An important segment of milk marketing order reform involves replacing the current BFP. This working paper explains the background of the BFP issue, the options considered and the provisions of the proposed rule as related to the BFP issue.Marketing,

Anderson, David P.

Knutson, Ronald D.

Siebert, John W.

English

Research Papers in Economics

AFPC
AGRICULTURAL & FOOD POLICY CENTER
TEXAS A&M UNIVERSITY SYSTEM
Explanation of the Basic Formula Price Provisions
of the Proposed Rule
AFPC Working Paper 98-2
January 1998
Department of Agricultural Economics
Texas Agricultural Experiment Station
Texas Agricultural Extension Service
Texas A&M University
Web Site: http://AFPC1@TAMU.EDU A policy working paper is designed to provide economic
research on a timely basis.  It is an interim product of a larger
AFPC research project which will eventually be published as a
policy research report.  These results are published at this time
because they are believed to contain relevant information to the
resolution of current policy issues.  AFPC welcomes comments
and discussions of these results and their implications.  Address
such comments to the author(s) at:
Agricultural and Food Policy Center
Department of Agricultural Economics
Texas A&M University
College Station, Texas  77843-2124
or call 409-845-5913.  Explanation of the Basic Formula Price Provisions
of the Proposed Rule
AFPC Working Paper 98-2
Ronald D. Knutson
David P. Anderson
John W. Siebert
Agricultural and Food Policy Center
Department of Agricultural Economics
Texas Agricultural Experiment Station
Texas Agricultural Extension Service
Texas A&M University
January 1998
College Station, Texas  77843-2124
Telephone: (409) 845-5913
Web Site: http://AFPC1@TAMU.EDUBASIC FORMULA PRICE
Ronald D. Knutson, David P. Anderson and John W. Siebert
Introduction
Federal orders establish Class prices that are synchronized to move together with a market-
determined price referred to as the Basic Formula Price (BFP).  BFP has been utilized to set the
price of milk used for manufacturing and as a mover of the higher Class prices.  As such, it is a
key determinant of changes in producer prices.  To administer the price of milk in a manner that
creates neither surplus nor deficit conditions, it is necessary to have a price that is competitively
determined and allows all products to be sold.  That is, it needs to be determined by economic
forces that reflect both supply and demand conditions.  
Background 
Historically, the price of milk used for manufacturing was determined from the price paid
for Grade B milk by unregulated manufacturing plants located in Minnesota and Wisconsin,
often referred to as the M-W price.  As the volume of Grade B milk has continuously declined,
the use of the M-W price has become increasingly suspect (Table 1).  Currently, about 10
percent of the milk in Minnesota and Wisconsin is Grade B.
In 1995, as a temporary measure, USDA began determining the BFP by adjusting the M-W
price to current market conditions with the use of bulk commodity prices.  In the minds of some,
these product prices were unreliable in that they were not determined by competitive market
forces.  
Another issue is whether all milk used in manufacturing ought to be priced the same or if
separate prices should be established for milk used for cheese and for the combination of butter
and nonfat dry milk (NDM).  This is essentially an issue of whether there are to be three or four 2
Table 1.  Percent Grade B Production by State.
Year Minnesota Wisconsin
---------------Percent---------------
1970 71 46
1989 26 17
1995 8 11
Source: AMS/USDA, proposed rule. 
milk classes.  In 1992, the number of milk Classes was expanded from three to four.  Thus, the
BFP effectively sets the price of milk used to make cheese (Class III) while the price of milk
used to make NDM is set at a lower level (Class IIIA).  The precipitating factors leading to the
establishment of the fourth Class included:  
# The lower California state-regulated price for NDM.
# The higher costs of operating butter-powder plants which frequently operated at less
than full capacity as the residual use for milk because they performed the market
balancing function.  
The updated M-W (BFP) was installed as a temporary measure.  It was never intended that it be
used for an extended time period.  The updating process drew more attention to commodity
prices established by exchanges.  Questions arose as to whether these prices were competitively
established.  As a result, USDA began surveying transaction prices.3
BFP Alternatives
In seeking alternatives to the M-W price series, over 30 BFP options were analyzed.  These
analyses were conducted by the USDA Basic Formula Price Replacement Committee, by a
University BFP Study Committee, and many industry interests as reflected in comments received
by USDA.  
Most of these 30 options were rejected.  These fall into four categories which were rejected
for the following reasons:
# Competitive pay prices are prices of raw/producer milk is determined based on prices
paid in actual market transitions.  The M-W price was an example of a competitive pay
price.  In the absence of a viable supply of Grade B milk, all competitive pay price
options either were found to be highly influenced by Federal Orders or to be
competitively unreliable.  In addition, they tended to be either substantially higher or
lower than the current BFP.  
# Economic formulas utilize indicators of cost of production or economic models to set
the price of milk.  Cost of production models suffer from not giving adequate
consideration to demand conditions.  Economic models are complex, not transparent in
