Formula pricing-good, bad or plain risky?

In an ideal world the milk price would be determined by taking the gross income from a particular plant or company, deducting the processing, packaging and distribution costs, paying the farmers the cost of production and dividing any profit between processor and farmer.

The co-op model is the closest, although a lot of the numbers are taken on trust and payments are made before the market outcomes are known, the co-op’s profit and capital value belongs to its members.

The production cost element is recognised, but is not part of the co-op payment system.

With PLCs the outcomes are similar, but methodology is completely different. The milk price paid is a judgement call based on the level of profitability required by shareholders and the price needed to secure the milk supply.

In the 20 years since milk market deregulation some milk processors have been guilty of paying more than they could afford and no longer exist.

While others are suspected of undercutting their competitors to gain market share only to recoup profit margin by slashing the raw milk price, confident that other processors would follow to maintain their own margins.

Recent market behaviour and the impending abolition of milk quotas means we are heading into weather dependent production and highly volatile markets which would only serve to test relationships to breaking point as 2012 proved.

Where milk prices are set in such an arbitrary way there will always be cause for conflict. The more volatile the markets the greater the conflict and hence the rise of formula pricing to eliminate price negotiations.

Two types of formula pricing

There are two basic kinds of formula price; those based on a selection of indicators that cover the types of product and production costs, and those underwritten by a retailer so that price is based on the formula, almost irrespective of extremes of market returns and/or milk production costs.


The advantages of a formula price is it reduces the need for negotiation and reduces confrontation between farmer and processor. They can be linked to markets for which the milk and resulting dairy product is destined. They can use both production cost indicators and market returns to attempt to ensure the milk price is fair to both farmer and processor. It needs to be remembered this is not a calculation of the value of raw milk, but an estimation of the value from key indicators. There should be formula revisions at pre-set intervals and farmers should be able to resign at three clear months’ notice as there is no tangible reason to disallow it.


The disadvantages are that price can be linked to commodities despite milk being destined for domestic liquid or cheese markets. Traded commodities will always reflect the marginal value of production and not the core value. The gearing to production costs can mean that rises or falls in feed costs could have a disproportionate effect on milk price. Termination rights are waived due to the frequency of milk price adjustments.

The source of data and its reliability is key, but when most data is some form of survey, the recent Libor scandal or false estimations of double dip recessions are a warning.

Panel data indicates rising liquid consumption (+1.3%), however DEFRA milk use figures show liquid to have fallen (-2.8%) in the last year. They are measuring different things, but give a different indication of future prospects.

Producing a formula when many of the indicators are at an all time high could lead to an under valuation of milk when commodities crash and could leave milk prices well below the cost of production. This will result in a number of dairy farmers unable or unwilling to fund the loss and exit the industry.

For the processor there is a significant reduction in risk as it provides a key piece of information when negotiating with customers.

For farmers there is greater certainty of how milk price would evolve in a given set of circumstances, the sensitivity to changes in each indicator can be (and should be) fully understood.

To date, there seems to have been a rush for signing up rather than having a period of shadowing the current price. If the formula is right, farmers would sign up once confident of its operation.

Formula pricing is here to stay and many farmers won’t have a choice, so understanding the downside risks will be paramount in planning the business to survive the aftermath of quota abolition.

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