Marketing and Policy Briefing Paper

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1 -\NDREW M. NOVAKuvl Marketing and Policy Briefing Paper ~ ~ I ~ ~ 1/\ l/ ~ Department of Agricultural Economics. College of Agricultural and Life Sciences. University of Wisconsin-Madison Cooperative Extension Service. University of Wisconsin-Extension v Paper No. 38 November 1991 Regional Competitive Advantage in the U.S. Cheddar Cheese Market Ronald Buekeboom and Ed Jesse 1 Abstract This purpose of this study is to evaluate the nature of regional competition in cheddar cheese markets. Cheddar cheese is the major variety produced in Wisconsin, and competition for sales from other cheese-producing states can have a major effect on milk prices in Wisconsin and, ultimately, the future of the Wisconsin dairy industry. Factors influencing relative regional com etitive advantage are assessed by comparing ilk costs cneese.qrocessing. co.ts,' and transportation costs across major competing states (Wisconsin, Minnesota, New York, Texas, and California). The major conclusion is that, under current milk pricing conditions, both California and Texas.aY,e wer delivered costs of cheddar cheese to all U.S. cities. Howeve t e ual lant sizes. isconsin has lower cheese manufacturing costs than any of the other states. And with milk prices commensurate with costs of producing milk, Wisconsin's competitive position is substantially better than what is suggested by current price relationships. lbuekeboom is a student at Christelijke Hogere Landbouwschool in Dronten, Holland. He was engaged in a special internship in the Department of Agricultural Economics, University of Wisconsin-Madison from September-December This report was prepared by Ed Jesse based in part on research and information obtained by Buekeboom during the course of his internship. The reader should be aware that freight cost data were reconstructed and that the cost simulation model results could not be reproduced because of lost data files. The views expressed are those of the author(s). Comments are welcome and should be sent to Marketing and Policy Briefing Paper. Department of Agricultural Economics, 427 Lorch St., University of Wisconsin-Madison, Madison. WI

2 I. I ntroductio n Wisconsin is the leading dairy state in the United States. In 1990, Wisconsin produced 24.4 billion pounds of milk, about 17 percent of total U.S. production. About 80 percent was used to manufacture cheese, indicating the immense importance of cheese to the Wisconsin dairy industry. To ensure a strong Wisconsin dairy future, the state must remain competitive in a growing cheese market. Dairy leaders in Wisconsin are concerned about rapidly growing milk production in the Southwest, much of which is being diverted into cheese plants. The dairying sector in both California and Texas is characterized by inexpensive housing systems and large herd sizes that cannot be replicated in Wisconsin. Hence, there is a legitimate concern that possible milk production and cheese processing advantages in the Southwest may result in a declining share of the U.S. cheese market held by Wisconsin. This report evaluates the competitive position of the Wisconsin cheddar cheese industry compared to four other leading states: Texas, California, New York, and Minnesota. The evaluation compares milk production costs, farm milk prices, cheddar cheese manufacturing costs, and distribution costs to major U.S. markets. II. Milk Production Costs Milk production costs provide an indication of the long-run competitiveness of the raw product supply sector for the cheese industry. As will be demonstrated later, the cost of milk for cheese may not bear a strong relationship to milk production costs because of cross-subsidization between fluid milk and milk for manufacturing. Nevertheless, costs of production are important in forecasting long-run competitiveness. High-cost regions of the country would not be expected to be major cheese supply regions in the long-run, regardless of short-term pricing distortions. Estimating dairy costs of production is not an easy undertaking, especially across states. Particularly important is consistency with respect to what costs are included and how they are measured. To ensure minimal consistency, cost of production data from the Economic Research Service (ERS) of the U.S. Department of Agriculture were used. ERS cost estimates are based on periodic farm surveys in

