University of Wisconsin Center for Wisconsin
Farmer Cooperatives, September 1995 Vol.62 No.6
Published by the Rural Business and Cooperative Development Service
Vertical Integration Patterns of Dairy Co-ops Reflect Changing MarketK. Charles Ling and Carolyn Betts Liebrand
In animal agriculture, such as the poultry and egg industries, investor-owned firms have been the primary force behind vertical integration. The dairy sector, however, has been the major exception. Long ago, dairy farmers forward-integrated into marketing channels in a major way. Dairy producers have achieved this through farmer-owned, farmer-controlled and farmer-used dairy cooperatives. Their experience can be a useful model for other agricultural industries facing the pressure of vertical integration.
Results of a 1993 USDA survey indicate that dairy cooperatives handled 82 percent of the nation's milk at the first handler level in fiscal 1992. In 1993, dairy cooperatives' milk payments to farmers constituted 85 percent of the nation's cash receipts from milk production.
Dairy farmers' integration at the first handler level usually entails a tacit or explicit marketing agreement with a cooperative that designates it as the exclusive marketing agent for the farmer's milk production. The majority of dairy cooperatives perform only bargaining functions, but they represent only 25 percent of cooperative milk volume (table 1). Prices members receive for their milk usually include minimal deductions, because bargaining co-ops incur minimal marketing expenses.
The remaining dairy cooperatives operate one or more plants and, to varying degrees, are further integrated down the market channel. Transmission of milk prices to farmers is somewhat more indirect because most of these co-ops "reblend" their earnings before paying members for milk. The blend price is calculated and paid to farmers after adding premiums and/or marketing earnings to and subtracting expenses and/or marketing losses from the total value of the milk pool.
In 1992, dairy cooperatives with processing/manufacturing operations handled 75 percent of the total volume of milk marketed by cooperatives (table 1).
Table 1- Dairy cooperatives by type of operation, 1992 Number/Percent of dairy co-ops/Percent of co-op volume Bargaining only 135 / 51 / 21 Bargaining with receiving facility only 44 / 17 / 4 Operating at least one processing/manufacturing plant 86 / 32 / 75 Total 265 / 100 / 100
These cooperatives manufactured major shares of the nation's "hard" dairy products: 65 percent of the butter, 81 percent of the dry milk products, and 43 percent of the cheese (table 2). However, their presence in the fluid and "soft" product categories was rather limited: 16 percent of packaged fluid milk, 13 percent of cottage cheese, 10 percent of ice cream and ice milk, and only 3 percent of yogurt.
How Dairy Cooperatives IntegrateBased on the functions dairy cooperatives perform in the market channel, vertical integration by dairy cooperatives can be classified into six categories. Each category shows a different level of vertical integration and involves different market opportunities and risks. (The categories are for the purpose of this article only, which may differ from conventional categorization.)
Bargaining cooperatives operate under the philosophy that dairy producers' place in the market is producing milk and the role of dairy cooperatives is to secure the most profitable outlets for the milk and in jointly preparing milk for market at the first-handler level. Further processing and sales of dairy products are left to other handlers. Business risk for bargaining cooperatives is low as long as there are buyers of milk. At the same time, they only have a limited opportunity to capture more of the consumer dollar. Members make minimal financial commitment in their cooperatives because little capital is needed for bargaining operations. They are takers of the milk piece determined when the economic law of supply and demand for milk is played out in the marketplace. Their strength is in numbers; in this case, the volume of milk cooperative members collectively possess. The government administered milk prices serve as a floor and the starting price in the bargaining process. Milk payment is usually pooled.
Table 2- Cooperative shares of national production of milk and milk products, 1992 Cooperative share (Percent) Member milk 80 Milk delivered to plants and dealers 82 Butter 65 Dry milk products 81 Cheese 43 Dry whey products 48 Packaged fluid milk 16 Cottage cheese 13 Ice cream mix and ice milk mix 13 Ice cream and ice milk 10 Yogurt 3In 1992, this category included 135 pure bargaining cooperatives and 44 bargaining cooperatives that operated receiving stations without other plant operations (tables 1 and 3). Together, the 179 cooperatives represented 68 percent of dairy cooperatives, but only 25 percent of milk marketed by all cooperatives. Most were small cooperatives in terms of milk volume. The majority were in the Northeast and the Upper Midwest.
The main funtion of these cooperatives is selling milk and performing related services to other handlers. A bargaining-balancing cooperative operates much like a bargaining cooperative, except that it has plant facilities to service handlers' needs and/or to balance milk supply. Having the capability to dispose of surplus milk substantially strengthens these cooperatives' bargaining position. Surplus milk is usually made into storable "hard" products -- butter, powder and cheese -- that are supported by the federal government's price-support program.
