1981 to $10.10 in 1990,where it remained through 1995.

Since the $10.10 level was below thefull cost of production for most dairyfarmers, government purchases, withthe exception of nonfat dry milk,essentially dried up. CCC purchases ofboth butter and cheese in calendaryears 1996–2007 averaged less than0.5% of production. And CCC stocks ofnonfat dry milk disappeared in 2006with escalating world market prices.

The 1996 Farm Bill increased thesupport price to $10.35 per hundred-weight for 1996, with three scheduledreductions of 15 cents each to bringthe level down to $9.90.The Billrequired termination of the programon December 31, 1999. Subsequentlegislation extended the program untilMay 2002,when the 2002 Farm Billreinstated the program at the $9.90support level for milk.

The $9.90 milk price objective and therelated dairy product prices specifiedin the Food, Conservation, and EnergyAct of 2008 are very low relative tomarket prices.There have been nogovernment purchases of butter,cheese, or nonfat dry milk since 2004.Given current dairy production inputcosts, especially for feed, large losseswould be incurred by dairy farmers ifthe manufacturing milk price fell to$9.90.

The extended dormancy of dairy pricesupports has raised questions as towhether the program can be justified.Some dairy market observers arguethat the program has outlived its use-fulness and should be discarded orreplaced. Critics also point to the largecontribution of the program to theUnited States’ “Aggregate Measure ofSupport”under the Uruguay Round oftheWorld Trade Organization (WTO),and question the viability of theprogram under a new agreement thatwould likely cut permitted levels ofdomestic price support.11

Others involved in the dairy industry,including most dairy cooperatives,strongly defend the support programas an effective, inexpensive way toprovide a floor on the prices of princi-pal dairy products—albeit a very lowfloor. Supporters argue that eliminat-ing the support program would leadto even greater milk price volatility,since down-side price movementswould be unconstrained.There is con-siderable fear about how low pricesmight fall without the price supportprogram safety net.


-400

-200

0

200

400

600

800

1,000

1,200

1,400

1,600

1,800

2,000

2,200

2,400

2,600

1970 1975 1980 1985 1990 1995 2000 2005

Mill

ion

lbs

Source: Economic Research Service, USDA

Cheese

Butter

Nonfatdry milk

Figure 5. Government purchases of dairy products

10Parity milk price does not reflect the cost toproduce milk but rather maintains the samepurchasing power of milk as it had in the baseyears of 1910–1914.

11The Milk Price Support Program accounted forabout 25% of the total annual level ofdomestic support ($19.1 billion) permitted bythe United States under the UruguayWTORound.The 2008 Farm Bill change to support-ing product prices instead of the milk price isexpected to reduce the contribution of dairybecause the volume of production used inthe calculation will presumably be the pro-duction of butter, cheese, and nonfat dry milkinstead of total U.S.milk production.

Federal milkmarketing ordersFederal milk marketing orders setminimum prices for about 70% of theGrade A milk produced in the UnitedStates, and Grade A milk constitutes99% of all U.S.milk (see sidebar: GradeA and Grade B milk). California, whichaccounts for more than 20% of U.S.milk production, uses a state pricingsystem that is very similar to federalorder pricing.

Federal orders are authorized underthe Agricultural Marketing AgreementAct of 1937, as amended.The Act isenabling legislation; that is, federalorders are not mandated. Dairy pro-ducers must request and approve anorder through a hearing and referen-dum process.

USDA cites three major objectives offederal milk orders:

1. To assure consumers of anadequate supply of wholesomemilk for beverage purposes, at areasonable price

2. To promote greater producer pricestability and orderly marketing

3. To provide adequate producerprices to assure an adequatecurrent and future Grade A milksupply

These objectives are achieved throughthe following methods:

• Classified pricing:Minimum payprices are established for milk andmilk components according towhat dairy products they are usedto produce.

• Pooling:Within each order, pro-ducers receive a uniform price fortheir milk (of equal quality andcomposition) or milk components,regardless of how their milk isused.

While producers approve orders, theorders regulate milk plants (calledhandlers), which acquire milk fromproducers or dairy cooperatives.Regulated handlers are required toaccount to the federal order pool atthe established minimum class andcomponent prices.

There are three types of regulatedhandlers:

1. Distributing plants: Plants thatprocess, package, and sell beveragemilk products within designatedmarketing areas. Distributing plantsmay procure milk directly from pro-ducers or (more likely) from supplyplants and cooperatives.

2. Supply plants: Plants that supplyraw milk to distributing plants.These are manufacturing milkplants, such as cheese plants.Whileengaged primarily in manufactur-ing, supply plants help assure anadequate supply of milk for fluidpurposes by carrying fluid milkreserves.When milk is needed forfluid purposes, supply plants arerequired to ship milk to fluidprocessors rather than use the milkto make manufactured dairyproducts. Supply plants also providea “balancing” service by manufac-turing milk that is not needed forfluid purposes on days whenbottling plants are not operating.

3. Dairy cooperatives: Some dairycooperatives bottle milk, and othershave manufacturing facilities. Stillothers are involved exclusively inrepresenting their members innegotiations with proprietary firmsand do not process milk. Dairycooperatives provide a number ofmarket-wide services that enablefederal orders to operate more effi-ciently. These include such servicesas milk procurement from produc-ers, full-supply arrangements to

milk bottlers (supplying specificvolumes of milk on an as-neededbasis),moving milk to the highestand best uses, and providing milkquality testing services.

Dairy cooperatives are obligated tothe federal order pool for the estab-lished minimum prices. But dairycooperatives are not obligated topay their members the orderminimum producer prices.This isbecause dairy cooperatives areviewed under the orders as being


Grade A andGrade B milkIn 2006, Grade A milk represented 99%

of the milk produced in the United

States and 96% of the Wisconsin milk

supply. Federal milk orders apply only to

Grade A milk. Grade A milk is defined as

milk that is eligible for use as beverage

(fluid) milk, but most Grade A milk is

converted to manufactured dairy

products. Grade B milk can only be used

for manufactured dairy products.

The grade of milk is determined from

quality standards and production stan-

dards. Somatic cell count and bacteria

count are the principal quality stan-

dards. Production standards pertain to

conditions in and around the milking

facility.

Because high quality milk is required for

both manufacturing and beverage

purposes, the quality of Grade B and

Grade A milk being produced today is

much closer than it was years ago.Most

Grade B milk is classified that way

because of producers’ inability to meet

production standards—not an inability

to meet quality standards.

an extension of their members’ farmfirms. Cooperatives often “re-blend”the proceeds from milk sales acrossfederal order markets and pay theirmembers a common price. Ofcourse, dairy cooperatives need topay producers competitive prices inorder to attract and keep producersas members.

Each milk order represents a definedmarket area (figure 6).This is a geo-graphical region where fluid(beverage) milk is sold to consumers,not necessarily where milk isproduced. Each order has performancestandards, which establish theminimum amount of fluid milk that

must be sold within the market areabefore a milk plant is regulated by thatorder. If a milk plant sells milk intomore than one federal order market-ing area, then it will be regulatedunder the order having the largestshare of the plant’s fluid milk sales. Sowhether a dairy producer receives theorder prices does not depend onwhere the producer is located (insideor outside the market area), but ratheron whether or not the producer’s milkplant meets the minimum perform-ance standards within the order.

Currently there are 10 federal orders.Under Congressional mandate, orderswere consolidated from 31 to 11 on

January 1, 2000. In April 2005, theWestern order was terminated.Thenumber of orders peaked in 1962 at82, and the number gradually fellthrough mergers (table 2).Thesemergers were motivated by evolvingimprovements in packaging and trans-portation that enabled milk to bemoved greater distances and encour-aged larger marketing areas.


Figure 6.Marketing areas for current federal milk marketing orders

Source: USDAAgricultural Marketing ServiceDairy Programs

Table 2. Evolution of federal milk orders

1960 1970 1980 1990 2000 2006

Orders (no.) 80 62 47 42 11 10

Producers (no.) 189,816 143,411 117,490 100,397 69,590 52,725

Producermilk (mil. lbs.) 44,812 65.104 83,998 102.396 116,920 120,618

% of U.S.milk:Grade A 64 79 80 77 72 68All Milk 43 59 67 70 70 67

Classified pricingThe current set of federal orders uni-formly define the following fourclasses of milk, from highest to lowestvalue (under most circumstances):

• Class I is milk used for beverageproducts.This includes “white”whole, low-fat, and skim milk in allcontainer sizes; chocolate andother flavored milks; liquid butter-milk; and eggnog.

• Class II is milk used for soft manu-factured products such as icecream and other frozen dairydesserts, cottage cheese, andcreams (sour cream, aerosolwhipped cream and whippingcream, half and half, and coffeecream).