3 selected states augmented by annual estimates of major input costs such as purchased feed, utilities, and labor. ERS uses the individual state cost estimates to generate published regional estimates. The state data are not published, but are occasionally made available for research purposes. II-A. Cash Costs ERS estimates of cash costs to produce milk represent all out-of-pocket expenses. These include variable costs such as purchased feed, veterinary and medicine, and milk hauling as well as some fixed cash expenses such as interest. Cash costs are an indicator of short-term viability. In the long run, dairying must be profitable enough to cover all costs of production, including depreciation and a competitive rate of return on owner equity. But in the short run, operators can continue in business if they are covering cash costs and earning enough additional revenue to meet family living expenses. Cash costs for the five study states are shown in Chart 1. They vary by almost $3.00 per hundredweight among states. In 1989, New York and Wisconsin had the lowest cash costs; Minnesota had the highest. California and Texas had cash costs about $1.00 and $2.00 higher than Wisconsin in These differences reflect the heavier use of hired labor and purchased (as opposed to home-grown) dairy feed and forage in the southwestern U.S. II-B. Full Costs By ERS definition, full costs include cash costs plus depreciation and imputed returns to equity capital and unpaid family labor. Hence, the difference between cash and full costs of production will be greater the larger the capital investment per dairy cow, the larger the ratio of owned to borrowed capital, and the greater the reliance on family labor. 2

4 Chart 1. Cash Costs of Producing Milk Dollara per Hundredweight 15.00r ~ ~ Minn Texa. ~ Calif. --*- WI.. -Q- N.Y. I ====:::::: ~.~... Economic Reaearch Service. USDA Full costs by state are shown in Chart 2. In 1989, full costs varied from $12.15 per hundredweight (California) to $16.22 (Minnesota). From 1985 through 1989, full costs were within $1.00 per hundredweight for California, New York, and Wisconsin. These are the top three dairy states. Minnesota (#4) and Texas (#6) showed significantly higher costs. Texas costs appear to be approaching those in the top three states, but Minnesota costs seem to be diverging. The difference between full costs and cash costs is smallest in California, $.48 per hundredeweight in Minnesota showed the largest difference at $3.18. Distinctions reflect differences in housing and manure handling facilities, milk production per cow, and crop production machinery and land investment. 3

5 Chart 2. Full Costs of Producing Milk Dollar. per Hundredweight , Minn _ Texu ~WI. --&- N.Y. -Q- Calif. I Minn. Texas Wi. N.Y. Calif Economic Re.earch Service. USDA II-C. Returns to Management and Risk One indicator of dairy farm viability is net returns to the operation. This is measured by ERS as gross returns minus full production costs, and is termed, returns to management and risk. Gross returns include receipts from milk sales as well as sales of dairy-related cattle (bull calves, cull cows, and replacement stock). Revenue from milk sales reflect weighted average prices to producers for fluid and manufacturing milk. Hence, there is not a strong correlation between prices and the farm value of milk used to make cheese. 4

6 Chart 3 shows net dairy returns for the five study states. Returns are lowest for Minnesota, and consistently negative for the five-year period. For the other four states, net returns are very similar, averaging between $1-$3 per hundredweight during Each of the four states experienced the highest estimated net returns during at least one of the five years. Chart 3. Returns to Management and Risk Dollare per Hundredweight , ' r i _,.00.. 'h' ~ h X -2.00, '985 '986 '987 '988 '989 N.Y ' Wie '.93 Calif. '.99 2.'8 2.4' 0.85 '.38 Texae '.34, '.32 Minn ' '0 -'.37 Economic Reaearcl'l Service, USDA 5

