Chapter 4

Prices and profitability in the supply chain

Farm gate prices

Differences between States/regions

4.1        Historically, the farm gate prices of drinking milk and manufacturing milk have been set differently, with drinking milk attracting a premium due to the increased costs associated with the production of milk year round to ensure continuous supply and the price for manufacturing milk, used in the production of manufactured dairy goods for both domestic and export consumption, set in accordance with movements in international commodity prices.[1]

Figure 4.1: Pre- and post-deregulation factory paid prices (cents/L)

Source: Dairy Australia, Australian Dairy Industry in Focus 2010, p.15.

4.2        In Tasmania, Victoria and South Australia, where milk produced is primarily destined for the manufacturing milk market and is export-focused, producers are more exposed to volatility in the farm gate price of milk. Traditionally, these same producers have tended to produce on a seasonal basis thus reducing their production input costs.

4.3        In contrast, producers in the states of Western Australia, Queensland and New South Wales, where the majority of milk produced is drinking milk for the domestic market, have been protected from the volatility of the export market. A premium price is also paid to producers in these areas to secure supply and to avoid high transport costs.[2] However, the required year round milk supply generally imposes higher production costs as supplementary inputs are sourced during the winter months.[3]

4.4        Another defining factor of dairy production in these regions is that the supply contracts are generally of longer duration given the processors' need to secure year round drinking milk supply. In May 2010 Dairy Australia noted that farmers supplying processors in NSW and Queensland were on two to three-year contracts.[4]

4.5        The strength of competition may also be another factor which causes divergences in farm gate prices across states. During the committee's previous dairy inquiry evidence was given that National Foods was offering farmers in New South Wales 44 cents per litre while only offering Tasmanian farmers 33 cents per litre. A Tasmanian expert gave the following explanation:

Senator MILNE—...Is there no logical explanation for this business of National Foods offering 44c in New South Wales compared with their offering down here?

Mr Smith—...It is the market that they are in there. It is not the costs of production...

Senator MILNE—So you think it is because there is competition in the marketplace in New South Wales [that prices there are higher].

Mr Smith—Yes.[5]

Trends in farm gate prices

4.6        Changes in farm gate prices over the past few financial years have been summarised as follows:

Farmgate milk prices reached record highs in 2007/08; and despite falling 15% during 2008/09, remained well above those of previous seasons. However the collapse in world dairy commodity prices during late-2008 saw a stepdown in milk prices during the second half of the 2008/09 season for the 75% of Australian dairy farmers who supply exporting companies. Consequently, the 2009/10 season opened with the lowest milk prices in a number of years. Nevertheless, prices improved strongly during the year to finish within 12% of the previous season.[6]

Table 4.1: Trends in typical factory paid prices

		2004–05	2005–06	2006–07	2007–08	2008–09	2009–10 (p)
NSW	Cents/litre	32.9	34.3	35.7	48.6	52.4	48.7
	$/kg MS*	4.62	4.80	5.02	6.73	7.29	6.72
VIC	Cents/litre	31.5	32.9	32.0	50.0	39.1	33.9
	$/kg MS	4.23	4.44	4.32	6.68	5.14	4.49
QLD	Cents/litre	35.0	36.6	38.8	51.8	57.2	55.8
	$/kg MS	4.84	4.99	5.38	7.14	7.89	7.57
SA	Cents/litre	30.1	32.0	32.6	48.6	44.6	34.6
	$/kg MS	4.19	4.49	4.57	6.75	6.19	4.73
WA	Cents/litre	27.3	29.1	32.4	41.4	49.0	42.4
	$/kg MS	3.91	4.12	4.55	5.80	6.77	5.96
TAS	Cents/litre	30.9	33.6	36.5	50.2	41.3	34.6
	$/kg MS	4.05	4.39	4.79	6.63	5.40	4.46
Australia	Cents/litre	31.5	33.1	33.2	49.6	42.4	37.3
	$/kg MS	4.28	4.50	4.51	6.68	5.66	4.98

* MS refers to milk solids.

Source: Dairy Australia, www.dairyaustralia.com.au/Our-Dairy-Industry/Industry-Statistics/Milk/Farmgate-Prices.aspx
(accessed 23 February 2011), originally sourced from dairy manufacturers.

