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 Market

K. Charles Ling and Carolyn Betts Liebrand

Agricultural Economists
USDA/RBCDS Cooperative Services


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 Integrate

Based 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.)
  1. Bargaining Cooperatives: Cooperatives that operate as bargaining associations and refrain from product processing/manufacturing.
  2. 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                 3
    In 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.
  3. Bargaining-Balancing Cooperatives: Co-ops that bargain for milk prices and manufacture the surplus into commodity dairy products for supply balancing.
  4. 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).

  5. Undifferentiated Hard-Product Manufacturing Cooperatives: These cooperatives capture processor margins by manufacturing undifferentiated, commodity dairy products in their well-run, large-scale modern plants. They sell little milk to other handlers. Most of the milk supply is used in their own plants.
  6. Margins are slim to nonexistent in making commodity products. So, three things are required to operate a successful manufacturing cooperative.

     

    • A very efficient large-scale plant(s) that takes advantage of modern technology and economies of scale;
    • A very large volume of milk that allows the cooperative to operate its plant(s) at or close to maximum capacity; and
    • A ready market for manufactured products, including the Commodity Credit Corporation (CCC).
    Undifferentiated hard-product manufacturing cooperatives have very large scale, state-of-the-art, efficient plants. They are usually operated at or near capacity and at very low cost. However, because these plants are usually used for high-volume manufacturing of butter, powder and cheese, the operations are not flexible enough to take advantage of changes in market opportunities. The continuing declines in the government support prices for dairy products affect market product prices and have made manufacturing operations less profitable. However, recent relaxation of trade barriers may help cooperatives manufacturing butter and powder find new and promising markets in the international arena.
    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).

  7. Niche Marketing Cooperatives: These cooperatives capture processor margins and at least some marketing margins. They manufacture and market differentiated products as the main line of business. They typically process all of their members' milk in the cooperative's plants.
  8. 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).

  9. Fluid Processing Cooperatives: These cooperatives also capture processor margins and at least some marketing margins. Processing fluid milk products is the main business of these cooperatives. As with niche marketing cooperatives, fluid processing cooperatives typically process all of their members' milk in their own plants.
  10. 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).

  11. Diversified Dairy Cooperatives: These cooperatives are the most vertically integrated. They bargain for milk prices, process and market both differentiated and commodity products, and balance the residuals combination of categories 2, 3, 4 and/or 5.
  12. 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 Integration

Dairy 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:

Less or no government support:
When the government support price for milk was high, it essentially set market prices for milk and milk products. The market was very stable. Since the early 1980s, government policy has been to reduce surplus production by reducing production capacity and support prices. Price fluctuations have become more common and sometimes volatile. Inventory management has been a challenging task, especially for cooperatives that age cheese. Current discussions on the dairy portion of the 1995 farm bill seem to point to further reduction of the government's role in the dairy market, thus challenging farmers to manage their own industry.
Globalization of market:
Greater market access under the Uruguay Round agreement of GATT and NAFTA thrusts the dairy industry into international competition. The world dairy market will be an increasingly important factor in making business decisions.
Rule changes:
 Rules and regulations concerning labeling, food safety, environmental protection, etc. have been undergoing major overhauls, in response to advancement in biological and food sciences and increased public concerns. Keeping in compliance with new and changing regulations raises the cost of doing business. In addition, there have been many federal market order changes in recent years. The order system seems to be heading for some major overhauls in the near future.
Consumer relations:
Discerning and adapting to consumers' shifting tastes, preferences, and perceptions of food nutrition will challenge the dairy industry. Consumers' demand for better quality and more services also must be satisfied.
Employee relations:
 Employees are increasingly demanding that work should also fulfill their personal needs such as family, flexible work schedule, alternative workplace, etc. To attract and retain quality, employees, businesses have to satisfy these needs while maintaining smooth and efficient operations.
Organizational strategies:
The traditional cooperative that is both a producer political organization and a business entity may not be conducive to the decisionmaking demanded by a dynamic marketplace. This is especially true for the diversified dairy cooperatives (category 6). The challenge is to devise a structure that allows for maximum management flexibility while maintaining producer control over the business and the organization. Darigold Farms/Darigold, Inc., Land O'Lakes/Country Lake and Agri-Mark/Cabot represent three different models.
Joint ventures and business alliances:
There has been a renewed awareness of the advantages of operating as a cooperative under the Capper-Volstead Act. Recently, several marketing-agencies-in-common have been forged for sharing market information (Dairy Marketing Cooperative Federation, Dairy Marketing Information Association and Western Cooperative Marketing Association) or jointly marketing products (Dari-West and DairyAmerica). Also, many joint ventures and business alliances have been formed between cooperatives and, in some cases, between cooperatives and investor-owned firms to serve some common needs (most notably, several cooperatives' joint ventures with Leprino Cheese). Some other cooperatives, such as Mid-America Dairymen and Dairylea, invest in investor owned firms to gain market access and improve earning potential.
Capital requirements:
Acquiring and maintaining modern efficient plants and marketing consumer dairy products require substantial capital. Currently, member equity in the manufacturing and processing cooperatives (categories 3, 4, 5 and 6) averages about $5 per hundredweight. As dairy cooperatives further integrate down the market channel, capital requirement will be much, much higher. As a general rule, capital in a dairy cooperative is mainly supplied by members, mostly through retained earnings or capital retains. The need for capital in the cooperative often conflicts with the need on the farm. The pressure to revolve equity to members may not allow the cooperative to be adequately capitalized. To get ahead of the game, dairy cooperatives must generate more earnings.
Diversity in milk production units:
Dairy farms have grown more divergent in size and production practices. Arguments among members for equitable vs. equal treatment tend to create tension within a cooperative. It is difficult to satisfy every member's needs when the characteristics of dairy farms are growing divergent.

Conclusions

Economic 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. 

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