7 II-D. Summary: Milk production costs. Wisconsin has relatively low cash costs of producing milk du'e primarily to the reliance of its dairy farmers on home-produced forages and feeds. In a sense, forage and feed costs are subsidized by owner equity in land and machinery used to produce crops. Moreover, a considerable portion of the labor used in both the crop production and milk production portions of integrated Wisconsin dairy farms is unpaid family labor. Combining crop production and milk production results in higher fixed costs, which elevates full costs of production. Wisconsin has relatively high full costs of production. However, part of the difference between full costs and cash costs is "imputed" costs; returns to owner equity and unpaid family labor. These "costs" are not actually incurred. Rather, they represent opportunity costs to the dairy enterprise. The major conclusion from comparing costs across states is that Wisconsin is in a reasonably good long run competitive position. Full costs for Wisconsin dairy farms compare favorably with other states, and cash costs are very low. The "red flag" is in Wisconsin's relatively large unpaid costs -- the imputed returns to family labor and owner equity. Major questions are whether Wisconsin dairy farmers will be able to continue to rely on family labor and whether they will continue to accept lessthan-market rates of return on their equity. While already relatively low, Wisconsin milk production costs might be reduced further by increasing milk production per cow and herd size. The state ranks relatively low on both of these measures. Chart 4 shows milk yield for the five comparison states. Wisconsin ranks lowest in 1990, and the rate of gain since 1980 was substantially less than the other states. 2 Chart 5 shows average dairy herd size based on Census of Agriculture estimates of the number of farms and total dairy cows by state. Herd size in Wisconsin is markedly smaller than in Texas and New York, and California dairy herds are more than six times larger than Wisconsin herds. 2The disappointing gain in Wisconsin milk production per cow between 1980 and 1990 is partially due to lingering effects of the 1988 drought and poor-quality forage in Wisconsin milk yield in both 1989 and 1990 were well-below trend. 6

8 Chart 4. Milk Production per Cow 1,000 Pound. ' D ~ CA NY TX MN WI 1990, e Source: USDA, Milk PcqduPtlqo Chart 5. Average Dairy Herd Size Cow. per Farm CA TX NY WI MN eo Source: Census 01 Agriculture 7 Wllll 1987 rilltil D 1874

9 Some caution is urged in making a direct linkage between yield per cow and herd size with milk production costs. Higher milk yields may require substantially higher purchased input costs, thus offsetting some of the advantage Wisconsin dairy farmers now enjoy from low-cost home-grown feeds. Larger herd size may require substantially more hired labor, offsetting the cost advantage of using family members in the dairy enterprise. The associated tradeoffs are not clearly understood. Nonetheless, it is abundantly clear that many Wisconsin dairy farms could achieve lower costs by expanding the size of their operations and using feeding, breeding, and management practices that increase milk production per cow. III. Cost of Milk Used for Cheese Estimating raw product costs for cheese plants in the comparison states is not a straightforward process. Milk prices received by farmers are not the same as the cost of milk to cheese plants, largely because of the influence o"f Federal milk marketing orders. Federal orders establish minimum prices for most of the Grade A milk produced in the U.S. Minimum prices differ according to use Class. All class prices are based on the Minnesota-Wisconsin price series (M-W price), the estimated average price paid for Grade B milk in those two states. Milk used for fluid purposes (Class I) is priced the highest. The monthly minimum Class I price in all orders is the M-W price from two months earlier plus a Class I differential that varies regionally among markets according to distance from the Upper Midwest. Minimum Class II prices, for milk used to make soft manufactured dairy products like cottage cheese and ice cream, are about the same in all orders. The minimum monthly Class II price is the M-W price for the current month plus a constant Class II differential of about 10 cents per hundredweight. Milk used to make cheese, butter, and nonfat dry milk (Class III) is priced the lowest. The minimum monthly Class III price in all orders is the current month M-W price. Setting the minimum Class III price at the Grade B price tends to equalize raw product costs between manufacturers of Grade A and Grade B milk. 8

