Processing costs are a function of technology used, economic efficiency (with which the technology and production factors are applied), quality of factors and their prices. The shape of a typical long-term cost curve indicates that the scale of processing plant/enterprise can represent an important cost determinant. This section focuses on the sources and importance of the economies of scale, scope and capacity utilisation in the industry. Technological change, efficiency, factor quality and prices will be the subject matter of other sections.
2.1.2.1 Economies of scale
Economies of scale can be distinguished into the real and pecuniary. The real economies of scale are those associated with a reduction in physical quantity of inputs, raw materials, various types of labour
2 Technology and Technological Change in the Milk Processing Industry 10 and capital. Pecuniary economies are economies realised from paying lower prices for factors used in the production or higher prices received in the distribution of the product, e.g. due to bulk-buying by the firm as the size increases (Koutsoyiannis, 1980). The pecuniary economies may further be divided into effects associated with reduction of costs (e.g. lower risk and transaction costs incurred by banks) or may arise from ability to exert (or countervail) bargain power on product and factor markets.
The optimal size of milk processing capacity is a result of two conflicting forces: increasing returns to scale in processing and unit cost progression in raw milk assembly. The latter reflects the increase in the average distance from which farm milk needs to be delivered with the increase in the size of plant. The effect also depends on the density of milk production in the neighbourhood of the factory (more milk available in the proximity of processing capacity) and on the number of milk producers (having fewer but bigger farms limits transaction costs, saves time and shortens the distance milk needs to be transported). With the fragmented supply of farm milk the assembly costs may also be increased by the necessity to maintain the collection points where pre-bulking takes place to enable further transportation by tankers.3 Advanced road infrastructure, modern tankers and the use of computerised techniques to optimise the logistics of milk assembly can partly compensate for the adverse effects of fragmented farm structure (Pimpicki et al., 1999).
Milk processing itself reveals increasing returns to scale: unit costs of processing tend to be lower in bigger plants. Major sources of these returns include unit cost decreases in capital, and other cost components. Moreover, the larger the capacity, the greater is the scope for specialisation of both capital equipment and labour. Returns to scale in the industry are also associated with the increasing scope for (technically determined) superior techniques or better organisation of production process (management). An example is the substitution of manually for automatically operated machinery or methods of batch for flow production (e.g. in butter or cheese production). Typically, such a technology switch is not only conducive to the reduction of unit costs but also to better control of product quality and hence higher output prices.
The rate of unit cost decreases, however, has a diminishing character, which leads to a concept of a minimum efficient scale (MES) defined as the scale of which the doubling brings unit costs decrease lower than 5% (EU Commission, 1988). The following points provide more or less direct evidence of the importance of the economies of scale in milk processing.
Engineering cost analysis
One of the empirical methods used in industrial cost analysis is the engineering method. The method consists of studying the technical relationship between input and output levels using available engineering information (mainly technical parameters of machinery or experimental measurements in
3 Additional cost consequences associated with quality aspects will be considered in one of the later sections.
2 Technology and Technological Change in the Milk Processing Industry 11 functioning product-lines). These technical relationships obtained for a range of output levels are combined with the set of corresponding prices and then used to estimate production functions. For the case of the milk processing industry, results of such analysis have been published by the IfBML in Kiel,4 Germany, and the Agricultural University in Olsztyn,5 Poland. Selected results of these studies have been used here to arrive at the approximate magnitudes of cost saving resulting from the doubling of processing capacity for selected product lines (Table 2.1). The results suggest that the costs of a typical processing line (i.e. costs limited to product-specific departments of a factory) for butter, SMP and ripening cheese show substantial decreases within the range of sizes typical (or above that) of Polish milk processing plants. In most of considered cases these decreases exceed the trigger value of 5%.
Table 2.1. Changes in input intensity resulting from an increase in capacity size and improvement in capacity utilisation, selected product-lines (in %).
Material input Labour
Product Change in capacity
Electricity Water and
sewage Steam Skilled Unskilled Total Capital Capacity size effects
(1) Average for ‘older’ (Brehm, K.P and E.Krell, 1976) and ‘newer’ (Krell, E. and H. Wietbrauk, 1993) vintages of technology.
Increase from size ca. 2 to ca. 4.5 thousand tons per year for the ‘older’ and from 2.4 to 5.4 thousand tons per years for the ‘newer’
technologies (at 66% of capacity utilisation).
(2) For ‘older’ technology vintage (Brehm, K.P and E.Krell, 1976). Increase from size ca. 4 thousand tons of output per year to ca. 8 thousand tons per year (values for 66% capacity utilisation).
(3) For ‘older’ technologies (Behme, G. and H. Wietbrauk, 1975). Increase from size of ca. 16 thousand tons of output per year to ca. 31 thousand tons per year (values for 66% capacity utilisation).