• Class III is milk used to manufac-ture cream cheese and hardcheeses.

• Class IV is milk used to make butterand dry milk products — princi-pally nonfat dry milk.

The orders specify minimum prices formilk and milk components accordingto Class.These are minimum prices tohandlers; minimum prices to producersare derived differently, as noted later.

For manufactured product classes —Classes II, III, and IV — the specifiedminimum prices are the same for eachof the ten orders. Prices for Class I skimmilk and butterfat differ by order.

Minimum prices for the hard manufac-tured classes — Classes III and IV —and for the butterfat portion of Class IIare announced monthly on the Fridayon or before the fifth of the month fol-lowing the month to which they apply(e.g., October prices are announced onthe Friday on or before November 5).

Minimum prices for Class I skim milkand butterfat and Class II skim milk areannounced on the Friday on or beforethe 23rd of the month prior to themonth to which they apply (e.g., theOctober Class I price is announced onthe Friday in September that falls onor before September 23).

Calculation of Class III andClass IV prices12Federal order Class III and IV prices areset using a three-stage process. In thefirst stage, product price formulas areused to set prices for four milk compo-nents: butterfat, protein, nonfat milksolids, and other (nonfat and non-protein) milk solids.

The general form of the product priceformulas is as follows:Component price/lb = (Productprice/lb – Make allowance/lb) X Yield

The priced Class IV milk componentsare nonfat milk solids and butterfat.Nonfat milk solids make up nonfat drymilk, and butterfat is the primaryingredient in butter.The Class III com-ponents are butterfat, protein, andother solids. Butterfat and protein arethe principal constituents of cheese,and other solids (mainly lactose), alongwith residual protein from the cheese-making process,make up dry whey.

Dairy product prices are monthlyaverages of USDA’s NationalAgricultural Statistics Service (NASS)weekly survey of wholesale prices forGrade AA butter, block and barrelcheddar cheese, nonfat dry milk, anddry whey. NASS collects weekly salesprices and associated volumes soldfrom major manufacturers of theseproducts. Prices reported on Friday ofeach week represent the weeklyaverages for the preceding week.

The NASS product prices used in theformulas are weighted averages of thereported weekly product prices for themonth that are available on the day ofthe Class III and IV price announce-ment. The weights are the reportedtotal volume of sales associated witheach weekly price.The monthly priceannouncement may average pricesfrom either four or five weekly reports,depending on the particular month.

The NASS prices for butter and cheeseare highly correlated with the CMEprices lagged one week, emphasizingthe extensive use of reference pricingat the wholesale level and the relatedinfluence of the CME cash markets onall milk prices.13

Make allowances are the assumed costper pound to manufacture theproducts (not counting the cost ofmilk). Subtracting the makeallowances from the product pricesyields a net value of the milk compo-nents to the manufacturer. Note thatthe higher the make allowance, thelower the component price. So insetting the make allowance, USDAneeds to strike a balance betweenprocessor and producer economicinterests. If the make allowance is settoo high, then processors obtainexcess profits at the expense of pro-ducers. If the make allowance is settoo low, then some processors losemoney and may be unwilling toaccept producer milk.


12The precise formulas used to calculate minimum prices for all classes of milk and milk components are presented in Appendix II.

13From September 1998,when NASS began reporting wholesale butter prices, through March 2008, the regression of NASS weekly butter prices onlagged (one week) CME prices yielded an R2 value of 0.99.The comparable R2 value for the regression of NASS weekly block cheddar cheese prices(reported by NASS since April 1997) on lagged CME prices was 0.98.

The yield factor in the product priceformulas generally indicates howmany pounds of product can be madefrom a pound of the associated milkcomponent. For example, the yieldfactor in the butterfat product priceformula is 1.2, which is the number ofpounds of butter that can be madefrom a pound of butterfat if the buttercontains 80% butterfat (the U.S. com-mercial standard).Yields are adjustedto reflect normal losses in milk volumebetween farm and plant (e.g., spillage).Some yields are also adjusted for otherfactors. For example, the nonfat solidsformula yield is adjusted to reflect thevalue of buttermilk powder, which istypically produced as a co-productwith butter and nonfat dry milk inbutter-powder plants but which is notseparately priced in deriving the ClassIV price.

The second stage in the three-stageprocess for deriving Class III and ClassIV prices links skim milk prices to thecomponent prices calculated in thefirst stage.

This calculation requires compositionstandards for skim milk. A hundred-weight of Class IV skim milk isassumed to contain 9 pounds ofnonfat milk solids. So the Class IV skimmilk price is expressed as 9 times thenonfat solids price.

A hundredweight of Class III skim milkis assumed to contain 3.1 pounds ofprotein and 5.9 pounds of other solids.So the Class III skim milk price isexpressed as 3.1 times the proteinprice plus 5.9 times the other solidsprice.

Finally, the third stage calculates theClass III and Class IV prices at 3.5%butterfat content.This calculationinvolves multiplying the applicableskim milk price calculated in thesecond stage by 0.965 and adding 3.5times the butterfat price calculated inthe first stage.

The derivation of the Class IV price isillustrated schematically in figure 7.

The Class IV price is linked to the NASSprices for butter and nonfat dry milkthrough formulas that contain onlyconstant terms.This relationshipallows the Class IV price to beexpressed directly in terms of the twoproduct prices as follows:

Class IV price/cwt = 4.2000 X NASSbutter price/lb + 8.5982 X NASSnonfat dry milk price/lb – 1.8547

This formula emphasizes the effectchanges in the underlying productprices have on the Class IV price. A 10-cent-per-pound increase (decrease) inthe butter price will increase(decrease) the Class IV price 42 centsper hundredweight. A 10-cent-per-pound increase (decrease) in thenonfat dry milk price will increase(decrease) the Class IV price 86 centsper hundredweight.The constantvalue (1.8547) can be interpreted asthe combined butter and nonfat drymilk make allowance expressed perhundredweight of milk used toproduce these products.


Figure 7.Deriving the Class IV price

NASS Grade AAButter price/lb

NASS NonfatDry milkprice/lb

Class IVSkim priceper cwt.

Class IVprice per cwt.

Butterfatprice/lb

Nonfatsolidsprice/lb

F(Butter)*

F(NDM)* X0.965X9.0

X3.5

*F denotes a product price formula (see appendix II).

The Class III derivation process is illus-trated in figure 8.

Expressing the Class III price in termsof its constituent product valuesyields:

Class III price/cwt = 9.6393 X NASScheese price/lb + 0.4199 X NASSbutter price/lb + 5.8643 X NASSdry whey price/lb – 2.8189

The formula indicates that 10-cent-per-pound increases (decreases) incheese, butter, and dry whey pricesincrease (decrease) the Class III priceby 96.4, 42.0, and 58.6 cents per hun-dredweight, respectively.Thecombined make allowance for cheeseplants is $2.82 per hundredweight ofmilk used to make cheese.

Calculation of Class I andClass II pricesFederal orders use advanced pricingfor Class I and Class II. In contrast toannounced Class III and Class IV prices,which apply to milk that has alreadybeen used to produce manufacturedproducts, prices per hundredweight

for the skim milk portion of Class I andClass II are announced before the milkwill be processed. Class I butterfat isalso advanced-priced.The priceannouncements are made on theFriday on or before the 23rd of themonth preceding the month to whichthe prices apply.

Advanced-pricing of Class I and Class IImilk is often justified on grounds thatraw milk made into fluid and freshproducts moves into retail channelswithin a few days of when it isproduced.Therefore, it is claimed, ClassI and Class II milk plants need to knowthe cost of raw milk prior to makingand moving these products into retailchannels.

The Class I and Class II prices arederived from exactly the same productprice formulas used to derive Class IIIand Class IV component values. Butsince advanced prices are announced6–7 weeks before Class III and Class IVprices, a different time period must beused to compute average productprices. For Classes I and II, USDA

averages only the last two weeks ofNASS prices that are available on theFriday on or before the 23rd of themonth. Usually, these are the first twoweeks of the month.

Advanced pricing results in a set ofadvanced product prices that, in turn,yield a set of advanced componentprices using the formulas outlinedearlier in reference to the first stage inderiving Class III and Class IV prices.

For Class II, an advanced Class IV skimmilk pricing factor is calculated by mul-tiplying the advanced nonfat solidsprice by 9.0. Note that the advancedClass IV skim milk pricing factor is cal-culated in the same way as the Class IVskim milk price but uses a nonfat solidsprice from a shorter time period. Avalue of 70 cents per hundredweight isthen added to the advanced Class IVskim milk pricing factor to derive theClass II skim milk price.The Class II but-terfat price is the Class III/IV butterfatprice plus 0.7 cents per pound.14

Finally, the Class II price is 0.965 timesthe Class II skim milk price plus 3.5times the Class II butterfat price.