10 Under Federal order pricing, dairy farmers receive a minimum blend price, which is a weighted average value of milk based on minimum class prices and the volume of milk in the market used in each use class. Because the Class I price is highest, blend prices are higher in markets with higher Class I utilization. And since Class I differentials increase with distance from the Upper Midwest, blend prices are higher in the South and East even when utilization is held constant. While Federal order prices for milk used for cheese (Class III) are the same in all orders, the actual cost of milk used for cheese is not. That is because order prices are minimum prices, and competition for milk results in prices higher than the order minimums in some markets. Moreover, California dairy plants are not regulated by Federal Orders. Rather, a California Grade A milk is priced under a state classified pricing system that uses economic formulas to set minimum prices instead of the M-W price. The California state pricing system establishes minimum prices for milk used to make cheese that are below the federal order Class III price. Federal order prices are readily available, but there are no published sources of information on the actual cost of milk used to make cheese. However, two recent studies provide evidence of the amounts by which actual milk costs exceeds Class III prices in some of the states considered in this study. A survey sponsored by the Wisconsin Milk Marketing Board estimated actual Grade A ilk costs to manufacturing plants in Wisconsin and Minnesota for the period 987 through June For the year, Wisconsin plants paid an average 65 cents per hundredweight more than the M-W price. Minnesota plants paid an average 77 cents per hundredweight over the M-W price. The same study showed that the California Class IV price, for milk used to manufacture cheese, averaged 76 cents below the M-W price over the same period. Industry sources indicate that there were no premiums paid on California Class IV milk during July June Christensen, R., J. Hammond, R. Jabobson, and E. Jesse, Plant Costs for Manufactured Dairy Products in Selected Regions, ESO 1590, Department of Agricultural Economics and Rural Sociology, The Ohio State University, August

11 A Cornell University study made a similar comparison for New York manufacturing plants during calendar year Premiums over the order manufacturing price averaged 80 cents per hundredweight for milk received directly by manufacturers. Excluding November and December 1989, when a national milk shortage pushed the M-W to record highs, the average premium was '75 cents. In a 1991 report, the Market Administrator for the Upper Midwest federal milk marketing order reported costs of Grade A milk to manufacturing plants in Minnesota and Wisconsin regulated under the Upper Midwest and Chicago Region orders. s For 1989 and 1990, weighted average Grade A pay prices (adjusted for marketing order pool draws) were 77 and 75 cents, respectively, higher than the M-W prices for those years. There is no comparable information on milk costs to Texas cheese plants. However, industry sources suggest that actual prices are no higher than order minimum Class III prices in Texas. Because of cooperative reblending, the value of Class III milk under the Texas order may even be less than the order Class III price. Based on these sources of information, relative milk costs for cheddar cheese plants in the five states compared in this study are specified as in table 1. 4Division of Dairy Industry Services, New York State Department of Agriculture and. Markets, and Program on Dairy Markets arid Policy, Cornell University, An Analysis of Over-Order Premiums Paid for Milk Used at Manufacturing Plants in New York State During 1989, November SMykrantz, John L. and Victor J. Halvorson, Prices Paid for Grade A Milk by Selected Manufacturing Plants in Minnesota and Wisconsin , Staff Paper 91-01, Upper Midwest Milk Marketing Order, Agricultural Marketing Service, U.S. Department of Agriculture, July

12 .-... ('.'~ Table 1. Relationship of Cost of Milk to Cheddar Cheese Plants and M-W Price. State Cost Relative to M-W price Cents/Cwt. Wisconsin Minnesota New York Texas California o - 75 l IV. Cheese Manufacturing Costs Ideally, the costs of converting milk to cheese would be estimated by obtaining accounting information from operating plants in the states under study. However, even if plants were willing to supply this sensitive information, it would be very expensive to acquire and authenticate. Our pragmatic alternative was to use a cost simulation model developed from a major study of cheese manufacturing costs conducted at Cornell University.6 The simulation model is based on information obtained from 11 cheese plants in Wisconsin, Minnesota and New York and technical parameters provided by an engineering consulting firm. The model estimates cheese manufacturing costs for various-size plants based on a set of inputs relating to fixed and variable expenses. For our comparison, we assumed production of 40-pound blocks (standard cheddaring) for plants operating 21 hours a day 6 days a week. Costs represent averages for Consequently, they are probably lower than experienced today, but regional differences should not be substantially different. 6See Mesa-Dishington, Jens K., Aplin, Richard D.and Barbano, David M., Economic Performance of 11 Cheddar Cheese Manufacturing Plants in Northeast and North Central Regions, A.E. Res. 87-2, Department of Agricultural Economics, Cornell University, Ithaca, NY, January

