Editor’s note: This is the first in a two-part series of articles that discuss milk pricing.

As most dairy producers are well aware, there are few agricultural commodity pricing systems that are more complex than milk. It doesn’t take long to get lost in the maze of milk pricing terms like pooling, producer price differentials, make allowances or to misunderstand the policies and regulations that determine how milk is priced in this country.

Since it is important for dairy producers to understand what this verbiage means and how their milk is priced, we’ll take a closer look at some common milk marketing terms. We will focus on Federal Milk Marketing Orders and component pricing, as nearly 85 percent of the nation’s milk supply is sold in regulated markets that price milk in this manner.

[First], we’ll explore the processor side of the equation and illustrate how processors are obligated to pay into the Federal Order pool. [In the next issue] we’ll take a closer look at producers and explain how dairies are paid for their milk out of this pool.

Milk marketing terms

• Federal Milk Marketing Order
The Federal Milk Marketing Order is a legal document that specifies the terms under which regulated milk handlers (cooperatives and proprietary plants) must operate when purchasing milk from dairy producers. Classified pricing and pooling are the two key elements of the Federal Order system.

There are now 10 Federal Orders across the country and their legal basis is the Agricultural Marketing Agreement Act of 1937, as amended. The geographical location of a Federal Order is determined by the market area of the processor, not the location of the farm.

• Classified pricing
Milk sold to processors through the Federal Order system is classified into one of four classes (I, II, III and IV) based on the end use of the milk – for bottling or manufacturing – and then priced accordingly.

• Class I milk
Class I milk is used for fluid products such as whole, reduced-fat milk, skim milk, buttermilk, eggnog and other milk beverages. Because Federal Orders were established in the 1930s to ensure the country had an adequate supply of high-quality fluid milk, Class I milk usually is the highest-priced milk. Processors who purchase milk for marketing Class I products are required to participate in the Federal Order pool, defined below.

• Class I price
The Class I price is the minimum price processors that make Class I products must pay for milk. The Class I price is the higher of either an advanced Class III or Class IV price plus a differential, which depends on the county in which the processing plant is located.

• Differential
All counties in the United States are assigned a constant Class I differential which reflects the cost of transporting milk to more populated areas. Differentials typically are higher as milk moves to the southern and eastern parts of the country.

• Class II milk
Class II milk is used for cream and to produce soft dairy products such as cottage cheese, yogurt and frozen desserts. Processors who purchase milk for Class II, III and IV products have the option of participating in the Federal Order pool.

• Class II price
The Class II price is the minimum amount processors must pay into the pool for milk used to make Class II products. Basically, the Class II price is the Class IV price plus $0.70 per hundredweight (cwt).

• Class III milk
Milk classified as Class III milk is used to manufacture cheese and cream cheese.

• Class III price
Processors making Class III products and participating in the Federal Orders must pay at least the minimum Class III price into the pool, based on market prices for cheddar cheese and dry whey. Generally, the Class III price is the class closest to a producer’s pay price.

• Class IV milk
Class IV milk is milk used to produce butter and milk powders. Class IV milk has traditionally been the lowest-priced category, as products manufactured from Class IV milk are less perishable.

• Class IV price
The Class IV price is the minimum amount processors must pay into the pool for milk used in the manufacture of Class IV products. This price reflects the market prices of butter and nonfat dry milk.

• Pooling
Pooling is a feature of the Federal Order system in which money paid for milk by processors is pooled and then distributed to producers (Figure 1). A processor’s obligation to the pool is based on the end product for which the milk is purchased. A producer’s receipts from the pool are based on the component value of the milk he or she supplies.

Pooling allows processors making lower-value products, such as butter and nonfat dry milk, to pay their producers the same amount as processors in the higher-value fluid milk market. The Class I processor pays more into the pool because their product sells for a higher price. The Class IV processor can take that money out of the pool to pay their producers an equal amount. This ability to draw from the pool is why many processors who produce Class II, Class III and Class IV products elect to participate in the pool.

Figure 2 shows a simplified example of two processor’s obligations to a Federal Order pool. Both purchased 5,000 cwt. Because Processor A used the milk for higher-value Class I and II products, its pool obligation is higher than Processor B’s obligation. Even though Processor B used its milk for lower-value Class II, III and IV products, it will be able to draw from the pool so it can pay its producers a value equal to Class I milk for their milk.

Now that we’ve examined how classified pricing determines processor payments going into the pool, we’ll take a look at how producers are paid from the pool in the next article. PD

—Excerpts from Jersey Journal, April 2008