Fresh thinking needed on farmgate pricing mechanisms

Published 23 May 18

As the industry awaits the Government’s public consultation on mandatory contracts in the dairy industry, Patty Clayton, Senior Dairy Market Analyst, looks at how current pricing practices in the GB dairy industry stack up against the ideal.

A well-functioning supply chain should be agile, adaptable and aligned. It needs to be able to respond quickly to changes in supply and demand, flexible enough to accommodate longer term shifts in the market and sufficiently aligned to ensure all supply chain partners are working towards shared objectives.

To deliver this, supply contracts between farmer and milk buyer should include:

1. Appropriate price setting mechanisms

2. The correct frequency and lead time for price changes

3. A direction on volumes

Within the dairy industry, the current lack of trust, exclusivity of supply contracts and ineffective pricing mechanisms can create barriers to achieving these ideals. Other challenges that need to be overcome in the dairy industry include the perishability of raw milk and the time required on farm to effectively react to market signals.

The use of appropriate price setting mechanisms in contracts, however, could go some way to help improve trust and transparency. To do that, pricing mechanisms are likely to be rated against a checklist of features:

1. Transparent

a. Influencing factors clearly set out

b. Both parties know when and why prices will move

2. Value driven

a. Price accurately reflects the value of milk for end use

b. Price rewards any additional costs or efficiencies appropriately

3. Mutually beneficial

a. Benefits both parties and encourages right response to market signals

b. Agreed by both parties

c. Actions of one party are not detrimental to other parties in the contract

4. Risk and reward

a. Should reflect appropriate reward based on risk of both parties

Pricing mechanisms currently used in GB are often lacking in one or more of these features, as summarised in the table below.

 Ideal features of pricing mechanisms

At present a significant volume of milk is priced based on buyer discretion. This is a mechanism that falls short in a number of key areas. Balanced negotiations and relevant formula-based pricing can improve the position, although they are not always easy to achieve. Only when farmers have the ability to be an equal party to the buyer can pricing mechanisms be mutually beneficial and ensure that rewards are distributed in relation to risk.

The goal for the industry should be to use the consultation as an opportunity to share opinions on how milk contracts can be developed, ensuring they are fit for the future, and move the industry towards a more efficient and aligned supply chain.