NASS Grade AA Butter price/lb

NASS Cheeseprice/lb

NASS DryWheyprice/lb

Other solidsprice/lb

Class IIISkim priceper cwt.

Class IIIprice per cwt.

Butterfatprice/lb

Proteinprice/lb

F(Butter)*

F(Cheese)*

F(Whey)*

X0.965X3.1

X5.9

X3.5

Figure 8.Deriving the Class III price

*F denotes a product price formula (see appendix II).

14Note that the Class II butterfat price is notadvanced priced — it is announced at the sametime as the Class III and IV prices, that is, on thefirst Friday on or before the fifth of the monthfollowing the month to which it applies.

Calculation of the Class I price issimilar but a bit more complex. As forClass II, an advanced Class IV skimmilkpricing factor is calculated, and also anadvanced Class III skimmilk pricingfactor, which combines the advancedprotein, butterfat, and other solidsprices in the same fashion as used tocalculate the Class III skim milk price.

The Class I skim milk price is thehigher of the two advanced skim milkpricing factors plus a Class I differen-tial that is specific to the location ofthe plant receiving the milk.The Class Ibutterfat price is the advanced ClassIII/IV butterfat plus the Class I differen-tial divided by 100. Finally, the Class Iprice is 0.965 times the Class I skimmilk price plus 3.5 times the Class Ibutterfat price.

Class I differentials are specified foreach county within a marketing area.In general, differentials decrease withdistance from the major consumptionlocation within the order marketingarea. Differentials for the UpperMidwest order (figure 9) are highestnear Chicago (base differential of$1.80 per hundredweight) and lowestin northwestern Minnesota and north-eastern North Dakota.

Among marketing orders, Class I differ-entials in the eight markets east of theRocky Mountains generally increasewith distance from the Upper

Midwest.This alignment of prices wasoriginally designed to attract milkfrom the direction of the large UpperMidwest milkshed when supplies wereshort in other regions. At one time, thedifference in Class I differentialsapproximated bulk milk hauling costs.So milk would move in response tothe price differences. Over time,hauling costs increased and therewere no compensating changes in thegeographical Class I price alignment.But at the same time, the need forsupplemental milk supplies alsodiminished.


Class I differential = 0.0026 x miles from Eau Claire + 0.6756R2 = 0.8647

0.00

1.00

2.00

3.00

4.00

5.00

6.00

0 200 400 600 800 1,000 1,200 1,400 1,600 1,800

$/c

wt

Miles from Eau Claire

Minneapolis

LouisvilleBoston

Miami

Atlanta

Detroit

Okla. City

Jacksonville

Figure 9. Class I Differentials: Upper MidwestFederal Milk Marketing Order

Figure 10. Class I differentials for selected eastern U.S. cities(effective May 1, 2008)

Class I differentials in the two marketswest of the Rocky Mountains are notaligned with eastern differentials. Thebase differentials in the PacificNorthwest are $1.90 per hundred-weight, 10 cents higher than the baseClass I differential in the UpperMidwest.The base Class I differentialfor the Arizona order is $2.45.

PoolingPooling is accomplished under federalmilk orders by obligating each regu-lated handler to account for their milkreceipts according to class. Handlerspay into or draw from a producer set-tlement fund depending on the valueof their milk receipts, priced at orderminimum prices relative to themarket-wide average value. Handlers’price obligation to their producers isat the market-wide average value ofmilk, called the uniform price.

The pool obligations by class aredetailed in table 3.

The following items are deductedfrom the gross value of each handler’smilk (determined as shown in table 3)to derive the net handler obligation tothe pool:

• Producer price differential

• Producer location adjustment

• Protein value

• Other solids value

• Butterfat value

• Somatic cell count adjustmentvalue

If the result of subtracting thesedeductions from gross milk value ispositive, the handler pays the differ-ence into the producer settlementfund. If the result is negative, thehandler draws the difference from thefund.

The deductions noted above intro-duce some new terminology thatneeds explanation.

Conceptually, the producer price dif-ferential (often abbreviated PPD) is ameasure of how much the averagevalue of handler receipts over theentire market exceeds the averagevalue if all milk were priced at Class III.Under federal orders using multiplecomponent pricing,minimum prices

to producers for milk components —butterfat, protein, and other milksolids — are the same prices used toderive the Class III price.15 Hence, theproducer price differential indicatesthe value of milk in excess of the valueof the Class III components. In otherwords, the PPD measures the relativevalue of class prices that exceed (or fallshort of ) Class III.

Among markets, the PPD varies posi-tively with the percent Class I utiliza-tion and the Class I differential.Withinany market, Class I utilization variesseasonally, resulting in a distinctseasonal pattern in the PPD.

The Class I price mover is the higher ofadvanced Class III or Class IV skim milkprices. In rapidly moving markets, themonthly Class III and Class IV skim milkprices — which are announced sixweeks after advanced prices — maymove substantially above or below theadvanced values. In an extreme situa-tion, the Class I mover could be lessthan the monthly Class III price bymore than the Class I differential. Thissituation results in a negative PPD.

In simple terms, the order-specific PPDis the sum of the following calculations:

(Class I price – Class III price) XClass I utilization

(Class II price – Class III price) XClass II utilization

(Class IV price – Class III price) XClass IV utilization

The actual PPD will differ from thissum due to other adjustments in theorder pool. Handlers’ producer settle-ment fund payments or receipts maybe adjusted by transportation creditsand assembly credits.Transportationand assembly credits for the entiremarketing area are subtracted fromtotal pool proceeds in the process ofcalculating the producer pricedifferential.


Table 3. Handler pool obligations under federal milk marketing orders

Milk use class Handler obligation to the producer settlement fund

Class I • Skim milk price at location X skim milk pounds• Butterfat price at location X butterfat pounds

Class II* • Nonfat solids price X nonfat solids pounds• Butterfat price X butterfat pounds

Class III* • Protein price X protein pounds• Other solids price X other solids pounds• Butterfat price X butterfat pounds

Class IV* • Nonfat solids price X nonfat solids pounds• Butterfat price X butterfat pounds

*Pool obligations in these classes are adjusted for somatic cell count of milk receipts in most orders thatuse multiple component pricing.

15Six of the ten federal orders use multiple component pricing for establishing milk value and producer pay prices.The remaining four orders use skimmilk-butterfat accounting (described later) and do not have a PPD.

Transportation credits apply to ship-ments of milk for Class I use fromsupply plants to distributing plants. Inthe Upper Midwest order, the creditsare paid to distributing plants at therate of 28 cents per hundredweightper mile to help defray the cost ofmoving milk to the Class I market.Transportation credits are adjusted fordifferences in the Class I differentialbetween the shipping and receivingplants.

Assembly credits are paid to poolplants (distributing plants, supplyplants, and cooperatives) on producermilk that is used for Class I purposes.Assembly credits provide an addi-tional incentive to “give up”milk forClass I use when it may otherwise bedestined for manufacturing.

Producer price differentials for theUpper Midwest order for 2000through 2007 are shown in figure 11.The PPD has ranged has from -$4.11per hundredweight (April 2004) to$1.43 per hundredweight (November2000).The overall average PPD from itsinception through December 2007

was 31 cents per hundredweight. Overthat span of 96 months, the UpperMidwest PPD was negative in 10months, and zero in one.

The producer location adjustmentaccounts for differences in the Class Idifferential at the base location for theorder (Cook County, Illinois for theUpper Midwest order) and the differ-ential at the location of the receivingplant.

The somatic cell value relates to priceadjustments for quality at theproducer level for milk used in Class II,Class III, and Class IV.The adjustmentapplies in four of the six federal ordersthat employ multiple componentpricing (Central, Mideast, Southwestand Upper Midwest). Quality ismeasured by somatic cell count ofproducer milk relative to a base levelof 350,000 cells per ml. A rate per1,000 cell count above or below thebase is derived by multiplying thecheese price used in the protein priceformula by 0.0005. For February 2008,the rate was 0.0005 X $1.8164 =$0.00091 per thousand.

The price adjustment per hundred-weight is calculated by subtracting theproducer somatic cell count in thou-sands from 350 and multiplying theresult by the rate per 1,000. Aproducer with a February 2008 cellcount of 120,000 would receive apremium of (350 – 120) = 230 X$0.00091 = $0.21 per hundredweight.A producer with a 500,000 cell countwould receive a deduction of (350 –500) = -150 X $0.00091 = -$0.14 perhundredweight.