Increasing divergence between state farm gate prices

4.7        As can be seen by Table 4.1 above, the farm gate prices in the regions that are focused on domestic drinking milk production have, over time, shifted away from the prices in the export states. For example, Queensland farm gate prices were 11 per cent above those in Victoria in 2004–05, but are estimated to be about 65 per cent more than Victorian prices in 2009–10. It is important to note that during this period factors such as the economic downturn caused by the global financial crisis had a significant effect on international prices, and therefore the farm gate prices in the exporting states. This clearly supports the argument that there are two distinct markets for drinking milk in Australia, and that the different characteristics and issues faced by each need to be considered individually.

Farmers' profitability

4.8        Income for dairy farmers has been decreasing in recent years. A survey of the financial performance of Australian dairy farms by ABARE found that average farm cash income for dairy industry farms fell from $129 300 per farm in 2007–08, to $88 000 per farm in 2008–09, and was estimated to fall to around $50 000 per farm for 2009–10. ABARE noted that, on a national level, this trend was as a result of lower farm gate prices, high purchases of fodder due to dry conditions and low availability of irrigation water and increased interest payments due to increased average debt.[7]

Figure 4.2: Farm cash income and farm business profit (average per farm)

Source: Australian Bureau of Agricultural and Resource Economics, Australian dairy: financial performance of Australian dairy farms, 2007–08 to 2009–10, June 2010, p. 3.

4.9        The Senate Select Committee on Agricultural and Related Industries examined dairy farm costs during its inquiry into food production:

ABARE data indicate that an average farm's total production costs would be approximately 38 cents per litre in 2008-09. National Foods however disputes this figure arguing that, based on its estimates, milk production costs would be around 35 cents per litre. The Tasmanian Department of Primary Industries estimated dairy farmers' costs of production at 42.3 cents per litre in 2007-08, 37.9 cents per litre in 2008-09 and 38.3 cents per litre in 2009-10.[8]

4.10      The costs faced by farmers differ between states and regions. The committee heard during its previous inquiry that costs are generally lower in Tasmania than in other regions.[9] Conversely, Queensland was acknowledged to be a less suitable area for dairy production, with the Queensland Dairyfarmers' Organisation noting that although Queensland farmers are paid more on average, this is countered by higher costs.

4.11      During this inquiry, the committee again heard evidence that the levels of profitability were low and precarious:

The ABARE farm survey exercises for 2009-10, said that the average farm profit in Queensland and northern New South Wales was 2c a litre for those farms. So if you took 2c a litre off those farm industry returns, there is the farm profit for that region.[10]

4.12      The nature of how farming investment decisions in the dairy industry are made was described to the committee:[11]

One of the other things, which we often miss with dairy farming, is that the time frames for business planning are so long...we were given some very strong price signals three years ago to grow business with incentives from all the milk companies to produce new milk. That led to a very large wave of investment and leveraging to do that because there were strong signals in all markets that milk was growing to say, ‘Here is additional money for you to produce more milk over and above the milk that you produced last year.’ Those investment decisions have three, five, 10 year turnaround times to get returns. On top of that the actual programming of decisions that we make with herd management and milk production in the short term have minimum 12-month turnarounds. But having no information that we can actually rely on it makes business development in this market next to impossible.[12]

4.13      Uncertainties in the dairy industry related to future prices and profitability could affect investment decisions made by farmers:

The current action instigated by Coles will further damage the confidence of the dairy industry and may have the added effect of reducing Australia's total milk production. Already, there are indications by some dairy farmers that they are not prepared to invest further funds in their farms and will exit the industry.[13]

Contracts between farmers and processors

4.14      The committee received helpful evidence about the contract arrangements between farmers and the major processors, notably those with National Foods and Parmalat.

4.15      The contracts between the major processors and farmers are usually for a few years in duration. National Foods advised that, typically, their contracts with farmers are for a minimum of one year, with a number of two and three year contracts also offered.[14] The contracts the processors have with the major supermarkets differ in duration; Woolworths advised that their contracts are for either 12 or 24 months, whereas Coles informed the committee that the majority of their contracts end in January 2014.[15] The interaction between the contracts the processors have with dairy farmers and those with the major supermarkets was explained by National Foods:

For farmers, the pressures arise because they must make investment decisions about the size and composition of their herds and the nature of their plant and equipment. Those decisions necessitate a longer term investment horizon and exposure to ongoing fixed costs. Consequently, farmers look to the processors to provide guaranteed cash flows over the farmers’ investment horizons. However, the processors are not able to commit to supply arrangements with farmers until the processors have finalised their contracts for house brand volumes with the supermarkets.[16]

4.16      After the merger of National Foods and Dairy Farmers in 2008, virtually all supermarket private label milk was provided by National Foods.[17] Since then other processors have gained contracts, such as Parmalat to supply Woolworths in Queensland.

