Outlook 2018: Cost of production analysis vital for dairy sector

Despite the milk price increases of 2017 and now the potential downturn of 2018, the dairy sector must become more focused on improving productivity and profitability fit for the highs and the lows of pricing, says Tony Evans, Andersons’ head of farm business consultancy.

During November, the milk price appeared to be approaching the top of the price curve, having passed the 30p/litre threshold.

However, it is clear that, over time, the real price paid for commodities reduces year on year, says Mr Evans. In real terms, farmers were receiving over 70p/litre in the mid-1970s, but just a third of that in 2016.

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“While immediate cash flow pressure is abating for many milk producers, any time at the top of this price curve needs to be utilised really well, as the volatility seen over the last decade is likely to remain a feature of the sector.”

A detailed analysis of costs of production (all costs) should be a prerequisite for all milk producers, says Mr Evans.

“Investments need to be reviewed to ensure they provide a genuine return on capital, in the region of 5-10%, while reducing costs of production. Target costs, pre-rent and finance, should be no more than 70%-75% of income.”

With the continued weakness of sterling, export opportunities are available for some processors, but there is a danger of cost/price inflation for those milk producers heavily reliant on purchased inputs, such as soya, fuel and fertiliser, he adds.

Risk management

Looking to the future, risk management should be a topic discussed by all businesses. “Futures markets and options are evolving, with Yew Tree Dairies, Müller Milk and Crediton Dairy leading the way for the milk processors,” says Mr Evans.

“Independent risk management systems are also emerging, such as Dairy Stabiliser and DairyVol. Producers in the UK should also take note of Glanbia’s world first of a five-year milk price guarantee in Ireland equivalent to 28p/litre, with the opportunity to offset this against feed prices.”

Mr Evans believes it will become more important to match supply and demand within the industry, both at home and worldwide, to reduce market volatility and provide a more stable platform for all participants, not least producers.

“The Organisation for Economic Co-operation and Development continues to suggest that demand will increase by approximately 2% a year for the next decade. The dairy industry needs to find a way of matching this, without exceeding the demand for milk and triggering the next downturn.

The UK dairy industry should prioritise building much stronger producer/processor relationships, says Mr Evans. These need genuine transparency and the sharing of risk and reward around individual factory or business models, to achieve sustainable long-term profitability.

More could be done to manage supply profiles by costs of production, in line with demand profiles, he says. For example, the recent AHDB report on systems found that 80% of GB farmers were operating all-year-round production systems.

“Current milk contracts encourage that, whereas it is clear that block calving usually delivers lower costs of production.

“Using technology such as chilling and cold stores to reduce the whole chain cost, rather than just thinking about the profit margin at each point of the chain in isolation, could also be very beneficial. Some smaller dairy businesses are doing this with their longer-term milk price contracts.”

Brexit

Brexit provides an opportunity for the dairy sector to reduce imports and increase exports if current exchange rates remain, says Mr Evans.

“We are not self-sufficient in dairy products and will benefit from a rise in demand as our population grows, and we can operate at lower costs compared to countries that have lower rainfall.

“That said, establishing Brexit certainty, whether positive or negative, will be helpful for most dairy businesses.

“Given that our government appears to pursue a cheap food policy, it might not be unreasonable to assume further trade liberalisation and therefore greater competition in the future.”

The industry needs to become significantly more proactive in adding value, promoting the many positive virtues of UK farm standards, animal welfare standards and food quality, building on positive moves by several processors to target added-value healthy products, says Mr Evans.