13 .0 r For most fixed costs, we used standard cost estimates built into the model, since we had no basis for determining differences among states. These common costs include land and buildings, equipment repair and maintenance, and insurance. Property taxes were separately specified based on information obtained from the Wisconsin Department of Revenue for the individual states? For variable costs, we used state-specific estimates derived from a variety of sources for labor and utility expense. Other costs were fixed at the levels built into the model. These included: o o o o o o Production supplies (calcium chloride, color, rennet, salt, and starter culture). Packaging supplies Laboratory supplies Cleaning supplies Miscellaneous expenses (accounting and office supplies, communications and travel, laundry, telephone, and other services). Inventory costs r State-specific cost estimates were made for labor and utilities (electricity, natural gas, and water and sewer). These costs are summarized in table 2, which also indicates the sources used to derive the estimates. Given these cost estimates and other costs included in the simulation model, estimates of cheddar cheese manufacturing costs (not including milk cost) were generated. These are shown in table 3. Manufacturing costs demonstrate considerable variability across states and \ even greater variability across size categories. Wisconsin shows the lowest costs per 7Corporate tax climate: a comparison of sixteen states, Wisconsin Department of Revenue,

14 hundredweight, California the highest. Most of the differences among states is attributable to differences in labor and utility costs. Simulated costs drop sharply with volume, with more than a $2 per hundredweight reduction between 480,000 pounds and 960,000 pounds rated capacity. There are substantial economies to size in cheddar cheese manufacturing, indicating substantial gains in competitive advantage to states with larger plants. Table 2. Estimated Labor and Utility Costs for Cheddar Cheese Plants by State, Averages. Labor 1 Electricitl Nat. Gas 3 Watet Sewage 4 $/hour $/Kwh $ftherm $/1,000g. $/1,000g. Wisconsin California Minnesota New York Texas Employment and Wages, Annual Averages. Various issues. U.S. Department of Labor, Bureau of Labor Statistics 2Statistical Year Book. Various issues. Edison Electric Institute 3Gas Facts. Various issues. American Gas Association. 4Ernst and Young's 1990 National Water and Wastewater Rate Survey. Table 3. Simulated Cheddar Cheese Manufacturing Costs by State and Plant Capacity, Manufacturing Cost per cwt. of milk at Plant Capacity: State 480,000 Lbs/Day 720,000 Lbs/Day 960,000 Lbs/Day Dollars Wisconsin California Minnesota New York Texas Capacity measured in pounds of milk intake per day. 13

15 0; Table 4. Estimated Cheddar Cheese Plant Volume, Averages Pounds of cheese manufactured per year 1 Pounds of milk manufactured per day 1,000 Lbs. 1,000 Lbs. Wisconsin 5, California 6, Minnesota 28, New York 6, Texas NA 3 NA 1 Annual cheddar cheese production divided by the reported number of plants manufacturing cheddar cheese. Production and plant numbers obtained from National Agricultural Statistics Service, USDA. 2Assumes 310 day operation and 9.71 pounds per hundredweight cheese yield. 3Texas cheese production is not reported by USDA because there are fewer than 3 plants. This raises the question of what volume to use for the specific states. Average plant size is very different among states. Using total state cheese production and reported numbers of plants yields an approximation of average plant milk intake per day shown in table 4. These large differences in average volume suggest that different plant capacities should be used for each state. However, the simple averages are misleading in the sense of not representing typical manufacturing plants. In particular, the implied average volumes reflect large numbers of very small plants in Wisconsin, New York, and California. Typical and, especially, new plants in these states would likely have daily capacity even larger than the 960,000 pound level. In an attempt to standardize cost estimates, we elected to use a single plant capacity for all states, 960,000 pounds of milk per day. Costs for different-sized plants will obviously deviate from the 960,000 standard. But we have no basis for distinguishing among states with respect to weighted average plant volume. 14