4.17      Both National Foods and Parmalat utilise a multi-tier pricing structure in their contracts, however, the milk that is allocated to each tier, and the variation in the prices between each tier, differ. Clover Hill Dairies described how they supply National Foods, through the Dairy Farmers Milk Co-operative:

The current practice is for LNNF [Lion Nathan National Foods] to announce what is known as an Anticipated Full Demand (AFD) to DFMC. For DFMC to meet their obligations under the AFD system our regional dairy farmers are allocated milk allotments akin to quota and sell this milk to DFMC at an announced price. This milk price is known as Tier 1 milk. Farmer suppliers who produce above their allotment or do not hold an allotment receive a lower price which is currently close to 50% of the price of Tier 1 allotment milk. This milk is known as Tier 2 milk...A secondary processor to processor milk markets occurs for Tier 2 milk. There is no transparency at farmer level as to what Tier 2 milk is being sold to other processors for.[18]

4.18      In July 2010, the Dairy Farmers Milk Co-operative (DFMC) described the basis of the AFD and two-tier pricing model used by National Foods as follows:

The overarching requirement of the AFD is to maintain the appropriate milk price signals for All Year Supply and to align DFMC milk intake to the commercial needs of National Foods Limited (NFL) and its subsidiaries. As a consequence, every DFMC member has an annual allocation.

Each supplier has been provided with their annual allocated maximum volumes per month (either as a flat allocation which attracts a flat milk price or a variable allocation which attracts a variable milk price). These monthly maximum volumes represent the T1 price which is negotiated by DFMC with NFL. Supply over these allocated litres may attract T2 pricing.

Excess milk supplied above the regional AFD will be sold on the best economic return possible.[19]

4.19      Parmalat appears to essentially follow the pricing system in place prior to deregulation, which paid different prices for drinking milk and manufacturing milk, except for the drinking milk which goes into the supermarkets' private label products, which is bought at the lower manufacturing price. While Parmalat also utilise a two‑tier pricing system, unlike National Foods' model their tiers are linked to specific end products:[20]

There is a group of farmers in Queensland who actually have an arrangement with their company where they get a certain percentage of their cheque from branded sales and then other. With a reduction in branded sales those farmers are expecting to see a cut in part of their margin this year. We do believe that there may be an anomaly in that because of the drop in production in Queensland. So the cents per litre figure might not necessarily change, but the total volume of the branded sales will change. We hope to be able to verify that when we see the milk cheques.[21]

4.20      The differences between the National Foods and Parmalat arrangements were examined further:

Parmalat base theirs directly on the branded sale. Their tier 1 is just the branded sales, and that is why it varies from month to month. It will drop off if you have a bad month or a slow month. December is always low with Christmas, because they do not sell as much milk, and we expect significantly less. So that is directly related to sales. Tier 2 is less, but is not quite as low as the National Foods one.[22]

4.21      Under the National Foods model, and to some degree under the Parmalat contractual arrangements as well, it is clear that the full effects the retail price cuts will have on the prices offered to farmers will not be realised until their contracts      are renegotiated. National Foods hinted at what the future may bring:

...the nature of our procurement with our farmer base is through longer term contractual arrangements and the impact of a sustained discounting arrangement that is beneath what last year we were saying was an unsustainable price will only be fully felt by the suppliers that supply milk to us when those contractual arrangements fall due.[23]

Clarity of contracts

4.22      After its previous inquiry into competition and prices in the Australian dairy industry, the committee recommended that contracts with farmers should offer a clear, consistent formula for milk pricing with unambiguous conditions.[24]

4.23      In its submission to this inquiry, this recommendation was supported by the Queensland Dairyfarmers' Organisation who claimed there is a 'real need for greater transparency and comparability for dairy farmers with regard to contracts offered by processors'.[25] Farmers in areas such as Queensland, where separate major processors hold contracts for supply of private label milk to the major supermarkets, could particularly benefit from this.