0.00

0.20

0.40

0.60

0.80

1.00

1.20

1.40

1.60

Jan '00 Jul Jan '01 Jul Jan '02 Jul Jan '03 Jul Jan '04 Jul Jan '05 Jul Jan '06 Jul Jan '07 Jul Jan '08

$/cw

t

Average sinceJan. 2000 ($0.31)

Negative values shown as zero:Jul-Nov 2003Apr-May 2004 Dec 2004 June 2007 Mar 2008 Source: Dairy Programs, AMS/USDA

Figure 11. Producer price differential, Upper Midwest order

Producer pricesWith federal order pooling, producersreceive a common price for their milkcomponents regardless of how theirmilk is used. For producers shipping tohandlers regulated under multiplecomponent pricing orders, totalmonthly producer milk value underthe order is the sum of the followingelements:16

• Total milk (cwt) X Producer pricedifferential (at handler location)17

• Protein pounds X Protein price

• Other solids pounds X Other solidsprice

• Butterfat pounds X Butterfat price

• Total milk (cwt) X Somatic celladjustment

The protein, other solids, and butterfatprices that are applied to producerpounds of these components areexactly the same as the prices derivedabove for Class III milk that apply toregulated handlers.

Producer prices expressed per hun-dredweight of milk will differ accord-ing to three factors:milk composition,milk quality, and the location of thereceiving plant.To illustrate extremes,consider two producers, each shipping100,000 pounds of Grade A milk to ahandler regulated under the UpperMidwest federal milk marketing orderduring the month of February 2008.The PPD at the base zone for Februarywas 60 cents per hundredweight,decreasing to 40 cents in the outer-most zone.The somatic cell adjust-ment per 1,000 was 0.091 cents.

Producer A ships to a plant in Harvard,IL (Class I differential = $1.80; PPD =$0.60). Producer A milks Jersey cowswith February herd tests of 4.5% but-terfat, 3.7% protein, and 6.0% othersolids.The herd somatic cell count was110,000.

Producer B milks Holsteins and shipsto a plant in Grand Forks, ND (Class Idifferential = $1.60; PPD = $0.40).Producer B’s February 2008 tests were3.2% butterfat, 2.8% protein, and 5.7%other solids.The somatic cell countwas 420,000.

Under these conditions, UpperMidwest federal order milk values forProducer A would be calculated asshown in table 5.

Producer B’s milk value as determinedfrom the federal order pricingelements would be calculated asshown in table 6.

While the rates of payment for milkcomponents are the same for eachproducer, the federal order paymentper hundredweight differs because ofdifferent milk composition, quality,and location. Producer B actuallyreceives 82 cents per hundredweightless than the $17.03 Class III price forFebruary 2008.This occurs mainlybecause lower butterfat and proteinvalues relative to the values used tocompute the Class III price more thanoffset the producer price differential.


Table 5. Producer A order price calculation

Pricing element Units Rate/unit ($) Value ($)

Producer price differential 1,000 cwt 0.60 600.00

Protein 3,700 lbs 4.0180 14,866.60

Other solids 6,000 lbs 0.0803 481.80

Butterfat 4,500 lbs 1.3010 5,854.50

Somatic cell adjustment 1,000 cwt 0.2184 218.40

TOTAL VALUE: 22,021.30VALUE PER CWT: 22.02

Table 6. Producer B order price calculation

Pricing element Units Rate Value

Producer price differential 1,000 cwt 0.40 400.00

Protein 2,800 lbs 4.0180 11,250.40

Other solids 5,700 lbs 0.0803 457.71

Butterfat 3,200 lbs 1.3010 4,163.20

Somatic cell adjustment 1,000 cwt (0.0637) (63.70)

TOTAL VALUE: 16,207.61VALUE PER CWT: 16.21

16Note that producers may receive “extra-order”payments: premiums for other milk characteristics (e.g., volume premiums) or payments for milkquality or protein beyond what is required by federal order pricing rules. Producers may also be paid under a different pricing arrangement (e.g., viaa cheese yield formula). However, the total producer payment cannot be less than what would be calculated using the federal order pricingelements. An exception is producer payments by a dairy cooperative.

17Producer price differentials are reported at the base, or highest Class I differential zone, and are adjusted downward by the difference between thebase zone differential and the differential applicable to the location of the receiving handler.

Other milk checkcomponentsWhat dairy producers receive in theirmonthly milk checks from their milkplants is usually different from thefederal order calculation.That’sbecause of various premiums anddeductions, some uniform across allplants and some plant-specific.

In the former category is the 15 centsper hundredweight National DairyPromotion and Research Board “check-off” for state and national generic pro-motion of dairy products.

Plant-specific premiums and deduc-tions are often associated with milkcharacteristics.Many plants havequality payment schedules thatreward or penalize producers accord-ing to standard plate count (SPC) andsomatic cell count (SCC).The SCCpremiums or penalties are in additionto what is required by the federalorder schedules. Some plants payprotein premiums on top of thefederal order protein payment.

Other premiums and deductions arerelated to producer characteristics,principally scale. In Wisconsin andMinnesota, volume premiums arecommon.Most volume premiumprograms contain daily or monthlymilk shipment “brackets” and associ-ated payments per hundredweight.Other programs indirectly pay volumepremiums through varying haulingsubsidies or by imposing a fixedmonthly hauling charge regardless ofvolume.

Another class of premiums, commonlycalled plant premiums, is unrelated toeither milk or producer characteristics.Plant premiums result from the abilityor willingness of a plant to out-payminimum federal order prices.Thesource of additional revenue may bebetter plant efficiency or higher

product prices than indicated in thepricing formulas used to derive com-ponent and class prices.

For many cooperatives, particularly inthe Upper Midwest, another source ofrevenue to support plant premiums isover-order premiums for Class I andClass II milk sales. Dairy cooperativesorganize marketing agencies-in-common to negotiate with milkhandlers for a premium above federalorder minimum Class I and Class IIprices.These premiums are called overorder premiums or super-poolpremiums. A portion of the premium isreimbursement for services that coop-eratives perform, such as full-supplycommitments to handlers, transporta-tion of milk, balancing functions (e.g.,coordinating milk deliveries with pro-cessing schedules), and the like.Theexcess over the out-of-pocket costs toprovide these services is paid out toproducers.

As an example, Central Milk ProducersCooperative (CMPC) is the federatedbargaining cooperative for a group ofUpper Midwest dairy cooperativesthat supply fluid milk to distributingplants operating in the Chicago area.Each month, CMPC negotiates a pricefor Class I deliveries from its membercooperatives that exceeds theannounced federal order price. Atypical premium, or over-order charge,on Class I milk is $1.50 per hundred-weight. Class I utilization in the UpperMidwest market is about 20%.Suppose a member of CMPC incursout-of-pocket costs of 25 cents perhundredweight in supplying Class Imilk. In that case, the cooperativewould have ($1.50 – $0.25) X 0.20 =$0.25 per hundredweight in additionalrevenue to distribute to its members.This additional revenue would likelybe included as part of a plantpremium in members’milk checks.


Producer prices infat/skim milk marketsFour federal milk marketing orders use

fat/skim milk pricing for setting

producer prices (Arizona, Appalachian,

Southeast, and Florida). Dairy producers

in these markets are not paid for milk

components other than butterfat.

Instead, they are paid a uniform skim

milk price per hundredweight for the

volume of skim milk marketed, plus a

uniform butterfat price per pound times

the total butterfat pounds marketed.

The uniform skim milk price is the

weighted average skim milk price from

each of the four classes of milk, where

the weights are the percentage utiliza-

tion by class. The uniform butterfat price

in fat/skim milk markets is the weighted

average butterfat price from the four

classes of milk. These four orders also

have a plant location adjustment per

hundredweight of milk marketed that

may be positive or negative depending

upon the location of the milk plant.

Some states have state-controlledover-order pricing of Class I milk.Pennsylvania, for example, requiresdistributing plants to make a separatepayment for milk for the amount inexcess of the minimum federal orderprice.These over-order revenues arepooled at the plant level and paid outto Pennsylvania producers.

In 1997, the Northeast Interstate DairyCompact was implemented, creating adifferent form of over-order pricing.The compact established a minimumprice for all fluid milk sold in thecompact region (the six New Englandstates). Fluid milk handlers madepayments to a compact pool (separatefrom the federal order pool) equal toany positive difference between theminimum compact price and theannounced federal order price. Poolpayments were then made to produc-ers supplying milk to New Englandbottlers. Since the compact wouldhave otherwise violated interstatecommerce laws, its creation requiredCongressional and presidentialapproval.

The Northeast Compact was contro-versial for several reasons. Consumergroups objected to the high andinflexible fluid milk price. Producers innearby markets objected to beingeffectively closed out of the compactarea. Producer groups in the Midwestobjected to the compact’s potentialfor stimulating production of milk formanufacturing uses.