In recent years, continuing declines in the government support prices for dairy products have had the effect of making supply balancing operations unprofitable or, more commonly, a losing proposition. Furthermore, a balancing plant is usually a high-cost operation because the facility is used only part of the year and usually at low capacity. The impact of these factors on cooperatives depends on what proportion of a cooperative's total milk volume goes into supply balancing operations. A large cooperative with a modem efficient manufacturing plant(s) that services fluid milk and soft product customer-handlers and balances only a small proportion of its milk may be able to absorb the cost of supply balancing. However, many balancing plants are old and inefficient.
A smaller cooperative with an outmoded plant(s) may be able to live off the depreciated assets and "milk the old plant" for a while. Eventually, the plant has to be replaced. The cooperative then finds it does not have the financial ability or enough milk volume to sustain a modern plant. As a result, some bargaining-balancing cooperatives have merged with a larger cooperative or have abandoned their balancing operations and become bargaining cooperatives. Others divested their own plants but invested in or have joint ventures in milk processing facilities, whereby they could maintain an outlet for milk in excess of what they could sell.
Some other bargaining-balancing cooperatives attempted to cover their high cost of operations by going into the consumer market, thinking that the solution was in capturing a higher share of the marketing margin. In many cases, they underestimated the fierce competitive nature of the consumer market and the financial resources needed to break into that market, and ended up in further demise.
In 1992, there were 24 bargaining-balancing dairy cooperatives (table 3). They accounted for 9 percent of dairy cooperatives and 17 percent of all milk marketed cooperatively. Their share of the milk processed or manufactured by cooperatives was 11 percent. Seventy-five percent of their milk was sold to other handlers and the remaining 25 percent manufactured in their own plants (table 4). They operated 7 plants for American cheese, 17 for butter and 11 for powder (table 5).
Margins are slim to nonexistent in making commodity products. So, three things are required to operate a successful manufacturing cooperative.
Table 3- Share of cooperative milk by operating category of dairy cooperatives Category Cooperatives Share of Share processed/ coop milk manufactured by (%) co-ops (%) Number (Percent) 1. Bargaining Cooperatives 179 (68) 25 0 2. Bargaining- Balancing Cooperatives 24 (9) 17 11 3. Undifferentiated Hard-Product Manufacturing Cooperative 5 (2) 4 8 4. Niche Marketing Cooperatives 29 (11) 2 4 5. Fluid Processing Cooperatives 7 (3) 4 8 6. Diversified Dairy Cooperatives 21 (8) 49 70 Total 265 (Totals do not add to 100 percent due to rounding.)
There were five dairy cooperatives in this category in 1992 (table 3). They represented less than 2 percent of dairy cooperatives but handled 4 percent of cooperatively marketed milk. Their manufacturing volume accounted for 8 percent of milk processed or manufactured by all cooperatives. These cooperatives sold only 19 percent of their milk to other handlers and manufactured the other 81 percent (table 4). Table 5 shows the plants were mainly used for manufacturing American cheese (2), butter (4) and powder (4).
These cooperatives are mostly located in the traditional dairying areas of the country. They manufacture and market specialty or branded cheese and other dairy products for particular market niches. They are usually long-established cooperatives with small scale plants; many need to be modernized.
Niche marketing cooperatives face both domestic and foreign market pressures. Domestically, as milk production shifts to lower cost regions and milk supply tightens in the traditional milksheds, competition for the available supply can be financially stressful for these cooperatives. On the international front, the relaxation of Section 22 import quotas may bring more foreign-produced specialty cheese into the United States to compete with the products of these cooperatives.
Regardless of these pressures, the few cooperatives with well-established brands and high-quality premium cheese no doubt will continue to flourish. Other, less entrenched cooperatives will be under mounting pressures to improve their operating and marketing efficiency. Many of them are likely to merge with cooperatives that have more financial resources and marketing expertise.
Twenty-nine cooperatives, or 11 percent of all dairy cooperatives, were in this category in 1992 (table 3). Their share of cooperatively marketed milk was 2 percent. Their processing volume was 4 percent of the milk put through plants owned and operated by cooperatives. They processed 81 percent of their members' milk and sold the remaining 19 percent to other handlers, on average (table 4). The majority of their plants were for making cheese (table 5).
The continuous state of structural adjustment in the fluid milk processing industry is caused by several factors. Per capita fluid consumption has been in long-term decline. Aggregate demand has been growing since it hit the bottom in 1982, but at a slow pace. Excess plant capacity in the industry makes it a very competitive business. Above all, dominance of retail outlets by supermarket chains and by dairy/convenience store chains tends to depress processor margins.
To survive in this environment, a firm must be a low-cost, high-volume and very efficient operator. It must continually upgrade its plant(s) to take advantage of new technology and economies of scale. This requires ample financial resources and a management team that is on constant alert regarding the market pulse and operating efficiency. Few cooperatives are expected to remain in the business of processing fluid products as their main line of operation.
Some fluid processing cooperatives deliberately keep membership below a certain level and purchase milk from outside sources when necessary to avoid the cost of supply balancing or disposing of surplus milk. Together, they processed 90 percent of their members' milk and sold the remaining 10 percent to other handlers in 1992 (table 4).