Processors' profitability

4.24      The prices paid by the major supermarkets, and consequently the profits earned by the processors, are quite different for branded and generic milk. Dairy Farmers Milk Co-operative suggested that private label milk could have a significant effect on the profitability of a processor:

...when Dairy Farmers was about a $1.2 billion business, with a lot of products and a lot of milk in a lot of places, Parmalat was half the size and made equal if not more profit, and the simple reasoning was that they were not in private label milk. They were not in the game. That is the effect of being in this game. Of course there is a lot of milk for the processors. They have got a lot of milk and farmers in localities. They need throughput. They bid for this. Part of it is the processor fault. But it is just the exposure of the market to these two big players, and one of them now is abusing that game.[26]

4.25      Coles' submission claims that National Foods, Fonterra and Parmalat have announced profit margins higher than Coles.[27] Coles also suggested:

In terms of their overall margins, there is an assumption made that lowering the retail price automatically means that the farm-gate price will be put under pressure. Our view on that is that there are higher levels of profitability within those companies overall and they can look for alternatives to improve their overall efficiency, improve their innovation, improve their product development and look to other ways to make savings should they wish to protect the margin, or invest some of it in the dairy industry here. There are a number of different ways in which they can take action through their broader level of economic strength, rather than just simply taking the easy route of squeezing the dairy farmers.[28]

4.26      National Foods' submission provided information about their profit levels:

An EBIT this year of approximately $100 million provides a return on invested capital of approximately 2.5%, whereas the accepted cost of capital in Australia is around 10%. The book value for Kirin of National Foods’ business was written down by $832.3 million in 2010.

Kirin has a strong commitment to social responsibility and has a longer term focus for delivering acceptable shareholder returns. Indeed, patience has been required by Kirin who recently updated the market in Japan that there has been a significant deterioration in business conditions affecting National Foods.[29]

4.27      National Foods elaborated at their hearing, advising the committee that their margin on Coles and Woolworths' private label milk was close to zero, with their overall profitability on milk sales (generic milk plus National Foods' branded milk) being approximately two per cent.[30] National Foods also advised that they were making a loss on their private label contract with Coles prior to the wholesale price increase recently paid by Coles.[31]

4.28      Fonterra also objected to statements about the comparative profitability of milk processors:

It has been suggested that the processors who sit between the farmers and retailers are the ones who are making unreasonably high margins and taking value out of the system. Nothing could be further from the truth. Dairy processing is a capital intensive exercise and those in the industry struggle with seasonal conditions, price volatility, higher input and energy costs, higher safety and quality costs, and erosion of margin. Further, developing market leading dairy brands with consumer propositions around health, wellbeing, superior nutrition, taste and convenience, requires significant investment in research and development. Dairy processors in Australia make only a modest return on their invested capital and this may be a reason why Australian interests have sold dairy assets to foreign entities in recent years.[32]

4.29      Suppliers of the processors were also willing to recognise that milk processing companies are in a difficult operating environment:

Senator O’BRIEN—In the circumstances of New South Wales and Queensland markets, for example, they are already higher than Victoria and Tasmania. The point that I am raising with you is: is there a point below which the processor cannot go if the processor wants to keep a consistent supply of milk for processing?

Mr Phillips—There will be a challenge for them. If the retail price gets squeezed down, they will have to take it in their own margins. But since January there has not been any change in actual processing costs: the costs of buying the bottles, packaging and all that associated with production. So it is a drop in processor margins. Ultimately that will have to come back to a lower farm gate price. Given that ABARE said that the average profit for farmers in Queensland and northern New South Wales last year was 2c a litre, it does not take much of a price movement to see that farm gate profit disappear if there is a drop in farm gate prices. Then you either have a reduction in local production, and there is a question then about what actually happens to pricing in the longer term. That is one of the issues the industry have about the sustainability of the move. It may drop prices now but if we see a reduction in regional production in those areas, to get sustainable milk supplies in those volumes you are either going to have to move it from another region, with a lot of transport added in, or pay farmers higher prices. Neither of those are consistent with the dollar a litre retail price.[33]

[Coles] are going to use any excuse to extract value, and one of them is: ‘Everyone else is making more money than we are.’ They probably are, the price they paid. But I do not think National Foods is making a lot of money in dairy at the moment, and this will squeeze them further.[34]

Transparency of pricing information

4.30      The committee received evidence from a number of submissions and witnesses regarding the lack of transparency of pricing and other conditions throughout the dairy industry supply chain. This is likely to result in information asymmetry between participants in the industry which may affect contract negotiations.