(4) Average for 5 various technologies. Source: Brehm, K.P and E.Krell, (1976); Gornowicz, M. and T. Stachowski (1991); Krell, E. and H. Wietbrauk, (1993); Behme, G. and H. Wietbrauk, 1975 and author’s calculation.
Source: quoted above and author’s calculation.
The survivor technique evidence
The survivor technique to the analyse economies of scale is based on the Darwinian doctrine of the survival of the fittest. The doctrine implies that the firms with the lowest costs should survive through
4 See Behme and Wietbrauk (1975); Brehm and Krell (1975, 1976); Krell and Wieterbrauk (1993).
5 See Gornowicz (1983); Gornowicz and Stachowski (1991).
2 Technology and Technological Change in the Milk Processing Industry 12 time (Koutsoyannis, 1980). Evidence corresponding to the survival criterion is provided by the study of Traill and Gilpin (1998), who show that the milk industry is the most concentrated among the European food and drink industries: 2.13% of firms generate 55.6% of output. It is important to bear in mind that this study is concerned with the concentration of ownership structure (capital concentration), and not directly with the concentration of processing capacities.6 Hence the results may suggest importance of other than only technically determined size advantages in areas like R&D and marketing as well as pecuniary economies of scale. The latter may include the size-related possibility of control over market. The gains to firms involve not only the ‘improved’ private prices faced (higher output prices and lower factor prices) but may also contribute to a lower risk of output fluctuation, reduction in costs of over-capacities and a higher propensity to invest and hence the use of more efficient technologies.
Evidence from restructuring the East German milk processing industry
The restructuring of the milk processing industry in the East German states after the reunification of the country in 1989 provides unique, almost experimental, evidence on the importance of the economies of scale. The restructuring has been carried out with a high capital subsidy and in a relatively short time. On the basis of engineering studies, the IfBML has predicted that an optimal structure would require a reduction in the number of processing plants from the initial 264 units (with an average volume of milk processed equal to 30 Mio kg per year) to only 6 units (with an average capacity 1040 Mio kg milk per year) (Glöer, et al., 1997, and Hülsemeyer and Glöer, 1998). In reality the restructuring resulted in the reduction of the number of plants to 33 units (with a capacity of 180 Mio kg milk per year).
2.1.2.2 Economies of scope
The term economies of scope applies to a situation where the production of two or more products reduces costs or raises revenues compared to the position where each product is produced separately in similar quantities. As dairies vary in terms of product specialisation the question emerges of what are the sources of economies of scope in the industry. Several such potential sources can be listed.
First are the inherent complementarity relations among products. Second, a certain part of processing machinery is not specific to any of products, which means that in some situations reaping gains from economies of scale is possible by increasing the throughput of farm milk by widened range of final products. Third, relatively short shelf life of many dairy products, in combination with increasing demand for traceability and quality may limit the willingness of buyers to bulk the variety of products from several distanced producers. Fourth, the portfolio of products may play an important role in
6 See comprehensive discussion of the scale-effects gains due to the single market of EU in EU Commission
2 Technology and Technological Change in the Milk Processing Industry 13 coping with market risk – in periods characterised by enhanced price volatility (e.g. during economy liberalisation) tendency to lower specialisation may be observed. However, the actually observed product portfolios of firms may also reflect the lags in adjustment of product structure of output to new relative profitability, whereby presently less attractive product-lines are maintained merely due to the lengthy depreciation of fixed capital.
2.1.2.3 Capacity utilisation
The tendency to seasonality in farm milk production leads to swings in the seasonal volume of milk processed and under-utilisation of capacity.7 At the farm level the factors determining the degree of seasonality include feeding and calving patterns. In the countries with extensive low-cost production based on grass as a major feeding component the majority of calving takes place in spring: this leads to high seasonal swings in milk supply with peaks falling in summer, with downs in winter months.8 Moderate climate, greater share of feeding concentrates and incentive policy (winter milk bonuses) promote less seasonal milk supply. The seasonality does not affect all products to the same extent:
butter and SMP and to lesser extent ripening cheeses account for the major share of summer increases in the volume of processed milk. Effects of capacity utilisation on the unit cost are presented in Table 2.1. Magnitude of seasonality can be diminished by provision of financial incentives to farmers to change the calving pattern (reflection of the trade off between the increased processing costs and decreased milk production costs). These incentives (e.g. in the form of higher winter prices or another premium) must compensate for associated increases in feeding costs.
While the seasonality is an inherent cause of capacity under-utilisation and is difficult to avoid, there are other potential causes. In particular, under-utilisation may be a side effect of rapid unexpected changes in market conditions due to policy, or policy-neutral reasons, e.g. the transition-related shifts in the relative prices. Over-capacities in the ‘declining’ products may lead to the increased detected costs due to the increased fixed costs and decelerated rate of technological progress (diminished rate of replacement investment).