The Northeast Compact did providesubstantial revenue enhancement todairy farmers in the New Englandstates. Consequently, farmers in manyother states successfully lobbied theirstate legislatures to pass legislationauthorizing their joining the NortheastCompact or creating new compactregions. A bill was submitted toCongress in 2001 that would haveexpanded the Northeast Compact to

include six additional states andauthorized the creation of several newcompacts.The bill was defeated alongwith several efforts to extend theexisting Northeast Compact, and theCompact expired on September 30,2001.

There were attempts to resurrect theNortheast Compact during debateover the Dairy Title of the FarmSecurity and Rural Investment Act of2002.While these attempts were notsuccessful, the Milk Income LossContract (MILC) program containsremnants of the Compact. Specifically,deficiency payments were initially setequal to 45% of the monthly differ-ence between $16.94 and the BostonClass I price.These values match thepayment rate and target price usedunder the Compact.

Milk pricing issuesThe dairy industry is extensively regu-lated, with much of the regulationdirectly affecting prices. Contentiousissues often arise because of per-ceived or actual differences in howregulations affect prices for dairyproducts or farm milk prices. In whatfollows, we provide a brief overview ofsome of these issues.

Dairy price supportsAfter nearly 60 years of continuousoperation, the dairy price supportprogram has provided several lessons.One lesson is that the program cannotconsistently enhance milk pricesabove market-clearing levels withoutsome kind of supply control. Thatlesson came in the late 1970s, whenCongress raised the support level to80% of parity,mandated semi-annualadjustments in the support price, andprevented the Secretary of Agriculturefrom interceding to reduce thesupport price.

The support price was ratcheted up$5.00 per hundredweight betweenApril 1977 and October 1980. Dairyfarming became unusually profitable,setting in motion a rapid expansion inmilk production,much of it in new drylot western dairies. Commercial saleswere stagnant, leading to large CCCpurchases and annual governmentcosts as high as $2.7 billion. A badpolicy in place for only five yearscreated a surplus situation that tookten years to rectify.

Another dairy price support programlesson is that fixed relative prices forproducts purchased by the CCC candistort product markets and the allo-cation of milk among products. Duringmuch of the 1980s, the CCC was theprimary market outlet for nonfat drymilk.Much nonfat dry milk use wasdisplaced by whey solids andimported casein, both of which were acheaper source of milk protein. FixedCCC prices for nonfat dry milk pre-vented appropriate market adjust-ments to this displacement.

In the early 1990s, the CCC purchaseprice for butter dictated the U.S. pricefor butterfat. Consumers weredemanding lower-fat products,leading to conflicting signals in themarketplace. Butter surpluses and CCCstocks mounted.The price of butterfatwas not permitted to change in accor-dance with consumer preferencesuntil butter-powder tilts weremandated by Congress in 1990.18 Theindustry responded to these tilts byproducing less butter and using morebutterfat in other dairy products.

These lessons are often forgotten.Many dairy groups consistently lobbyfor an increase in the support price.Few proposals include a correspon-ding method for controlling supply,and those that do typically favor weak


18Butter-powder tilts involved the Secretary of Agriculture altering the relative purchase prices for butter and nonfat dry milk by reducing the price forthe product in surplus and increasing the price for the other product to keep the value of milk used for making butter and nonfat dry milk constant.

systems that pay bonuses to produc-ers who do not expand productionrather than penalize those who do.

The negative effects of misalignedproduct prices due to inflexible CCCpurchase prices were also soon forgot-ten. The high nonfat dry milk-butterprice ratio problem of the 1980s wasrepeated starting in the late 1990s andearly 2000s,when the CCC once againbegan purchasing large volumes ofnonfat dry milk. By early 2003, CCCnonfat dry milk stocks exceeded 1.2billion pounds, about 80% of annualnonfat dry milk production. Some dairytrade associations complained aboutexpanding imports of milk proteinconcentrates,which were a directresult of nonfat dry milk prices clearlyout of line with market conditions.

In 2001 and 2002,most of the industrystrenuously fought the butter-powdertilts that eventually addressed theproblem, at least in part. Strong oppo-sition to altering CCC purchase pricesoccurred because, at the time, theadvanced Class IV price was the moverof the Class I milk price, even thoughthe market price for nonfat dry milkwas at the CCC purchase price.19

Consequently, lowering the CCCpurchase price for nonfat dry milkwould have simultaneously loweredthe Class I mover and the entire struc-ture of Class I prices. In this case,economic interests related to theoperation of federal milk marketingorders interfered with the effectiveoperation of the price supportprogram.

These lessons stress the need for flexi-bility andmarket orientation in admin-istering the dairy price supports.TheSecretary of Agriculture must have dis-cretion to alter the support level toprevent milk surpluses and to changerelative product prices when marketdistortions are apparent.

The support program can be usedeffectively to establish a safety net,but, without supply management, itcannot be used to keep prices abovemarket-clearing levels. If supportingdairy farmer income rather than main-taining a safety net is the politicalgoal, then direct payment programslike the MILC program distort marketsless than raising support prices.

Federal milk marketingordersStructure of Class IdifferentialsOne of the most contentious aspectsof federal orders is the setting of ClassI differentials in reference to location.As noted earlier, Class I differentials ineastern markets increase with distancefrom the Upper Midwest.This geo-graphical Class I pricing pattern isknown in economics as single basingpoint pricing.20

Single basing point pricing occurs nat-urally only when there is either onlyone producing area for a commodityor only one producing area that pos-sesses a surplus.These conditions donot apply in the case of fluid milk.Some markets are deficit in fluid milkduring some parts of the year, and thecost of acquiring supplementary milkwould be a major factor in determin-ing the local milk price. But in mostmarkets,milk production is far inexcess of fluid milk needs plus areserve. Consequently, there is noreason to expect that the fluid milkprice in those markets would berelated to the cost of hauling milkfrom another market.

Administered prices using the singlebasing point structure distorts fluidmilk shipment patterns and increaseshauling costs. For example, fluid milkprocessors in deficit Florida markets

would logically draw milk from theclosest surplus market to minimizetransportation costs. But single basingpoint pricing makes it less costly toprocure milk from the direction of thebasing point regardless of where thesurplus milk might be located. Singlebasing point pricing may also encour-age production of unneeded milk formanufacturing. Class I differentialsthat are higher than necessary toattract an adequate supply of milk forfluid purposes can lead to expandedmilk production.

In 1985, Congress passed legislationthat increased Class I differentials withdistance from the Upper Midwest.Since then, producer groups andothers in the Upper Midwest haveattempted in several different ways toeliminate single basing point pricing.A suit challenging the legality of ClassI differentials was filed by theMinnesota Milk Producers Associationin early 1990.The suit was ultimatelydismissed in 1999 after severalappeals, reversals, and remands. Alsoin 1990, the Secretary of Agricultureheld a nation-wide hearing to reviewClass I pricing. Following 43 days oftestimony in five locations, theSecretary issued a decision thatretained the existing structure of ClassI differentials.

In 1996, Congress mandated federalorder reform, including a review of thestructure of Class I differentials. USDArecommended a substantially “flat-tened” Class I price structure.The finalrule was approved by producers in anAugust 1999 referendum. But beforethe modified price surface could beimplemented, Congress passed legisla-tion requiring USDA to adopt a pricesurface very similar to the status quo.


19Relatively high market prices for butter kept the Class IV price above the $9.90 support price and above the Class III price.

20We should note that USDA has repeatedly and strenuously denied that the geographical pattern of Class I differentials represents single basingpoint pricing. USDA’s position is that the alignment of Class I prices is coincidental.

These actions emphasize the difficultiesin changing federal order provisions thatbestow economic benefits on certainregions,even though those benefitsmay come at the expense of otherregions.The process of change becomespoliticized,and changes are determinedby numbers of votes rather than effi-ciency or equity considerations.

Class I price moverSince the 1960s, Class I prices havebeen set in reference to prices for milkused for manufacturing by adding aClass I differential to a manufacturingprice “mover.”The Minnesota-Wisconsin Price Series, or M-W Price,was the Class I price mover until 1995.The M-W Price was an estimate of theGrade B milk price paid to producersin Minnesota andWisconsin.Most ofthe Grade B milk in the two states wasand is used to make cheese.

Declining Grade B milk production ledUSDA to adopt the Basic FormulaPrice, or BFP, as the Class I price moverin May 1995.The BFP used the M-WPrice as a base, but adjusted theprevious month’s value by weightedaverage month-to-month changes inmanufactured product prices. Sincecheese absorbed the majority of milkused for manufacturing, the BFP con-tinued to closely link fluid milk pricesto cheese prices.