4.31      Coles suggested:

While retail milk prices are available on shelf every day for everyone to see, there is a lack of transparency about what the multinational milk processing companies pay Australian dairy farmers at the farm gate.

Coles believes there should be greater transparency of farm gate pricing by the multinational milk processing companies so that everyone knows what is really going on. The multinational milk processing companies should not be able to sit between Australian dairy farmers and customers and protect their profit margins.[35]

4.32      National Foods were asked for their view on Coles' statement, with their Group Sustainability Director stating:

I do not know how to respond to that other than to say that we are being very transparent. We do not have a lot of margin to share. To the extent our margins are pressurised from to two to one to zero, there is not a lot to share with the farmers, but we recognise that the farmers need to have a sustainable business proposition as well. Other than that, I do not know how to respond to that, because I just disagree with it.[36]

4.33      In fact, it seems that information on farm gate prices is readily available (as demonstrated by Table 4.1). Murray Goulburn appears to issue a media release detailing changes to their farm gate prices when they are made. Dairy Australia collects and publishes both on their website and in regular publications farm gate prices by region. The availability of this information was mentioned to the committee:

Senator O’BRIEN—I am interested to know whether Dairy Australia can supply the committee with details of the sorts of prices that dairy farmers have been obtaining for their milk in the various states over the last two years. Are you able to supply us with that information?

Mr Phillips—That is public information. That is up on our website. We can provide that. It is in our Dairy in Focus publication, which has the farm gate price by state.[37]

4.34      Norco also advised that it publishes its farm gate prices each year, and pointed out:

The reality is that when farmers are investigating their options regarding which processor to supply they freely share other processors' prices between themselves.[38]

4.35      The apparent discrepancy in the transparency of the prices between the processor and the producers, compared to the retailers and the processors, was further discussed during Australian Dairy Farmers' appearance at a public hearing:

Senator COLBECK—...I wanted to make sure it was on the record that some of the arguments that are being used by Coles in this whole debate are pretty spurious. In their letter they talk about transparency in pricing. You gave some evidence that farm gate prices are on your website, so it is pretty easy to get information on farm gate prices. The real place where prices are hidden is, in fact, between the wholesaler and the retailer. That is where we have trouble getting a real understanding of what the numbers are. So where costs are really hidden is not at the farm gate; they are, in fact, hidden because of commercial-in-confidence reasons between the wholesaler and the retailer. Would that be correct?

Mr Drury—Yes.

Senator COLBECK—You do not have any sense of any of those numbers?

Mr Griffin—No, I am not aware of any. I have asked the question: is it commercial in confidence? That is the answer we get.

Senator COLBECK—So for Coles to claim that the lack of transparency is, in fact, at the farm gate is not necessarily the case.

Mr Griffin—That is right.[39]

4.36      The confidentiality agreements between retailers and processors and the resulting lack of transparency in their pricing was also noted by a number of other producer organisations, including the South Australian Dairyfarmers' Association, the DFMC and the Queensland Dairyfarmers' Organisation.[40]

4.37      This limits the ability of individuals and organisations to analyse pricing and related issues in the dairy industry:

Given that the company margins are confidential it is hard to be 100 per cent specific, but, in the work that we do in tracking it, there is probably between a 30c to 40c a litre difference in the margins for the processors between their branded product lines at the moment and what they sell to the supermarkets as house brands. If there is a significant shift to house brands then most of that milk is being sold at a significantly reduced margin and that just means that there has to be a drop-off in industry revenue somewhere that has got to be worked through.[41]

4.38      The Australian Bureau of Agricultural and Resource Economics and Sciences (ABARES) aims to 'provide professionally independent, world-class research, analysis and advice to inform decision-makers on current and future policy challenges affecting Australia's primary industries'.[42] However, their work in the dairy industry is also limited by key information being treated as commercial-in-confidence:

Senator MILNE—...You said that, in the work that you are doing on this issue, you are looking at the various factors, including farm gate prices. Have you done an analysis from the farm gate to the retail sector of the different margins? Is there a graph or an analysis of exactly what those margins in various states, for example?