Fluid processing cooperatives are usually long-established firms. Most are small scale businesses-only two are relatively large scale, modern operations.
In 1992, seven cooperatives, or 3 percent of all dairy cooperatives, specialized in processing fluid products (table 3). Their share of cooperative milk was 4 percent. Their processing volume was 8 percent of the milk that was processed or manufactured by cooperatives. They operated 27 fluid processing plants and 18 ice cream plants (table 5).
Most of the diversified dairy cooperatives did not start out as such. They grew into this category gradually through the years. Originally, many were bargaining- balancing or undifferentiated hard-product manufacturing cooperatives. Many diversified into related dairy enterprises as a defense mechanism to adapt to market evolution and changes in government policies. The pace of growing into diversified dairy cooperatives quickened in the mid-1980s as the government promulgated market-oriented dairy policies and in reaction to fast-changing consumer tastes and preferences.
Most of the diversified cooperatives are dominant in terms of member milk volume. Each cooperative operates a system of plants that process or manufacture a variety of dairy products. They typically sell a substantial amount of milk to other handlers, while maintaining a steady volume to their own processing or manufacturing plants to fully use available capacity. The residual surplus milk is usually used in their balancing plant(s) to manufacture butter and nonfat dry milk. Some cooperatives are sophisticated marketers of consumer products.
Diversified dairy cooperatives have an advantage in being able to shift milk to the most profitable enterprises. The cooperative has to have a multi-plant processing complex and a sufficient supply of milk to use the plants. The business requires ample financial resources and an able management team.
In 1992, there were 21 dairy cooperatives in this category. While that number represented only 8 percent of dairy cooperatives, their milk accounted for 49 percent of total cooperatively marketed volume (table 3). Their share of milk processed or manufactured by cooperatives was 70 percent. Collectively, they sold 43 percent of their members' milk to other handlers and processed the other 57 percent in their plants (table 4). Most cooperatively owned milk processing and manufacturing plants were operated by diversified dairy cooperatives (table 5).
Prospects for Vertical IntegrationDairy cooperatives market more than 80 percent of the nation's milk supply. With the energy unleashed by a more market oriented dairy economy, they are going to do more with their milk and add value to it. Their presence in the market channel will be more prominent. In the future, most dairy cooperatives will head in two divergent directions -- to more or less vertical integration. Many will merge with or evolve into diversified dairy cooperatives (category 6), while others, usually small cooperatives, will divest and become bargaining cooperatives (category 1). Some large cooperatives will remain in the bargaining-balancing mode as long as their balancing operations are a relatively minor part of their operations.
Some farmers are striving to form organic or other niche marketing cooperatives. While they may provide limited benefits to their select group of members, they are not likely to be a major factor in the foreseeable future.
Diversified dairy cooperatives will handle the major share of the nation's milk volume. The market will be more vertically integrated by these cooperatives. In the process, they will confront a fast-changing business environment and many unprecedented challenges, including:
ConclusionsEconomic reality is forcing dairy farmers to manage their industry and earn more dollars from the marketplace. Dairy cooperatives have been effective vehicles for farmers' integrating down the market channel. In the future, dairy cooperatives will control an even larger share of the nation's milk supply. They will continue to grow and diversify and reach closer to consumers to capture a greater share of the consumer dollar.
The second half of the decade and beyond will be very challenging. However, cooperatives that have ample capital, astute management and a forward-looking board of directors will find the challenge both exciting and rewarding.
For other agricultural industries that are facing vertical integration by investor owned firms, dairy cooperatives are examples of how farmers can legally take matters into their own hands. Vertical integration through cooperatives has enabled dairy farmers to capture margins from the marketplace that otherwise would go to middlemen. By working together in cooperatives, dairy farmer members can better control their own economic destiny.
Table 4- Percent of milk sold raw and processed/manufactured by operating category of cooperatives Category Milk sold raw Milk processed or manufactured (Percent) 1. Bargaining Cooperatives 100 0 2. Bargaining-Balancing Cooperatives 75 25 3.Undifferentiated Hard-Product Manufacturing Cooperatives 19 81 4. Niche Marketing Cooperatives 13 87 5. Fluid Processing Cooperatives 10 90 6. Diversified Dairy Cooperatives 43 57
Table 5- Number of plants owned and operated by groups of dairy cooperatives that perform processing/manufacturing functions, 1992 Category/Function #2 #3 #4 #5 #6 Total Number Make American cheese 7 2 14 0 57 80 Make Italian cheese 0 0 3 0 43 46 Make process cheese 1 1 0 0 8 10 Churn butter 17 4 5 2 20 48 Packaged fluid milk 0 0 4 27 44 75 Make dry products 11 4 1 2 34 52 Make dry whey products 3 2 2 0 33 40 Make cottage cheese 0 0 1 8 16 25 Make ice cream 0 0 3 18 16 37
This material has been reproduced in electronic format with the permission of Farmer Cooperatives.