As part of the federal order reformpackage implemented on January 1,2000, the BFP was replaced by a newClass I price mover.The current moveris the “higher of” the advanced Class IIIor Class IV skim milk values. Use of the“higher of”mover was intended togive a temporary “bump” to Class Iprices if and when nonfat dry milk wasin relatively tight supply compared tocheese. For most of the year, the ClassIII skim milk value was expected toexceed the Class IV skim milk value,and Class I prices were expected tomove with changes in the price ofcheese.

To the surprise of most dairyobservers, Class IV was the “higher of”in most months in 2000 and 2001.Nonfat dry milk prices were practicallyconstant at just above the CCCsupport price prior to USDA’s “tilt” inrelative butter and nonfat dry milkprices in May 2001. Following thatprice adjustment, the nonfat dry milkprice remained steady at near the newsupport level of 90 cents per pound.This yielded Class IV skim milk pricesin a narrow range of $6.85 to $7.90 perhundredweight. But butter prices werehigh relative to cheese prices duringmuch of this period. And since thebutterfat price negatively affected theprotein price in the formula used then,the Class III skim milk price was oftenlower than the Class IV skim milk price.The gap reached as much as $3.61 forDecember 2000.

With the Class IV skim milk price as themover of Class I milk prices everymonth during 2000, the Class I priceexceeded the Class III price by theapplicable Class I differential plus anadditional amount averaging $1.76per hundredweight for the year. Ineffect, order reform increased theClass I differential by $1.76 and madethe CCC purchase price for nonfat drymilk a floor for fluid milk prices.Thedecoupling of Class I milk prices fromcheese prices resulted in conflictingmarket signals. Producers in high ClassIII use markets felt the full brunt oflower cheese prices while those inhigh Class I use markets were partiallyinsulated.

The November 2002 tilt reduced theCCC purchase price for nonfat dry milkto 80 cents per pound,where it standsin 2008.The Class IV skim milk priceassociated with the 80 cents perpound CCC nonfat dry milk price is$5.88 per hundredweight.Thus, the tiltmakes it less likely that the advancedClass IV price will consistently move

Class I. In fact, since 2003 theadvanced Class III price has been themover most months.

Pricing formulasThe “higher of”problem noted aboveillustrates a larger issue of how effec-tively the federal order pricingformulas capture supply and demandconditions for producer milk. For manyyears, federal milk orders tiedminimum prices by class of milk tocompetitively-determined prices formanufacturing milk.There was acertain sense of confidence associatedwith that linkage, as competition forthe milk supply tended to dictateplant margins, profitability, and viabil-ity. Efficient plants attracted milk awayfrom those that were less efficient.Plants making products with strongdemand attracted milk away fromthose making products with weakdemand.

That confidence was weakened whenfederal order reform moved toproduct price formulas.Milk compo-nent values and prices are nowderived through mathematical equa-tions that employ assumed yields andmanufacturing costs. Assumptions donot replicate reality very well. Plantsvary significantly with respect to man-ufacturing costs and efficiency. Plantmanufacturing costs can changequickly with changes in energy, labor,and other costs.The fixed manufactur-ing margins built into the formulascan only be changed through alengthy administrative process. Plantscannot offset higher manufacturingcosts by increasing their selling priceof cheese, butter, or nonfat dry milk —any price increases are immediatelyreflected in higher NASS productprices and elevate minimum payprices for Class III and Class IV milkthrough the formulas.


Product price formulas requirereliable, representative product pricesto derive accurate component values.NASS summarizes actual sales pricesfor reporting companies. But theextensive use of reference pricing forbutter and cheese tied to the thinlytraded CME spot market prices leadsto considerable uneasiness. Do thespot markets consistently and appro-priately reflect broad market condi-tions for cheese and butter? Do theyover-react? Are they subject to manip-ulation?

Another issue is whether the correctdairy products are used in the productprice formulas.This issue came to ahead when dry whey prices increaseddramatically in 2007. Dry whey is usedto derive the other solids price in theClass III price formula, and higherwhey/other solids prices were respon-sible for a large part of the elevatedClass III price in 2007.The problem isthat most cheese plants do notprocess dry whey and thus did notexperience the increased valueassumed by the other solids formula.Many cheese plants experienced unfa-vorable operating margins as a result.

Increasingly larger volumes of wheyare being processed into value-addedproducts such as whey protein con-centrates, de-mineralized andreduced-lactose whey, and whey-protein isolates. Prices for these whey-based products do not move in lockstep with dry whey prices,meaningthat dry whey prices may be anincreasingly deficient indicator of thevalue of other solids.

A similar situation is occurring withnonfat dry milk.With expanding U.S.export opportunities, an increasingproportion of dry milk powder pro-duction is in the form of skim milkpowder (SMP). SMP has a differentcomposition (lower protein content;higher lactose) than nonfat dry milk,and SMP prices are influenced by dif-ferent factors.

Amending ordersAmending federal milk marketingorders has become a lengthy andoften frustrating process for dairyfarmers and dairy processors.Yearscan pass between the time a requestfor a hearing is received by USDA andthe time a decision is rendered.Thislag can lead to situations where thedecision no longer addresses the con-ditions that existed when the hearingwas requested.

The Agricultural Marketing Service, theUSDA agency responsible for adminis-tering federal orders, has attempted toaddress industry concerns by expedit-ing those parts of the order amend-ment process under its control. Butdelays are often due to inaction athigher levels of the Department.The2008 Farm Bill requires USDA to adoptrules of practice that would expeditethe amendment process. How success-ful this mandate will be remains to beseen.

Appendix I. Recenthistory of federalmilk marketingorder reformFederal milk marketing orders havebeen in an almost constant state ofamendment since 1996,when theFederal Agriculture Improvement andReform Act of 1996 instructed USDAto consolidate orders and modify pro-cedures for setting minimum classprices. Following passage of this legis-lation, USDA commissioned severalstudies relating to the Class I pricestructure and alternative methods ofestablishing prices for milk used toproduce non-perishable manufac-tured products (Classes III and IV).Based on these studies and internalanalyses, USDA issued preliminarydecisions, which were debated amongdairy interests and within Congress.Indeed, Congress intervened in thereform process by rejecting USDA’spreferred Class I geographical pricestructure and requiring Class I pricealignment more similar to the statusquo and by requiring that USDA revisitthe product price formulas initially putin place.

What emerged from this process onJanuary 1, 2000 was a set of 11 “stan-dardized” orders, each including fourclasses of milk identical across orderswith minimum class prices set usingproduct price formulas. Seven of the11 orders used a common method ofmultiple component pricing (MCP) forpaying dairy farmers — minimum payprices were established for butterfat,protein, and other milk solids insteadof for milk. Four of the seven MCPorders included a price adjustment formilk quality as measured by somaticcell count; three did not. Four ordersused “fat/skim”pricing, settingproducer prices for butterfat and skim


milk instead of skim milk components.The reforms made in the year 2000also modified the timing of Class Iprice announcements to shorten thetime between when the price wasannounced and when it becameeffective.

Shortly after implementation of theamended orders, USDA called ahearing to adjust Class III and Class IVpricing formulas to conform toCongressional mandate. Resultingamendments in response to thehearing were implemented onJanuary 1, 2001. Changes were minor,except for a proposed separation ofClass III and Class IV butterfat prices,which was enjoined by a federal courtbefore it could be implemented.

In late 2001, USDA issued a recom-mended decision to address theinjunction, reverting to a commonprice for butterfat in Classes III and IV.USDA also altered the protein priceformula and made small changes insome product formula makeallowances and yields.

USDA issued a final decision inNovember 2002 that adopted thechanges proposed in 2001 and madea few other minor changes in the ClassIII and Class IV formulas. A subsequentrequest for an injunction was denied,and the final decision was imple-mented for milk priced in April 2003.

The orders implemented in 2000made it easier for “outside”milk (fromplants located outside a marketingarea) to be pooled on distant orders. Inthe ensuing years, several orders wereamended to address what somereferred to critically as “paper pooling”— delivering a small volume of milk inorder to become eligible to receivethe PPD on a much larger volume.These amendments tightened deliveryqualification standards and restricted

how milk in excess of that needed toqualify could be diverted to manufac-turing in the originating market.

In June 2005, a hearing was held toconsider proposals seeking to amendthe Class I fluid milk product definitionin all federal orders. Dairy Farmers ofAmerica, Inc. (DFA) asked USDA toreconsider which dairy productsshould be classified as Class Iproducts, arguing that some“drink-able” milk products were currentlyclassified as Class II products thatshould legitimately be Class Iproducts. In May 2006, USDA issued arecommended decision to amend theClass I fluid product definition toincorporate a 2.25% true proteincriteria in determining whether aproduct meets the fluid milk productdefinition. A final decision has notbeen issued.