16 V. Cheddar Cheese Yield Yield of cheese per hundredweight of milk depends on protein (casein), and fat content in the milk and moisture content in the cheese. To the extent fat and protein differ among states (due to differences in climate, genetics and feeds), cheese yields and costs per pound of cheese would also vary. Dairy Herd Improvement Association (DHIA) records demonstrate that butterfat and protein are different among the comparison states. For 1989, average DHIA tests are shown in table 5. Table 5. Dairy Herd Improvement Association Average Tests, Butterfat (%) Protein (%) Wisconsin California Minnesota New York Texas These values indicates that cheese yields at state average tests would vary among states. However, milk costs would also be different, since plants in all states use a butterfat differential and most pay premiums for protein. Since our milk price comparisons are based on the M-W price adjusted to 3.5 percent butterfat, we elected to use a common cheese yield for all states. The yield used was 9.71 pounds per hundredweight, based on the Van Slyke and Price cheese yield formula at 3.5 percent butterfat and 3.15 percent protein. We assumed 93 percent fat recovery, casein/protein ratio of 78 percent, and 37 percent moisture in the formula. 8 BThere may be other factors that cause cheese yield variations among states. In particular, protein recovery may vary due to weather or feed composition. However, we were unable to document possible differences in yield due to these factors. 15

17 VI. F.O.B. Plant Costs Combining milk costs and cheese manufacturing costs yields the total cost of cheese at the plant. Table 6 is derived using an M-W price of $12.00 per hundredweight and state milk costs relative to the M-W, a cheese yield of 9.71 pounds of cheese per hundredweight of milk, and cheese manufacturing costs (960,000 pounds per day capacity) from table 3. Table 6. Simulated Cost of Cheddar Cheese f.o.b. Plant with M-W Price at $12.00 per Hundredweight State Wisconsin California Minnesota New York Texas Cost per Cwt. of Milk Milk Mfg. Total $/Cwt $/Cwt $/Cwt Cost per Lb. of Cheese $/Lb [ Differences among states in manufacturing costs are very small in comparison to differences in the cost of raw product. Given the relative milk price relationships we used, California and, to a lesser extent, Texas have a major total cost advantage over the other states. For example, the total cost of one pound of cheddar cheese f.o.b. California plants is estimated to be 13 cents less than for Wisconsin plants. This 13 cent cost advantage can be used to offset higher costs of transporting California cheese to consuming points. VII. Delivered Costs Costs of transporting cheese from manufacturing plants to where it is consumed vary by producing region. Obviously, hauling distance is important. Moreover, transportation costs are not symmetric; the cost to haul a pound of cheese from Madison, Wisconsin to San Francisco is not the same as the cost to haul a pound of cheese from San Francisco to Madison. This asymmetry is due to opportunities for 16

18 backhauls. For example, freight shipments to Florida and Texas are relatively expensive because these states generally consume more than they produce, yielding competition among transport companies for backhauls. In contrast, Wisconsin produces large quantities of paper products, which increases the opportunities for backhauls from the state, and thus decreases the cost of shipments to Wisconsin. We obtained commodity hauling rates applicable to 40-pound blocks of cheddar cheese from one national freight company, which quoted rates for all states. 9 Rates were specified in terms of cents per loaded mile, with a minimum total charge and maximum weight load. We selected a set of U.S. cities to represent consumption locations and calculated mileage from specific locations in each of the five cheese production states. Resulting estimates of freight charges per pound of cheese are shown in table 7. Table 7. Estimated Freight Charges for Cheddar Cheese. From: Wisconsin California New York Minnesota Texas To: (Milwaukee) (San Fran.) (Albany) (Mpls.) (Dallas) Dollars per Pound Atlanta Boise Chicago Dallas Denver Kansas City Louisville Memphis Miami Minneapolis New Orleans New York Phoenix Pittsburgh San Francisco Seatlle ~he company requested anonymity. 17

