Ms. Rebecca Johnson
U.S. General Accounting Office
441 G Street NW, Room 2T23
Washington, DC20548

Dear Ms. Johnson:

    The Food Marketing Institute appreciates the opportunity to provide input as you update GAO’s 1998 report on prices for fluid milk and the factors that influence the price of milk as moves from farm to the consumer. GAO/RCED-99-4, Oct. 8, 1998.    Specifically, you have asked us to review the 1998 Report and to identify factors that are no longer relevant, new factors that have arisen since the report and any revisions or updates that should be made.

    As you know, FMI and its members, our nations’ neighborhood supermarkets, are vitally concerned with the marketing of milk and other dairy products. The dominant influence on the marketing and pricing of milk has been and continues to be government regulation. Processing, packaging and distribution costs are, of course, also reflected in consumer prices. Since 1998 those costs have increased considerably. We have reviewed the 1998 Report and asked several of our members who are directly involved with milk marketing to review it as well. A summary of their input follows. Our comments follow the structure of the 1998 Report

Federal & State Policies Influence Milk Prices at the Farm

    Milk is probably the most highly regulated commodity in the supermarket. Federal and state support programs, marketing orders, compacts and a variety of other regulations artificially drive up the cost of milk. They also result in a disparity of prices between different regions of the country and among different types of dairy products. The Northeast Interstate Dairy Compact is an example. The Compact is designed to increase income on the farm in the six compact states. However, according to the International Dairy Foods Association, the Compact has cost New England consumers $131 million since its inception. The cost increases to publicly funded feeding programs exemplify the impact. The Food Stamp Program in the Northeast has seen an additional $12.2 million in costs as a result of the Compact and the Child & Adult Health Care Food Program has faced $987,000 in additional costs. The Compact has cost the Nutrition Program for the Elderly $416,000 and School Meals Programs have incurred additional costs of $1.9 million. Clearly, whatever the impact on farm income, consumers and taxpayers are paying for these federal and state programs to support the farmer.

    Additionally, it should be noted that subsequent to the 1998 report, the federal order has been changed (marketing order regions have shrunk from 33 to 16). This has resulted in fluid milk prices being less volatile. There is forward contracting now for all classes of milk, except Class I (fluid milk). The formula for Class I pricing of butterfat and the skim component has changed. Butterfat now stands on its own.

    The 1998 Report states on page 32 that some “contend” that state laws prohibiting below cost pricing result in higher milk prices. This is a fact, not a contention. What other impact could these laws have had? The intent of these laws is to raise prices and that is their result.

Services Provided by Dairy Cooperatives Affect the Price of Milk

    With the adoption of dairy reform in 2000, this area has experienced significant change since the 1998 Report was issued. First and foremost, the minimum price for milk is no longer based on the Minnesota and Wisconsin price. The price now is based on average prices paid for specific commodities that use milk. These commodities are cheese, butter, non-fat milk powder and other solids. To complicate matters further, some federal orders go even deeper basing part of the value of raw milk on the protein level. Protein is the main driver of cheese yields and thus price.

    Second, from month to month, either cheese or butter can impact the minimum price for fluid milk. Reform states that Class I fluid milk will be moved by the “HIGHER” of the Class III (cheese) or Class IV (butter/powder). Thus, additional factors exist now for fluid milk prices including the supply and market values for cheese, butter and powder.

    The services provided by cooperatives and the cost of these services can vary from area to area. Much depends on whether the area (state) is a milk surplus or deficit state. A milk deficit state will most likely have additional costs in their over-order premiums based on the need to balance milk throughout the year. Balancing includes the moving of milk out of state in heavy (cooler fall/winter months) months and supplementing from out of state when local supply is short (hot summer months). In net deficit states, the additional cost influence comes from the freight to get out of state milk in.

Wholesalers’ Processing, Packaging and Distribution Costs

    All the cost factors noted in the 1998 report relating to wholesaling and processing continue in place and continue to grow. These include labor costs, energy costs, rent and regulatory costs. Energy and fuel have a huge influence on the cost of distributing milk and not just from the obvious cost of fuel for the trucks used to distribute product and the utility costs of running plants. They also impact packaging cost because of the corresponding increases in the cost of plastic, which is derived from the fossil fuels. With plastic being used for the packaging of jugs (gallons, halves and now single serve bottles), the impact on packaging costs should not be overlooked.

    Skyrocketing energy costs in California and their impact on food and other consumer prices have received wide attention. But rising energy costs are not limited to the west coast. In New England natural gas prices have tripled in some areas and the increased costs for food processors and retail stores will be reflected in food prices, although retailers will persevere in their efforts to hold down prices in the face of rising costs. The just released January Consumer Price Index (CPI) numbers show that over the last year energy costs increased by 17.8 percent. During that same period the CPI for food at home increased by just 2.4 percent even though energy is a significant portion of our operating costs.   We believe improved efficiencies and productivity by retailers should be recognized as important factors in keeping consumer prices down

    We received one comment about the “cost-pie” on page 30. Obviously, most of the non-milk costs would be higher in 2001 dollars then they were in 1995. They also commented that the “cost-pie” does not reflect marketing costs from a processor perspective.