Mr Morris—We at this stage only have the information up to the farm gate. In the submission that we provided to the committee, we provided some information on the costs of production for farmers, which is derived from our farm surveys and the price that is received at the farm gate. Unfortunately, there is not a lot of information that we can access at this stage, anyway, on the costs through the rest of the chain through to the retail sector. We would love to have that information, but unfortunately we do not.[43]

4.39      The committee noted in Milking it for all it’s worth that ‘it is not an easy matter to apportion the typical supermarket price of milk...between the costs and profit margins of the various players in the chain'.[44]  The report’s attempt to allocate the components of the retail price of milk from the information available to the committee resulted in a significant residual remaining.[45]

4.40      The evidence submitted to this inquiry has provided some insights into wholesale pricing at this point in time:

I have looked at the National Foods presentation and they are saying about 54 per cent of the wholesale price is the cost of milk. I think they have let us in the door there because no-one wants to talk about these things, but I know from the Dairy Farmers Milk Cooperative that the average milk price is probably about 54c or 55c. We are looking at a dollar offer price.[46]

4.41      The availability of pricing information in Australia may not be in line with other jurisdictions:

Information on wholesale and retail prices is more difficult to obtain. Unlike the United Kingdom where Dairy Co (the United Kingdom equivalent of Dairy Australia) regularly publishes the margins obtained along the supply chain, the prices received by processors in Australia remains a mystery.[47]

Impact on dairy farmers

4.42      The unclear pricing arrangements between processors and retailers may affect the ability of dairy farmers to collectively bargain effectively:

Mr Brokenshire—At the least I and my colleagues in the dairy industry would like access so we can see some transparency. Then I guess it is up to us to be able to drive our argument based on some knowledge...

Senator O’BRIEN—I suggest that, if you are involved in bargaining, these are the sorts of issues that dairy farmers ought to be bargaining about.

Mr Brokenshire—I totally agree, but there is one problem—they say, ‘We can’t give you that information,’ ‘We won’t give you that information,’ or, ‘We don’t have to give you that information.’ That is our dilemma. If we had that information, it would make it much easier for us to bargain. We are bargaining pretty much blind— seriously.[48]

4.43      The DFMC recommended that the government require the major supermarket chains to publish the contract terms and wholesale prices of their private label milk contracts with processors in each state.[49] The DFMC discussed this recommendation at a public hearing:

Senator RYAN—...I wanted to talk about your suggestion that you recommend the government require Coles, Woolworths, Aldi and Franklins chains to publish the contract terms and wholesale prices of their private label milk contracts with the processors in each state. I am not sure but is that required in any other sector that you are aware of?

Mr Zandstra—No, honestly I cannot say.

Senator RYAN—I was not sure whether you were drawing upon another idea for it.

Mr Zandstra—No. The issue here is that everyone is wondering: what really is the wholesale price? This revolves around Coles still selling this at a pretty tidy margin. We can imagine from the previous Tasmanian inquiry on the percentage margin that they said they had, and the amount of drop that they have had, and also the increase in the wholesale price, but I do not know where that line of margin is.[50]

4.44      The DFMC was also asked why the dairy industry should be singled out for transparency of contracts when this was not the case for other industries, including for suppliers of other grocery items:

...the reason this is happening in milk is that it is exposed to this sort of hold-up situation. It is a staple; it is sold every day; it is produced every day; there is a cold chain there—National Foods and others, say. Milk can easily be used for marketing reasons rather than value reasons and that is the issue here. We like to know what the value point is on the shelf, because it has clearly been used for marketing reasons here now. It is to generate traffic down to the back of the store and all these sorts of things and to get convenience trade. Pretty well, Coles have said they have forfeited their margin or are carrying the cost of this. Well what is that? Are they still there at margin? We can hardly say it is loss leading if we do find they are making some money on this—I clearly believe it is loss leading in certain areas. So we really have to know this relative to milk.[51]

4.45      Some submissions proposed that the government go further. Clover Hill Dairies suggested that the terms and conditions of contracts should be monitored, with onerous conditions removed, and that each processor must gain ACCC approval of their contract.[52]

Navigation: Previous Page | Contents | Next Page