Executive Summary

The University Study Committee (USC) for the basic formula price (BFP) was assembled to evaluate the performance of alternative BFP pricing procedures. It was established to draw analytical conclusions but not to make recommendations. The establishment of USC recognizes that in the absence of a sufficient supply of Grade B milk, there can be no reliable M-W price. USC concludes that there are sufficient concerns about the reliability of the M-W price that the Secretary should install a replacement BFP.

Thirty-two BFP options were evaluated including six competitive pay prices, 22 product formulas, two economic formulas and two having no BFP. To evaluate these options, a two-step procedure was pursued.

In step 1, the original 32 options were narrowed to 11 utilizing criteria of long life, understandability, geographic uniformity and reflecting the manufactured milk market. All of these criteria were decisive in eliminating one or more of the 21 options that were concluded not to merit further consideration. However, the most influential of these step 1 criteria included long life, understandability and reflecting the manufactured milk market. Of particular significance was the conclusion that product formulas had to include all three manufactured products (butter, NDM and cheese) to survive step 1 and that derived make allowances were too volatile to reflect the prices of manufactured products (an aspect of reflecting the manufactured milk market).

In step 2 the 11 remaining options were subjected to econometric analyses and statistical tests designed to measure:

How well does the calculated BFP reflect national supply and demand conditions for manufactured products?

How well does the calculated BFP reflect changes in the value of milk used in manufacturing?

How stable is the calculated BFP?

These three criteria have obvious roots in the Agricultural Marketing Agreements Act of 1937 (AMAA) as amended.

The application of statistical measures to these three criteria led to the conclusions that the performance of the following two options was superior to the other 9 step 2 alternative pricing procedures:

Pricing components with no BFP. This option sets no minimum price for milk used for manufacturing. However, uniform minimum component values are set based on transaction or spot market prices. Plants are audited to assure that producers are paid consistent with the established procedure. A benchmark price per cwt can be determined to move the Class I and II prices.
Butter/powder-cheese formula, seasonal yields, CA cost-based make allowance with national product weights. This option calculates the BFP utilizing product prices that are seasonally adjusted for yield. A cost based make allowance is utilized with weights based on national production.

The following observations are relevant to the conclusion that 9 of the 11 options did not indicate superior performance:

Product formulas with prices adjusted for seasonal yields tended to perform superior in reflecting national supply-demand conditions.
Grade A/B competitive pay price options indicated an unexpected positive price response to an increase in stocks. In addition, their performance was not in the upper quartile of options for any of the three criterion.
Pooling with no BFP was not quantitatively evaluated. However, USC concluded that this option could be expected to generate geographically variable market prices for milk used for manufacturing as determined by competitive conditions and that these prices would be more unstable.

The AMAA authorizes the establishment of minimum prices to be applied to each milk Class. These minimum price provisions applied to Class III would provide latitude for market forces to operate on a regional basis while providing stability, orderliness and a reflection of national supply and demand conditions. In the absence of a support program, clearing the market is assured only if prices are free to fall to the point where supply and demand are equal.

If the dairy industry is to maintain the classified pricing system, it must find a way to come to grips with the Class IIIA issue. The current Class IIIA price is undermining the Class II and Class III price by providing the incentive for milk to be manufactured into NDM at a lower price which, in turn, is being utilized in increasingly large quantities to produce cheese and soft products. An increasingly large share of the soft product production appears to be occurring in unregulated plants.

Coming to grips with the Class IIIA issue requires that federal order and California state dairy policies be coordinated. It may not only require the elimination of Class IIIA and its California counterpart but also that all soft and hard products be part of the same Class. The movement back to a two-Class system will be a particularly relevant consideration as barriers to trade in dairy products are reduced. At that point, U.S. soft and hard product manufacturers will need to be in a position to compete with NDM traded at the world market price and with products made therefrom.

Because of the thin market controversy involving manufactured products, it is critically important that the industry provide the USDA with transaction price information from which it can determine the BFP and/or the related component values. If the industry is unwilling to provide this information voluntarily, it should be mandated utilizing order provisions. This is essential to allowing the order system to continue to operate in a competitive, trustworthy and orderly environment.

Product formulas require make allowances. Even component pricing with no BFP arguably requires a make allowance if it is to be used to move higher Class prices. Since formulas have been demonstrated to perform better with cost-based make allowances, a procedure would need to be established for ascertaining manufacturing costs. This might include the development of representative cheese and butter/powder plants to act as an indicator/mover of cost changes.

It makes no sense for prices in one milk Class to be moving in one direction while another Class moves in the opposite direction. The resulting problems have been demonstrated time and again in pricing Class II and III products. Accordingly, coordination of Class prices is an integral part of an orderly marketing system.

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