19 Compared to raw product and processing costs, the costs of hauling cheese are relatively low. Freight costs per pound range from 1 cent (minimum load charge) to about 9 cents. The latter cost, for shipments from California to Miami, reflects a distance of 3,100 miles. Using this freight cost matrix and the f.o.b. plant costs shown in table 6, we calculated the delivered cost of cheddar cheese at each consumption location. Table 8 shows these results in the form of a comparison between Wisconsin and the other four cheese-producing states. The table entries indicate whether Wisconsin or the comparison state has a lower delivered cost to the indicated consumption location. Table 8. Delivered Cost Advantage by State, Cheddar Cheese. Selected U.S. Cities Wisconsin Versus... City California New York Minnesota Texas Atlanta CA WI WI TX Boise CA WI MN TX Chicago CA WI WI TX Dallas CA WI WI TX Denver CA WI WI TX Kansas City CA WI MN TX Louisville CA WI WI TX Memphis CA WI WI TX Miami CA WI WI TX Minneapolis CA WI WI TX New Orleans CA WI WI TX New York CA NY WI TX Phoenix CA WI WI TX Pittsburgh CA WI WI TX San Francisco CA WI WI TX Seattle CA WI WI TX Table 8 is sobering for Wisconsin. While the state has a delivered cost advantage over Minnesota and New York to most locations, both California and Texas can ship block cheddar cheese to all of the cities at a lower total delivered cost than Wisconsin. The cost advantages of California and Texas are attributable entirely to lower cost of milk used to make cheese. Texas milk cost was specified to cost 75 cents per hundredweight less than Wisconsin. The spread for California was specified at $1.50 in favor of California. To explore the sensitivity of delivered cost advantage to milk cost, we calculated a breakeven milk cost difference for each location. Recall that Wisconsin has 18

20 lower cheese manufacturing costs than the other four states. Hence, at equal milk costs, Wisconsin would have a delivered cost advantage wherever the state possessed a freight cost advantage. The results of the breakeven analysis are shown in table 9. Again, the comparison is between Wisconsin and the other four states. The entries indicate the difference in milk cost between Wisconsin and the comparison state that would result in equal delivered cost of cheese at the consumption locations. For example, Wisconsin and California would have the same delivered cost of cheese at Atlanta if Wisconsin plants paid 51 cents per hundredweight more for milk than their California counterparts. To be competitive in Boise, Wisconsin plants would have to acquire milk at 18 cents per hundredweight less than California plants. Table 9. Breakeven Milk Cost: Difference in Cost of Milk Consistent with Equal Delivered Cheddar Cheese Costs, Selected U.S. Cities Wisconsin Milk Price Minus Price in..... City California New York Minnesota Texas Dollars per Hundredweight Atlanta Boise Chicago Dallas Denver Kansas City Louisville Memphis Miami Minneapolis New Orleans New York Phoenix Pittsburgh San Francisco Seattle Table 9 shows that, in most markets, Wisconsin can offset higher milk costs by its lower manufacturing costs and favorable geographical location. However, the breakeven milk cost difference is substantially less than the actual difference for Caljfornia and Texas. In other words, if Wisconsin plants continue to substantially 19

21 outpay plants in California and Texas, then these states will likely gain market share, at least in the short run. In the long run, differences in milk costs to cheese plants are likely to be closer to differences in milk production costs than currently. Consequently, it is instructive to examine cheese costs by state that correspond to costs of production. Table 10 uses the ERS full cost estimates to show that relationship. Table 10. Simulated Cost of Cheddar Cheese f.o.b. Plant, Milk Cost at Full Cost of Production State Wisconsin California Minnesota New York Texas Cost per Cwt. of Milk Milk' Mfg. Total $/Cwt $/Cwt $/Cwt Cost per Lb. of Cheese $/Lb , Priced at full cost of production (see Chart 2). With milk for cheddar cheese priced at its cost of production, the relative competitive position of Wisconsin is markedly improved. California shows only a 5 cents per pound advantage f.o.b. plant, an amount that would be offset by higher freight costs in most major population centers in the U.S. However, New York would have an advantage in most eastern markets. VIII. Conclusions and Implications The ultimate question is, how competitive is Wisconsin in the national market for cheddar cheese? The answer depends on how one measures competitiveness. Looking at the total simulated cost of cheddar cheese delivered to major U.S. consumption centers (milk cost, cheese manufacturing cost, and freight cost) from major producing states shows Wisconsin at a competitive disadvantage to California and Texas. Differences in the cost of milk to manufacturing plants are entirely responsible for this disadvantage, which is shared by Minnesota and New York. Mainly because 20