terms of how price is determined, and are often considered to be unreliable. 
# Futures markets have been developed for fluid milk on the Coffee, Sugar and Cocoa
Exchange and for the BFP on the Chicago Mercantile Exchange.  While futures markets
could hold long-run potential for pricing milk used for manufacturing, the volume of
trading has not always been sufficient to be reliable.  In addition, the resulting price4
” Butterfat price = (NASS AA butter survey price - 0.079) / 0.82 
” Protein price ((NASS block cheese survey price - 0.127) X 1.32) +
((((NASS block cheese survey price - 0.127) X 1.582) - butterfat price)
X 1.20)
” Other solids price = (NASS dry whey survey price - 0.10) / 0.968 
may, at times, reflect the demand for milk for fluid use rather than the demand for
manufacturing use.    
# Proposals were made not to set a BFP and to only pool the Class differentials.  The price
of milk for manufacturing uses would be completely unregulated.  USDA determined
that this option does not fulfill the requirements for classified pricing under the enabling
legislation for Federal Orders.
The Proposed BFP Rule
USDA proposes to establish two manufacturing product Classes.  It uses a component
system in pricing Class III milk used for cheese and a product formula in pricing Class IV milk
used for butter and NDM.  
Component pricing, used for Class III,  involves paying farmers based on the actual protein,
butterfat and other solids content of milk.  The component values are based on product prices. 
While a BFP is not calculated for pricing milk used for manufacturing, it can be derived for use
as a mover of higher Class prices. 
Class III prices protein, butterfat and other solids (whey).  All components are proposed to
be priced utilizing NASS/USDA product prices resulting from a survey of actual processor sales
transactions.  The rule proposes to subtract from the survey prices make allowances that are
based on cost analysis/surveys.  It then utilizes standard industry yield factors to derive a
butterfat, protein and other solids price.  The specific proposed formulas are:  
  5
 (NASS NDM survey price - 0.125) / 0.96)
For example, the butterfat component price subtracts from the NASS AA butter survey price a
make allowance of 7.9 cents per pound and divides this by 0.82, reflecting the fact that butter is
82 percent fat.  The 1.32 in the protein formula is the number of pounds of cheese made by 1
pound of protein.  
Product price formulas derive a manufacturing milk price from the product yields from 100
pounds of milk, multiplied by the related product prices and subtracting a cost of processing —
often referred to as a make allowance.  An acceptable product formula requires reliable product
prices and a make allowance. The Class IV product formula utilizes the same butterfat price as
for Class III:
The NDM price is established utilizing the NASS NDM survey price, a cost-based make
allowance of 12.5 cents and a recognition that NDM is 4 percent  moisture. 
Orders lacking an interest in component pricing can maintain a per cwt skim/butterfat
pricing system.  Four orders lacking significant cheese production have proposed not using
component pricing.  Prices are adjusted for somatic cell count in four orders.  
The Class II price is set as a fixed differential of $0.70 per cwt over the Class IV price. 
This reflects the cost of drying NDM and of reconstituting it for use in Class II products. 
Consequences of Proposed Rule
The proposed rule represents a viable system for the pricing of milk used for manufacturing. 
Therefore, it is a significant advancement over the current M-W based pricing system. 
However, in essence, the proposed rule effectively eliminates the BFP and substitutes a Class III6
and Class IV pricing system for setting prices for manufacturing and for moving higher Class
prices.
Component price provisions provide a more equitable payment system based on protein for
both producers and processors.  Over time, the result should be incentives to produce higher
protein milk to the benefit of consumers.
The prices generated track the current BFP quite closely, generally being within a few cents
per cwt.  Although the prices in Figures 1 and 2 appear to be a bit higher than those generated
under the current system, this may not be the case when they are implemented.  The survey
prices that are proposed will likely average lower than the spot market prices used here.  Survey
prices were not available over the period presented in Figures 1 and 2.7
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BFP Class III
Figure 1.  Proposed Class III Price Compared with BFP,
1994 - August 1997.
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BFP
Class IIIA
Class IV
Figure 2.  Proposed Class IV Price Compared with Class 
IIIA Price and BFP, 1994 - August 1997.Copies of this publication have been deposited with the Texas State Library in compliance with the State
Depository Law.
Mention of a trademark or a proprietary product does not constitute a guarantee or a warranty of the product by
The Texas Agricultural Experiment Station or The Texas Agricultural Extension Service and does not imply its
approval to the exclusion of other products that also may be suitable.
All programs and information of The Texas Agricultural Experiment Station or The Texas Agricultural Extension
Service are available to everyone without regard to race, color, religion, sex, age, handicap, or national origin. 

EXPLANATION OF THE BASIC FORMULA PRICE PROVISIONS OF THE PROPOSED RULE

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