Cheese is What Dairy is all About. Revenue Management is Required at all Levels

April 5, 2020

The most important parameter in the Class III milk price is the wholesale price of Cheddar cheese.  (See these prior posts,  October 13, 2019 and March 22, 2020, for detail on the relationship between the price of Cheddar cheese and the Class III price.)  Chart I below shows graphically the correlation between the two.  Statistically, it is a 96 percent correlation.  If you know the price of Cheddar cheese, one can accurately predict the Class III price.

Chart I - Cheese and Class III Milk Prices

Understanding the drivers behind the price of Cheddar cheese is important to see where the price of Class III milk is going.  This post will analyze some of the elements influencing cheese pricing at the wholesale and retail levels.  There are four very different levels of management involved in cheese production and distribution; the milk producer, the cheese maker, the processor and distributer of retail cheese, and the grocer. Producers have the most variation in revenue and the last paragraph of the post will address what can be done to manage revenue at the producer level.

Chart II below shows the ups and downs of cheddar cheese prices over the last 20 years at the retail and wholesale levels.  The retail price shown here is for purchases of Cheddar cheese by consumers.  Cheddar used in food service and Cheddar used as an ingredient in other products are not included.  Trend lines are also shown for both the wholesale and retail prices of cheese.  Both the wholesale and retail prices have grown over time.  Wholesale cheese prices are what a cheese maker gets for blocks and barrels of bulk cheese.  The retail price is what the consumer pays at the grocery store.

The retail prices are more than three times the wholesale bulk cheese prices. The spread between the retail and wholesale prices includes processing the cheese into consumer forms including slicing, shredding, etc., packaging, branding, logistics, and marketing.  

Also included in Chart II is the "make allowance" which is used in the FMMO formulas to calculate the value of milk used to make cheese.  The Class III price is calculated by subtracting the cost of making Cheddar cheese from the wholesale price of Cheddar cheese.  The make allowance is what the cheese maker gets for his efforts.  In 2007, that make allowance was $.165/lb. and through two increases in 2008, the make allowance was increased to $.2003/lb. in the Class III formulas.  That formula change increased the cheese makers allowance from $.068/lb. to $.083/lb.  The make allowances have stayed the same since 2008.  Various studies indicate that making cheese from milk costs about $.07/lb., so the make allowance appears to be reasonable.  The advance to a cheese maker is that he has no variability in his revenue for cheese making.  The variability of the wholesale price of cheese is pushed down to the producer while the make allowance does not vary.  The cheese maker can also improve revenue by selling whey, managing his cheese production and inventories. and sales to food service and food processors who use cheese as an ingredient.

The next level in cheese pricing is the processor and distributor of packaged cheese for retail sales.  A company making and selling cheese for the retail market can manage revenue by timely purchasing of wholesale cheese, managing branding, and providing promotional opportunities for increased sales.

Chart II - Retail and Wholesale price of Cheddar Cheese and Cheese Makers Make Allowance

Chart III shows the change in consumer consumption with changes in the retail price.  While cheese consumption has steadily grown, when prices escalate, the growth is slower and when the price is lower, the growth is faster.  In 2012, when retail prices of Cheddar cheese increased to a record high, the growth in consumption slowed.  In 2016 and 2017 when the price was low, the growth in consumption accelerated.  These periods of slow growth and fast growth are circled in Chart III.

The consumption line in Chart III is based on the available data for American cheese which is primarily Cheddar cheese.

Chart III - American Cheese Consumption vs. Retail Price of Cheddar

Chart IV is a stacked graph which shows the buildup of Cheddar pricing.  The four levels of management mentioned above are very different. The price of the milk used varies considerably from month to month.  The revenue of making cheese has little variability.  The branding and processing of bulk cheese into the consumer market primarily involves management of marketing.  

The grocer's job of managing consumers sales is complex and operates with typically thin margins.  Margins at the grocer's level are very carefully managed and the largest grocers manage these margins based on daily analytics.

Chart IV - Stacked Graph of Cheddar Pricing

All the four levels as defined above are complex and require very different skills.  Much of the revenue variability is pushed down to the producer.  What are the management skills needed at the producer level maximize revenue?

Obviously, control of costs is very important for milk producers to survive, and these skills are honed over time with a lot of "on-the-job" experience.  However, management of revenue for producers is often not as well managed because it is complex and because it requires very different skills.

Revenue for the majority of milk producers is paid on the component system and the money comes from selling components, not milk.  Those three components are milk protein, butterfat, and other solids.  Selling other solids is a small revenue contributor and requires almost no management at the producer level.  Managing butterfat levels is something that has always been managed in the producer environment, because payment for butterfat has been standard for all producers for at least a century.  

Maximizing milk protein revenue is the most complex.  In areas where milk is paid on the advanced system, there is no specific payment for protein, so there was little incentive to manage protein levels.  However, 90 percent of the Federal Order milk is paid on the Component system which does specifically pay for protein, measured by "true protein" in the milk. The skills to manage protein levels have evolved over a few decades, but there is still a great opportunity to implement practices to improve milk protein levels.  With half of the milk now used for cheese production (see the recent post on Class usage of milk), the importance of milk protein has reached the highest level of importance.  In addition to the Federal Order pricing, most cheese makers pay an additional bonus for higher levels of protein.  Revenue management of milk protein should be on the top of most every producer's priority list.  Techniques such as the balancing of amino acids in feed is a proven technology, but the management of this technology is newer and complex.   To be successful, amino acid balancing requires the right specialized feed supplements and formulating skills.