Retail Pricing

    While the discussion of retail pricing in the 1998 Report remains generally applicable, certain aspects need updating. For example, the Report states that the demand for milk is relatively price insensitive, but notes the belief by some that demand for milk was becoming more price sensitive. We believe that this trend toward increased price sensitivity may be evidenced by the fact that, as discussed below, supermarkets have lost market share of milk sales to lower priced formats.

    The discussion in the 1998 Report of “vertical” and “horizontal” pricing strategies is too simplistic. While the report notes that retailers may use a combination of strategies, it suggests that most retailers use one or the other; that is, prices are based either on their costs or on their competitions’ prices.   In reality, essentially all retailers use a combination of both strategies. They consider their costs, their marketplace and their marketing strategy in determining prices. It is not an either/or situation.

    The statement in the last paragraph on page 31 that “some retailers. . . charge different markups on various products sold in their stores while seeking an overall profit margin target. . .” is wrong. All supermarkets and, we believe most other types of food retailers as well, follow this practice.   This concept is crucial to understanding the supermarket industry. Supermarket companies merchandise each department and product category to attract the target customer mix and to achieve their overall margin goals.   

    This concept, known as category management, enables supermarket companies, which sell on average more than 30,000 items in each store, to view assortment and price strategically. Success is not measured by sales of individual items, but by the performance of groups of products. The goal is to maximize sales and profit for entire categories and, ultimately, for the store as a whole. The use of scanning data makes this process possible and it results in more informed decision-making and in item selection more geared toward customer needs.

    With this in mind it is understandable that milk prices vary by store format and category plan. For many years, retailers used milk as a loss leader to draw consumers into the store. Category management has led to major changes in the dairy case, often including abandonment of this practice. Category analyses show that consumers want a greater variety of dairy products, including soy, whole, skim, 1 percent and 2 percent milk. Demand is also increasing for smaller sizes and for flavors such as chocolate milk. Also, milk often is no longer a “destination” product that draws customers to stores. As a result loss leader pricing of milk has become less common.   

    In addition to the diversification of the dairy case, consumer demand for many other types of beverages is increasing sharply. As noted, retailer analyses of the beverage and dairy categories may show that low-priced gallons of milk no longer draw consumers into their stores. In today’s highly competitive market, consumers seeking low-cost milk can shop at limited assortment stores, warehouse clubs, supercenters and other discount formats that use an every-day-low-price (EDL) strategy. Conventional supermarkets may use other features and services to draw consumers into their stores.

    According to MilkPEP (milk processors education program) traditional supermarkets and convenience stores have seen a decline in percentage of milk gallon sales from 87.4% in 1998 to 85.0% in 1999. The increase in milk gallon sales is in warehouse clubs, mass merchandisers and others whose sales increased from 7.8% to 9.7%. According to a recent MilkPEP report, “Food stores are clearly losing market share to warehouse clubs and mass merchandisers. Share growth in mass merchandisers, warehouse clubs and the “all other channels” can be traced to gains in household penetration and an increase in purchase occasions. Penetration gains were observed across all sizes “While super centers account for only 9% of single serve milk this outlet was responsible for 23% of the segment’s growth in 1999. Similarly, the All Other Outlets (primarily military stores, home delivery, delis and dairy stores) was responsible for 27% of 1999 growth with only 10% of single serve sales.” MilkPEP goes on to say, “It is no coincidence that the two fastest growing outlets for milk, warehouse clubs and mass merchandisers, offer significantly lower prices. In fact, warehouse club prices are 52 center per gallon less than the all outlet average and 56 cents less than average supermarket price. Also, worth noting, the average price is lower in c-stores than the regular supermarkets.” MilkPEP also notes that sales volume does seem to track retail prices, with overall sales increasing when prices are lower.

    All of these developments must be taken into consideration when analyzing milk prices and price spreads: the increase in value added (with higher production and promotion costs) products; the reduction in sales of whole milk products; the increase in sales by lower priced retail formats which have generally not been included in the calculations for average retail milk prices; and the rapidly increasing costs of energy and labor for retailers. We believe that a better understanding of these factors will eliminate existing misconceptions about milk pricing and marketing.

Conclusion

    FMI is pleased to be able to provide these comments to GAO as you develop your update to the 1998 Report. We are in the process of completing a Backgrounder on food retailing that provides further insight into the nature of the industry and on some of the questions relevant to this study. I will forward it to you when it is completed in the next several weeks. We also look forward to seeing the updated data in the report and to providing you with any other information that we can. If you have any further questions, please feel free to contact me.

Sincerely,

George Green
Vice President
General Counsel