22 of excess capacity in manufacturing, competition for milk among cheese plants in Wisconsin, Minnesota, and New York is intense. Plants are attempting to operate near full capacity, with only a limited supply of milk to go around. This has led to plant pay prices well above the M-W price. Plant premiums have increased in general as milk production in these states has stabilized or declined, and were particularly large during the late 1989 milk shortage. In contrast, California uses a state pricing arrangement that permits cheesemakers a relatively large manufacturing margin (make allowance), causing milk costs for Golden State cheese plants to be substantially below the M-W price. Despite low prices for milk used for manufacturing, California dairy farmers have expanded milk production rapidly in the last ten years. Because of this expanding supply of milk, cheese plants have not been forced to pay the competitive premiums observed in Wisconsin, Minnesota, or New York. The cost of milk to Texas cheese plants is relatively low for different reasons. Until recently, Texas milk production was used primarily for 'fluid uses. High fluid utilization combined with a high fluid milk price administered under federal milk marketing orders resulted in relatively high blend prices at the same time that costs of production were falling in the Lone Star State. This elevated profitability and attracted resources into dairying. Cheese manufacturing capacity was expanded to absorb production not needed for fluid milk, since it was cheaper to process the milk in-state than to transport it to out-of-state manufacturers. At least initially, milk in excess of fluid needs represented more of a surplus disposal problem than a marketing opportunity. This has kept the cost of milk for cheese very close to minimum federal order price for Class III milk, the M-W price. Federal legislation in 1990 prohibits California from using a larger make allowance than what is used in federal dairy programs to set prices. But reducing the make allowance will elevate manufacturing milk prices, possibly giving even greater impetus to the rapid expansion in milk production if plants were willing to accept the added milk. Dairy cooperatives would likely "reblend" if forced to accept lower margins, keeping their milk costs at current levels despite a lower make allowance. These uncertainties made it hard to predict the outcome of a lower make allowance. In Texas, blend prices have been gradually reduced as fluid utilization has declined with expanded production. This, along with lower M-W prices in 1991, has 21

23 appeared to slow the upward trend in production. Texas cheese plants may soon face the problem of excess capacity, which could narrow the gap in milk costs between Texas and Wisconsin. With respect to the other components of delivered cheese cost, Wisconsin fares better. Wisconsin has lower cheddar cheese processing costs for comparable plant capacity than the other states studied. This is due to lower labor and utility charges. For example, labor costs in Wisconsin were estimated to be about $2.00 per hour (19 percent) lower than in California, and Wisconsin had a 26 percent advantage in natural gas rates. However, plant capacity in Wisconsin is the smallest among the study states, and manufacturing costs are very sensitive to plant scale. Wisconsin is well-situated with respect to major cheese consumption centers, especially relative to California and Texas. This along with large volumes of cheese shipments results in favorable freight costs. Low manufacturing and freight costs offset some of the competitive disadvantage associated with Wisconsin's high milk cost. But the cost of milk remains the key element in comparing competitiveness. To be competitive, the Wisconsin dairy industry must pay careful attention to administrative and legislative policies that serve to reduce the relative cost of milk used for cheese in other states. The ability to compete in the long run depends on the ability to produce milk at a cost no higher than competitors. On this score, Wisconsin appears to be in reasonably good shape at this time. To stay competitive in the future, Wisconsin dairy farmers need to consider the adoption of management practices that can profitably increase milk yield. They also need to maintain profitable herd sizes. This is not to say that more milk or more cows always means more money. It means that management and expansion decisions should be made with an eye toward the bottom line of the financial statement. 22