In the fall of 2005, Agri-Mark, a majorNortheastern dairy cooperative, peti-tioned USDA to hold an emergencyhearing on Class III and Class IV makeallowances.The petition argued thatrapidly rising fuel and energy costshad rendered the allowances put inplace in April 2003 obsolete.Therequest was endorsed by several othercooperatives, and USDA responded byholding a hearing in January 2006 thatwas reconvened in September 2006.USDA issued an interim final rule thatraised all Class III and Class IV makeallowances effective February 2007.

In December 2006, USDA heard pro-posals from the National MilkProducers Federation (NMPF) toamend order pricing of Class I andClass II milk. Among other things,NMPF proposed that Class I prices beincreased in all markets by 73 centsper hundredweight and that Class Iand Class II prices be “decoupled” fromthe advanced Class III and Class IVformulas.There has been no decisionfrom this hearing.

An initial hearing was held in February2007 to further amend the Class III andClass IV product price formulas. USDAreceived eighteen separate proposalsaddressing issues such as sources ofproduct prices, product yields, andrepresentative manufacturing costs.Unable to hear all testimony at theFebruary hearing, USDA called twomore hearings, one in April 2007 andone in July 2007. In June 2008 USDAissued a tentative partial decision onmake allowances for cheese, dry whey,butter, and nonfat dry milk.Thedecision was partial because someproposals to further modify Class IIIand Class IV product pricing formulaswere addressed in a separate interimfinal rule issued in July 2008.

Finally, a hearing was held in May 2007to consider proposals to temporarilyraise Class I differentials in threefederal orders — Florida, Southeast,and Appalachian. Just 10 months later,USDA issued an interim final rulegranting the proposed increases. Sincethe elevated differentials in the threemarkets change the geographicalalignment of Class I prices in easternfederal order markets, requests toincrease differentials in other marketscan be expected.


Appendix II.Current federalorder pricingformulasIn this appendix, we display and inter-pret the actual formulas used by USDAto calculate minimum federal milkmarketing order prices for milk andmilk components.These are theformulas that were in effect on July 1,2008.They are subject to changebased on pending decisions fromprevious amendatory hearings anddecisions from new hearings.21 For themost current formulas, access theUniversity of Wisconsin-MadisonUnderstanding Dairy Markets website(http://future.aae.wisc.edu). Navigateto Dairy Data, Federal Order Class Pricesand Related Information, and then clickon the most recent year underSummary of Federal Order ClassifiedPricing Formulas.

Understanding Dairy Markets is alsoan excellent “one-stop” internet sourcefor current federal order prices andweekly NASS product prices used inderiving order prices.The site isupdated daily as price information isreleased. Spreadsheets containing theformulas that are outlined in thisappendix are also available on thewebsite.

Class IV priceThe Class IV price is composed of thevalue of nonfat milk solids and butter-fat contained in a hundredweight ofmilk.The price of nonfat milk solids islinked to the price of nonfat dry milk(NDM), and the price of butterfat islinked to the price of butter.

Butterfat prices are the same for ClassIII and Class IV.The butterfat priceformula is:

(1) Butterfat price/lb = (NASSmonthly AA butter price –0.1202) X 1.20

The butter make allowance is 12.02cents per pound of butter and theyield factor of 1.2 pounds of butter perpound of butterfat assumes buttercontaining 80% butterfat.

The Class IV nonfat milk solids formulais:

(2) Nonfat solids price/lb = (NASSmonthly NDM price – 0.157) X0.99

The product price in this formula is themonthly weighted average of NASSnational weekly survey prices fornonfat dry milk.The nonfat solidsmake allowance is 15.7 cents perpound, and the assumed yield is 0.99pound of nonfat dry milk per poundof nonfat milk solids.22

The Class IV skim milk price per hun-dredweight is calculated by multiply-ing the nonfat solids price by 9.0, theassumed number of pounds of nonfatmilk solids in 100 pounds of skim milkof standard composition:

(3) Class IV skimmilk price = 9.0 XNonfat solids price

Finally, the Class IV price (at 3.5% but-terfat) is expressed as:

(4) Class IV price = 3.5 X Butterfatprice + 0.965 X Class IV skimmilkprice

The Class IV price accounts for all ofthe value of a hundredweight of milktesting 3.5% butterfat and 8.685%total nonfat solids23 that is used tomake butter and nonfat dry milk.The100 pounds of milk consists of 3.5pounds of butterfat valued at theClass IV/III butterfat price (linked tothe price of butter) and 96.5 pounds ofskim milk valued at the Class IV skimmilk price (linked to the price ofnonfat dry milk).

Class III priceThe Class III price per hundredweightconsists of the combined value of but-terfat in butter and in cheese, proteinin cheese, and other (nonfat/non-protein) milk solids in whey.Therefore,three related product price formulaslink butterfat prices to butter prices,protein prices to cheese and butterfatprices, and other solids prices to drywhey prices.

The Class III butterfat formula is thesame as used in Class IV. Class III and IVbutterfat values are identical but arenot the same as the butterfat valuesfor Class II and Class I.


21The formulas shown in the appendix do not include changes in the interim final rule issued by USDA in July 2008.While these changes wereapproved by producers, their effective date has been delayed by an injunction.

22More than one pound of nonfat dry milk is normally recovered from one pound of nonfat milk solids because NDM contains some moisture.However, the production of nonfat dry milk also yields a small amount of buttermilk powder, which is not priced in the Class IV formula.The implicitformula yield factor adjusts the value of nonfat milk solids to account for the net value of buttermilk powder.

23Note that the skim milk portion of Class IV milk is assumed to contain 9% total solids. Since whole milk is assumed to contain 96.5% skim milk (plus3.5% butterfat), the assumed nonfat solids composition of whole milk is 0.965 X 9%, or 8.685%.

The formula for other solids is rela-tively straightforward:

(5) Other solids price/lb = (NASSmonthly dry whey price –0.1956) X 1.03

The NASS monthly survey price for drywhey is constructed in the same wayas the butter and nonfat dry milkprices as demonstrated for Class IV.The other solids price formula uses ahigher make allowance (0.1956) thanthe nonfat solids formula for Class IV.The yield factor (1.03) accounts for themoisture content of dry whey,meaning that a pound of other solidsyields more than one pound of drywhey.The other solids price is notfloored (or “snubbed”) at zero.Thismeans that if the NASS dry whey priceis less than 19.56 cents per pound, theother solids price is negative.

The protein formula in the Class IIIprice derivation is complex:

(6) Protein price/lb = (NASS monthlycheese price – 0.1682) X 1.383 +{[(NASS monthly cheese price –0.1682) X 1.572] – 0.9 X Butterfatprice} X 1.17

The first line of the equation is in thesame form as the other product priceequations. It represents the net valueof protein in cheese-making (cheeseprice less make allowance timespounds of cheese per pound ofprotein). The NASS cheese price is for40-pound blocks and 500-poundbarrels of cheddar cheese. It is con-structed like the other NASS pricesexcept (1) it is a weighted average ofthe two cheddar cheese styles withweights based on relative sales, (2) the500-pound barrel price is adjusted torepresent 38% moisture content, and(3) the barrel price is augmented by 3cents per pound (the assumed differ-ence in manufacturing costs betweenblocks and barrels). The cheese yield(1.383 pounds cheese per pound

protein) is from the Van Slyke cheeseyield formula using true protein andadjusting for farm-to-plant losses inprotein.24 The cheese make allowanceis 16.82 cents per pound of cheese.

The second line of the protein priceequation attempts to account for thevalue of butterfat in cheese in excessof the value of butterfat in butter.Without getting into the physiologicalbasis for the formula, it recognizes thatprotein has value in cheese over andabove its contribution to the cheeseitself. That added value is attributableto the fact that the casein in proteinallows retention of butterfat in cheese.

Given the values of the Class III com-ponents — butterfat, protein, andother solids — the Class III skim milkprice is:

(7) Class III skim milk price = 3.1 XProtein price + 5.9 X Other solidsprice

This formula assumes that skim milkcontains 9% total nonfat solids con-sisting of 3.1% true protein and 5.9%other (nonfat/non-protein) solids.

Finally, the Class III price is expressedas:

(8) Class III price = 3.5 X Butterfatprice + 0.965 X Class III skim milkprice

The Class III price formula accounts forall of the value of a hundredweight ofmilk testing 3.5% butterfat, 2.99% trueprotein (3.1 X 0.965), and 5.69% othersolids (5.9 X 0.965) that is used tomake cheese and whey.The 100pounds of milk consists of 3.5 poundsof butterfat valued at the Class III/IVbutterfat price and 96.5 pounds ofskim milk valued at the Class III skimmilk price, which is directly linked tothe prices for protein and other solids.

