How cost-of-production pricing sets the price of milk in Canada

Most prices in a grocery store are discovered: buyers and sellers meet, and a number comes out of the haggling. The price a Canadian dairy farmer receives for milk is different. It is calculated, once a year, through a process that starts with the account books of a few hundred farms and ends with a notice that takes effect on the first of February. Knowing how that calculation works explains a lot about the dairy debate, because both supporters and critics of supply management are really arguing about what goes into it.

This piece follows the process step by step, from the farm survey to the store shelf, and works through an illustrative example of the formula.

Step 1: measure what it costs to make 100 litres

The starting point is the annual cost of production survey run by the Canadian Dairy Commission, the federal Crown corporation set up under the Canadian Dairy Commission Act in the 1960s. The survey measures one thing: the on-farm cost of producing a hectolitre, which is 100 litres, of milk.

The sample is built to represent the country rather than any one province. According to the Commission's published process, at least 220 farms take part, drawn from four regions (the West, Ontario, Quebec and the Maritimes) and sorted by size within each region. Newfoundland and Labrador does not take part. Farms agree to stay in the survey for five years, and about a fifth of the sample is replaced each year. The very largest and very smallest farms in each region are left out of the draw, and two independent accounting firms collect and check the figures, one for the eastern provinces and one for the western ones.

Because the sample is designed for national accuracy, the Commission is clear that the survey cannot be split into reliable regional costs. A dairy farm in the Fraser Valley and one in the Eastern Townships face different feed, land and labour bills, but the price calculation uses one national number.

Step 2: decide which costs count

What goes into the cost figure matters as much as how it is measured. The survey groups costs into three families, then subtracts government payments that reduce the cost of making milk, such as the government share of crop and livestock insurance premiums.

Two exclusions stand out. The cost of buying quota is not included, so a farm that has borrowed heavily to buy production rights does not see that cost reflected in the price. And when a farm runs other businesses alongside the dairy herd, only the dairy side is counted.

The treatment of family labour is the part most often debated. Paying the farmer's own hours at an industrial wage is a deliberate choice: the price is meant to give efficient producers a fair return for their labour and investment, which is the language of the Commission's mandate. Critics argue that this builds a wage guarantee into the price of milk. Supporters reply that any business must cover the owner's time, or nobody would run one.

Step 3: weight, trim and standardize

Once the data arrive, each farm is weighted so that the sample reflects actual production in its region and size group. Farms whose results sit more than two standard deviations from the average are treated as outliers and removed. The result is a cost per hectolitre for the country as a whole, not a cost per farm.

That number is then converted to a standard milk composition (3.6 kilograms of butterfat and about 8.92 kilograms of solids non-fat per hectolitre) so that one year can be compared with another, regardless of whether cows happened to produce richer or leaner milk.

Step 4: bring old costs forward to the present

The survey has a timing problem. Costs are collected for one calendar year, used in pricing calculations the following autumn, and turned into a price change the February after that. From the first farm receipt to the new price, about 25 months pass.

To close that gap, the Commission indexes the survey result forward using Statistics Canada price indices for inputs such as dairy cattle feed, fertilizer, fuel, machinery repairs, electricity and hired labour, using readings from June to August. It also updates the return on equity and the management salary. The output is the indexed cost of production, usually shortened to iCOP.

Step 5: run the national pricing formula

The cost figure does not set the price on its own. Since the industry agreed on a national pricing formula, the annual adjustment has combined two measures with equal weight:

• 50 per cent of the year-over-year change in the indexed cost of production, plus
• 50 per cent of the year-over-year change in the Consumer Price Index.

The result is the percentage by which expected farm revenue should rise or fall. Notice what the formula uses: the change between years, not the level of cost. A farm sector whose costs sit well above the price will not catch up through the formula alone, and one whose costs have fallen will not see the full drop.

A worked example with illustrative numbers

Suppose the indexed cost of production goes from 100 to 103 between two years, a 3 per cent rise, while the Consumer Price Index goes from 100 to 102, a 2 per cent rise.

• Half of the cost change: 0.5 x 3% = 1.5%
• Half of the CPI change: 0.5 x 2% = 1.0%
• Formula result: 1.5% + 1.0% = 2.5%

Now apply that to an illustrative farm-gate price of 80 cents a litre. A 2.5 per cent increase adds 2 cents, taking the price to 82 cents. For an illustrative farm shipping 1 million litres a year, that is about $20,000 more revenue, before any change in the farm's own costs.

The real adjustments are usually of that order. The Commission's announcement for February 2023, for instance, was a 2.2 per cent increase, which it described as about 1.74 cents per litre.

Step 6: check for exceptional circumstances

The formula has a safety valve. Its result is tested against three criteria for exceptional circumstances: an unexpected event that the survey year did not capture, a gap of more than 5 percentage points between the changes in costs and in the CPI, or expected farm returns ending up more than 3.5 per cent above or below the indexed cost. If any criterion applies, industry groups (the farm organization, processors, retailers, restaurants and independent grocers) can ask to suspend the formula. The Commission's board then consults and decides.

The criteria do not change the price automatically. They open a discussion. The formula has been set aside in this way more than once, which shows how much the outcome can turn on judgment when costs move fast.

Step 7: from one percentage to many prices

The price adjustment is announced no later than November 1, together with the Commission's support price for butter. The Commission then works out what the percentage means for each class of milk. In Canada milk is sold to processors by what its components will become: drinking milk, yogurt and cream, cheese, butter and powders, and ingredients for further processing. Each class has its own prices for butterfat, protein and other solids.

The adjustment is applied to component prices in classes 1 to 4. Two exceptions are tied to world markets instead: milk components sold for animal feed, and the solids non-fat that go into butter and powder making. The regional milk pools review the new component prices in December, provincial authorities approve them, and they take effect on February 1. That gives buyers about three months' notice.

The support price for butter is the price at which the Commission buys and sells butter to even out seasonal swings, storing it when supply runs ahead of demand and releasing it when demand peaks around the holidays. Provinces also use it as a reference point for pricing industrial milk. The Commission used to set a support price for skim milk powder as well, but it stopped buying skim powder in 2017.

Step 8: what happens after the farm gate

Here the administered system ends. The Commission regulates the price farmers receive, not the price shoppers pay. Processors buy milk components at the set prices, turn them into products, and sell them to retailers and food service at prices set by negotiation and competition. Retail dairy prices are not regulated in Canada, with one exception: some provinces regulate the retail price of fluid milk.

Because farm milk is only part of what a shopper pays for cheese or yogurt, a 2 per cent farm increase rarely means a 2 per cent shelf increase. Packaging, transport, wages in the plant and the store, and retail margins all sit on top. For a broader look at how the quota and pricing pieces fit together, see the walk-through of how Canada's dairy quota system works, and for the arguments on each side, the milk supply management debate, explained. More pieces on the system are collected under dairy and supply management.

Why the details carry the argument

Most disputes about Canadian milk prices are really disputes about the inputs to this process. Leaving quota out of the cost base keeps the price from chasing quota values upward, but it also means the farmers with the heaviest quota debt are not covered by the formula. Valuing family hours at an industrial wage protects farm incomes, and it puts a floor under what processors pay. Blending costs with the CPI damps sudden jumps, though it also means farm prices can lag a sharp rise in feed or fuel for a year or more.

Anyone reading a price announcement can check it against the published survey results and formula on the Canadian Dairy Commission's pricing announcements page. The single most useful number to look for is the change in the indexed cost of production, because half of every farm price adjustment rides on it.