Know Your Costs of Production

The record milk prices of 2007 were nearly $7.00 per cwt higher than 2006 and were a welcome relief for every dairy producer. Class III futures indicate that 2008 will also provide producers with an opportunity to generate desirable profit margins. However, milk prices are only part of the profit equation. The cost of producing (COP) that milk is just as significant. Although cost of production varies from year to year and tends to be higher in high milk price years, the long term trends from different data sources indicate that the average five-year cost of production figures have increased by 60 cents to $1.00 per cwt over the past 15 years prior to 2007. The average milk price of those 5-year time periods has increased by approximately $1.25 per cwt. Then along came 2007, and everything changed. Cost of production increased nearly $2.00 per cwt from 2006 to 2007 and the rolling 5-year average which usually increased by 16-17 cents per year jumped over 60 cents per cwt. What does this mean? It emphasizes the need to know and monitor your cost of producing 100 pounds of milk.

Even with the $2.00 per cwt increase in production costs of 2007, producers still saw significant margins because of the $7.00 increase in milk price. However, milk prices are not projected to be nearly as strong this year as last and with production costs continuing to increase, it is imperative that the margins be closely monitored. A recent check of prices paid by a Pennsylvania dairy producer indicates that prices are continuing to rise. Feed and fuel costs for the 1st quarter of 2008 are 65 to 75 percent higher than the same period last year and 25 to 45 percent higher than the last quarter of 2007. Crop expenses including fertilizer, chemicals, custom machinery hire and in most areas land rent are also increasing. These will all translate into higher feed costs. A $1.50 drop in milk price and another $1.50 to $2.00 increase in cost of production will mean that many producers will be close to simply breaking even.

Let’s define cost of production. There are numerous methods to accomplish this and the results can be somewhat confusing. Anyone who has seen USDA figures for Pennsylvania knows what I am talking about. The total cost of producing milk in 2007 ranged from $24.00 to just under $28.00. That figure was $28.41 and $29.01 per cwt for the first two months of 2008, respectively. If this were truly the case, who in their right mind would continue to operate such a business? The COP figures include economic values for unpaid family labor, land use (at rental rates) and capital recovery costs for machinery and equipment (depreciation), as well as general farm overhead costs. There is no argument that some of these expenses should be included. But this method tends to distort the true COP in most operations. There is little doubt that our smaller herd size and traditional business model of own-all-do-all contribute to these high production costs, but let’s be real. How many businesses would continue to exist if their cost of production were continuously 7-10 dollars higher that the price they received for their product?

The Cornell Dairy Farm Business Analysis reports three separate COP figures for milk: operating cost, purchased input cost and total cost. The method uses a whole farm approach to calculating COP which adjusts the cost of production for non-milk income. All figures are calculated on an accrual basis, which adjusts COP for changes in inventories, accounts payable and accounts receivable. Operating cost includes all expenses except depreciation. Compensation for owner labor and management is also not included. The purchased input cost adds depreciation on machinery, equipment, and buildings to the operating cost. Finally, compensation for unpaid family labor, owner labor and management and a theoretical five percent return on equity capital are added to calculate the total cost of producing milk. Operating costs per cwt from a small sample of farms (63) increased from $11.87 in 2006 to $13.81 in 2007; purchased input cost per cwt. increased from $13.31 in 2006 to $15.16 in 2007; and total costs jumped from $15.06 to $17.05. These figures appear to be more representative than those published by USDA. However, we must point out that the average herd size of these 63 farms is considerably larger than the average Pennsylvania and New York dairy farm. This information provides a nice summary by which producers can benchmark COP on their farm from year to year.

However, producers may feel the need to benchmark these costs more often. In that case, an Excel spreadsheet is available for dairy producers who wish to calculate their cost of production on a more frequent basis. DairyCOP$ (cost of production spreadsheet) also uses the whole farm approach to calculating cost of production, and as with Cornell’s DFBS analysis, DairyCOP$ makes accrual adjustments. The program is set up to easily work with the standardized chart of accounts published by Dairy Alliance, but data from any accounting package can be easily entered. The program can be run monthly, quarterly, or annually, and it will calculate COP based on profitability (using depreciation) or cash flow (using principal payments). Monitoring COP on your farm using this tool will ensure that you have timely information on how your cost per cwt compares to your milk price. This information can be used to make shifts in management and marketing strategies. It is available on the Dairy Alliance website, www.dairyalliance.org, or you can obtain a copy by sending an email to bhilty@psu.edu.

There is little doubt that a major shift in the cost of producing milk has taken place and may continue for some time to come. Monitoring the COP for your dairy operation has always been important, but is even more so now.

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Bradley J. Hilty
Business and Information Management Specialist
Penn State Dairy Alliance,  a Penn State Cooperative Extension Initiative