Class II priceThe Class II butterfat price is themonthly butterfat price plus aconstant differential of 0.7 cents perpound.

(9) Class II butterfat price =Butterfat price + $0.007

Since the Class II butterfat price islinked to the monthly butterfat pricefor Classes III and IV, it is notannounced until as late as the fifth ofthe month following the month itapplies. In contrast, the Class II skimmilk price is announced no later thanthe 23rd of the month before itapplies. In other words, there isadvanced pricing of the skim milkportion of Class II but not the butterfatportion.

The Class II skim milk price is based onthe advanced nonfat solids price:

(10)Advanced nonfat solids price/lb= (NASS 2-week NDM price –0.157) X 0.99

This is the same formula used for theClass IV nonfat solids price (equation2), except it uses an abbreviated two-week weighted average of monthlynonfat dry milk prices from the pre-ceding month — the two weeks ofNASS price reports available on theFriday of the month on or before the23rd. Note that the two weeks used inthe advanced price formula for the fol-lowing month always appear in theClass IV formula for the current month,but the latter formula always includeslater weeks and may include earlierweeks.


24True protein is crude or total protein less non-protein nitrogen. Prior to January 1, 2000, federal order protein prices were based on crudeprotein tests.

The advanced Class IV skim milk pricefactor calculation is equivalent to theClass IV skim milk price:

(11)Advanced Class IV skimmilkpricing factor/cwt = 9.0 XAdvanced nonfat solids price

The Class II skim milk price adds a dif-ferential of 70 cents per hundred-weight to the advanced skim milkprice:

(12) Class II skim milk price/cwt =Advanced Class IV skimmilkprice factor + $0.70

Class II handlers must account to theirfederal order pool for pounds ofnonfat milk solids rather than hun-dredweight of skim milk.Therefore,another formula translates the Class IIskim milk price back to a per poundvalue for nonfat solids by dividing bythe yield of nonfat solids per hundred-weight of skim milk:

(13)Class II nonfat solids price/lb =Class II skim milk price/cwt ÷ 9.0

Finally, the Class II price combines theskim milk and butterfat values:

(14)Class II price/cwt = 0.965 X ClassII advanced skimmilk price +3.5 X Class II butterfat price

Class I PriceBoth the skim milk and butterfatportions of the Class I price areadvanced-priced and announced onthe Friday on or before the 23rd of themonth before the month to whichthey apply.The skim milk value ofClass I is based on the advanced ClassIII or Class IV skim milk pricing factors,whichever is higher. 25

Derivation of the advanced Class IVskim milk pricing factor is shownabove in equation 11.The advancedClass III skim milk pricing factor isbased on advanced product priceformulas for butterfat, protein, andother solids:

(15)Advanced butterfat price/lb =(NASS 2-week AA butter price –0.1202) X 1.20

(16)Advanced protein price/lb =(NASS 2-week cheese price –0.1682) X 1.383 + {[(NASS 2-week cheese price – 0.1682) X1.572] – 0.9 X Advanced butter-fat price} X 1.17

(17)Advanced other solids price/lb =(NASS 2-week dry whey price –0.1956) X 1.03

(18)Advanced Class III skim milkprice factor = 3.1 X Advancedprotein price + 5.9 X Advancedother solids price

The Class I skim milk price is the higherof the values obtained in equations 11and 18 plus a Class I differential:

(19)Class I skimmilk price =Higher of: (Advanced Class IIIskim milk price factor) or(Advanced Class IV skimmilkpricing factor) +Class I differential

The Class I butterfat price also variesby market. It is based on the advancedbutterfat price from equation 15:

(20)Class I butterfat price/lb =Advanced butterfat price +(Class I differential ÷ 100)

And the Class I price formula appliesstandard milk composition weights toClass I skim milk and butterfat prices:

(21)Class I price/cwt = 0.965 X ClassI skimmilk price + 3.5 X Class Ibutterfat price


25Technically, the Class I skim milk price is based on the higher of the advanced Class III or Class IV milk price at standard composition (the valueof 3.5 pounds of butterfat and 96.5 pounds of skim milk). But since advanced Class III and Class IV butterfat values are identical, the advancedskim milk pricing factors determine whether the Class III or Class IV whole milk pricing factor is higher.

Illustration of classprice calculations26It is instructive to use an example ofprice calculations for the various com-ponents and classes of milk. Appendixtable 1 shows the two-week andmonthly average product prices fromthe relevant weekly NASS pricesurveys applicable to federal orderprices announced for the month ofFebruary 2008.

Advanced prices applying to milk andmilk components procured byhandlers regulated under the UpperMidwest order during February 2008were reported on January 18, 2008(the Friday on or before the 23rd ofJanuary) as shown in appendix table 2.


26Spreadsheet files showing these calculations for each month since adoption of product price formulas in federal orders are accessible at theUnderstanding Dairy Markets website (http://future.aae.wisc.edu).

Appendix table 1.Two-week and monthly averages, NASS survey prices ($/lb)

2-Week—Jan. 18, 2008 Monthly—Feb. 29, 2008(Average of prices for 2 weeks (Average of prices for 4 wks

ending Jan. 11) ending Feb. 22)

————————$/lb.———————

Butter 1.2585 1.2044

Cheese 2.0126 1.8403

Dry whey 0.4380 0.2736

Nonfat dry milk 1.6931 1.3331

Appendix table 2. Advanced-priced component and milk price calculations, February 2008

Component/Class Price Eq. number Equation Equation value

Advanced butterfat ($/lb) 15 (1.2585 – 0.1202) X 1.20 1.3660

Advanced protein ($/lb) 16 (2.0126 – 0.1682) X 1.383 +{[(2.0126 – 0.1682) X 1.572] – 0.9 X 1.3660} X 1.17 4.5047

Advanced other solids ($/lb) 17 (0.4380 – 0.1956) X 1.03 0.2497

Advanced nonfat milk solids ($/lb) 10 (1.6931 – 0.157) X 0.99 1.5207

Class IV skim milk price factor ($/cwt) 11 9.0 X 1.5207 13.69

Class II skim milk ($/cwt) 12 13.69 + 0.70 14.39

Class II nonfat solids ($/lb) 13 14.39 ÷ 9.0 1.5989

Class III skim milk price factor ($/cwt) 18 3.1 X 4.5047 + 5.9 X 0.2497 15.44

Class I skim milk (@ base zone, $/cwt) 19 15.44 + 1.80 17.24

Class I butterfat (@ base zone, $/cwt) 20 1.3660 + (1.80 ÷ 100) 1.3840

Class I @ test (@ base zone, $/cwt) 21 (0.965 X 17.24) + (3.5 X 1.3840) 21.48

February 2008 Class III and Class IVmilk and component prices wereannounced on February 29 (the Fridayon or before the fifth of March). Class IIprices that involved butterfat valueswere announced on the same date.For the Upper Midwest order, theseannounced prices were calculated asshown in appendix table 3.


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Authors: Ed Jesse is a professor of agricultural and applied economics with the College of Agricultural and Life Sciences at theUniversity of Wisconsin-Madison and a dairy marketing and policy specialist with the University of Wisconsin-Extension, CooperativeExtension. Bob Cropp is professor emeritus of agricultural and applied economics with the College of Agricultural and Life Sciences atthe University of Wisconsin-Madison.

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Basic Milk Pricing Concepts for Dairy Farmers (A3379) R-09-2008

Appendix table 3.Monthly component and milk price calculations

Component/Class Price Eq. number Equation Equation value

Butterfat ($/lb) 1 (1.2044 – 0.1202) X 1.20 1.3010

Protein ($/lb) 6 (1.8403 – 0.1682) X 1.383 +{[(1.8403 – 0.1682 X 1.572] – 0.9 X 1.3010} X 1.17 4.0180

Other solids ($/lb) 5 (0.2736 – 0.1956) X 1.03 0.0803

Nonfat milk solids ($/lb) 2 (1.3331 – 0.157) X 0.99 1.1643

Class IV skim milk ($/cwt) 3 9.0 X 1.1643 10.48

Class IV milk @ std. test ($/cwt) 4 (3.5 X 1.3010) + (0.965 X 10.48) 14.67

Class III skim milk ($/cwt) 7 (3.1 X 4.0180) + (5.9 X 0.0803) 12.93

Class III milk @ std. test ($/cwt) 8 (3.5 X 1.3010) + (0.965 X 12.93) 17.03

Class II butterfat price ($/lb) 9 1.3010 + 0.007 1.3080

Class II milk @ std. test ($/cwt) 14 (0.965 X 14.39) + (3.5 X 1.3080) 18.46

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