(This article was first published in the August 2010 edition of the Australian Dairy Farmer Magazine)
A recent posting on the email forum Ausdairy-L raised questions about the fairness of three year contracts for milk supply. Contracts are not new to the industry but they are unusual. In the past the majority of processors have opted for handshake agreements. Times are however changing. Ongoing reduction in milk supply has resulted increased competition for suppliers. Furthermore, the low prices of the past 18 months have prompted supplier transfers in numbers that we haven?t seen for a long time. Changing processors is a tricky issue for the industry but here is a view on what needs to be considered.
Why change?
Over the years I have come across many reasons why suppliers change factories. There is a lot of emotion in the process but by far the major reason is cold hard issue of milk price and income. One or two cents per litre can be a lot of money when cash flow is tight and average profit margins are low. The message here is that long term price and income premiums do exist in the industry but suppliers should take care to ensure that the premium is real and that it will result in an increase in profit margin.
Words of caution
Get a second opinion on income estimates
It is not unknown for milk income comparisons to be wrong. It may be in the fine print, or it may be a deliberate error, but it is important to check. Most factories will provide income comparisons to competitors and you should at least check with your existing factory to see if they agree that the competitor is paying more.
Look to the history of closing price!
Full year milk price and income estimates at the beginning of the season normally have no credibility unless they are associated with a defined contract. The history of milk price for the major processors in southeast Australia shows a much narrower price range than you will see at the start of the season (ie. when field officers are recruiting!).
Consider carefully changes in calving pattern and seasonal milk distribution
It is important not to get lured into the trap of chasing the higher income from off peak milk unless you understand the cost and risk implications. Off peak milk generally means more silage, hay and brought in feed ? and all the associated harvesting, labour, and infrastructure costs. Change your milk supply pattern because it makes you more profitable ? not because it will give you a higher income.
Other income factors
Here are a few other factors to consider when assessing income comparisons:
- Subsidised feed and other supplies: The cash flow and finance cost benefit of feed subsidies can be considerable as can be discounted store supplies. The smaller processors are less inclined to provide these subsidies although short term loans against the future milk cheque are not unknown.
- Vat finance: When I was a factory manager I hated this incentive. It was grossly unfair and generally of limited benefit in the cost of milk pick up. In addition transferring suppliers would just pay out the loan (and often get an equivalent benefit from their new factory). If however you have the benefit of vat finance or a subsidy then be sure to factor this in.
- Money up front: Some processors will pay a higher price early in the season. Where this is in the form of a better opening price or an early step up it is usually gamesmanship. Prices tend to come back into alignment by year end. There are however some payment schemes that offer a higher price up front as an alternative to step ups. This is usually under contract (see also below). Suppliers should be cautious in a rising external market where the price can be overtaken.
- Quality payments: If your milk quality is patchy then there can be a benefit in a different quality payment system. Smaller processors find it hard to monitor this issue properly and will often give suppliers the benefit of the doubt for the sake of keeping the peace. Larger processors are normally more rigid and there are some pretty severe penalties in some cases for very poor quality milk.
- Share deductions : Personally I don?t buy the argument that the cash deduction for shares is a negative income factor. Whilst there is a cash flow effect, my analysis suggests that the dividend returns over time are better than the bank finance cost of the shares. There is also the longer term potential for a windfall gain (as witnessed by Dairy Farmers shareholders two years ago). In my view the share deduction is comparatively small investment in the future of the industry with returns better than most superannuation funds(1)
Contract or no contract?
As a result of supplier transfers the two major changes to the payment systems of the past year have been ?loyalty payments? (no back paid step ups if you leave) and fixed term contracts. Loyalty payments are effectively a 12 month contract ? it gets very expensive to move if you are half way through the year and one or two back paid step ups are at risk. Likewise contracts of two or more years can have significant benefit but also significant penalty for early termination. These changes are however an inevitable consequence of the milk shortage and supply competition and, like it or not, they are here to stay.
There will be lots of fine print in contracts that will worry suppliers. If that is a real concern consult your solicitor. Most likely that will be unnecessary expense. It is not in the processors interests to make things complicated ? they just want certainty of supply. In most cases it will be the early termination clauses that need closest scrutiny.
The other area to note carefully is the price variation clauses. There is a big difference between a fixed price contract and one that is benchmarked to competitor pricing. You may be smart and be able to lock in a higher price than the industry but it is just as likely that you will be below the industry benchmark in a three year cycle. In my experience both parties are happier if the price moves with the dairy market and the rest of the industry ? although suppliers and processors do tend to enjoy opposite sides of the price roller coaster.
What else is at stake?
I won?t apologise for giving a plug to dairy co-operatives here and this won?t be news to those of you that have followed our on-line discussion. I have always been a fan of competition and a mix of processor alternatives but fundamentally the benchmark milk price is generally set by the dominant co-operative. This is true world wide ? much to the frustration of private processors who compete in the same product area. Support for dairy co-operatives is something of a religious issue. For those farmers who don?t subscribe to the faith, let me assure you that, on purely economic grounds, you should be very thankful that there are a good number farmers who do.
(1) Note that this is a comment about the Australian industry where share deductions are made each year and accumulate over time. Australian farmers are not required to pay a large up front share contribution proportional to their milk supply.