Chapter 1 Ireland s dairy processing industry today. 1. Introduction Dairy Production Dairy Processing structure and efficiency 25

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1 Chapter 1 Ireland s dairy processing industry today Page 1. Introduction Study objectives and background and methodology 1.2 Policy environment of the dairy industry 2. Dairy Production Introduction 2.2 Profile of the production sector 2.3 Issues that need to be addressed at production level 3. Dairy Processing structure and efficiency Profile of the processing sector 3.2 Processing structure and efficiency issues 3.3 Product mix of the Irish dairy processing sector 3.4 Changes to Ireland s product output mix over the last decade 4. The value-added by the processing sector Dairy industry turnover 4.2 How does Ireland s capital and R&D investment levels compare? 4.3 Economic value added (EVA) 4.4 Value-added issues 5. Marketing and distribution How does Ireland s export performance compare with its main competitors? 5.2 Inability to influence market prices of base products 5.3 Routes to market 5.4 EU intervention market support 5.5 Marketing and distribution issues 6. Summary of key messages from current industry status 51 assessment and international competitor comparisons 14

2 1. Introduction 1.1 Study objectives, background and methodology The Department of Agriculture & Food and Enterprise Ireland, in conjunction with the Irish dairy processing industry, commissioned Prospectus and Promar International to carry out a strategic study of the industry. The purpose of the study is to set out options and recommendations to achieve the optimum structure necessary to enable the Irish dairy processing Industry face future challenges. The study will also contribute to the elaboration of national policy for the sector over the coming years, in the context of increased international competition and developments in comparable dairy producing and exporting countries. The overall objectives of the strategic study are to: Examine the existing structure of the Irish dairy processing sector Identify market opportunities for dairy products Assess product options to exploit these opportunities Make recommendations on actions to improve the efficiency and long-term competitiveness of the industry The scope of the strategic study covers the structure and international competitiveness of the milk assembly, processing, manufacturing, marketing and distribution operations of the dairy processing sector in the Republic of Ireland. The scope of the study does not include a detailed analysis of the structure and comparative competitiveness of the primary production end of the food supply chain, but assesses the current context and operating environment of the Irish primary production sector, its impact on dairy processing, and the requirements for change or adjustment in light of the identified market opportunities. (A brief history and background to the current dairy industry in Ireland 2 is contained in Appendix 1.) The main geographical areas covered are the Republic of Ireland (hereafter, referred to as Ireland, unless otherwise stated) and a detailed analysis of Ireland s major competing dairy exporting countries Denmark, the Netherlands and New Zealand. The rationale for benchmarking Ireland against these countries is as follows: Ireland is recognised as a significant exporter of base dairy products 3 within Europe, exporting over 83% of its output, and if it wishes to continue to compete internationally, it will need to compete with the main exporting players of these products. Therefore, Ireland has been compared with New Zealand, arguably the leading base dairy product supplier globally. One of the key strategic options for the Irish industry is to increase its presence in Europe. Therefore, comparison is made with the industries in the Netherlands and Denmark, which are major traders in this market. Another strategic option available to the Irish industry is to develop more added value products. The Danish industry has pursued this strategy, and thus it is again relevant for comparison. Consideration was given to the benchmarking of other countries such as Germany and France. However it was felt that Denmark, the Netherlands and New Zealand best represent the competitive challenges to the Irish, and the opportunities that are available to the Irish industry in the future. (Appendix 2 contains overview profiles of the three benchmark countries Denmark, Netherlands and New Zealand.) Comparisons with countries, which export only small quantities of their total output are of only limited value, and have therefore, been excluded. The study examines the current position and potential future developments at EU and global level and assesses the implications for the Irish industry. It also examines the major current and potential markets for Irish produce. Details of the methodology and approach are included in Appendix 3. 2 Ireland throughout the report refers to the Republic of Ireland unless otherwise stated 3 Throughout the report we use the term base products to cover SMP, WMP, casein, whey powder, bulk cheese and butter unless otherwise stated 15

3 1.2 Policy environment of the dairy industry The external environment facing the Irish dairy industry is subject to many influences, including dairy policies arising from the CAP and WTO, global demand for dairy products reflecting growth in the world economy and changing tastes and preferences, domestic economy factors, and developments among international competitors and buyers, including changing ownership and industry structure. The main factors in the policy environment over the next decade are discussed in this section and include the WTO Doha trade round, and further reform of the CAP regime following Agenda 2000 and EU enlargement WTO and dairy policy The inclusion of dairying (and all agri-food) under the GATT/WTO trade regulations represented a policy development of enormous long-term consequence. Prior to the GATT Uruguay round implementation in 1995, the EU had total discretion over trade policy with regard to both tariffs (import levies) and export refunds. However, the GATT Uruguay round fundamentally changed this, with export refunds being reduced by 21% and 36% in volume and value terms, import tariffs being reduced on average by 36%, and special low import tariffs for specified and growing import volumes (the in-quota tariffs). While a great deal of focus has been on export refunds, the gradual reduction of import tariffs is arguably of even greater long-term consequence. Ultimately, the whole CAP support system comes to be undermined if imports from the much lower priced world market can flow into the EU as a result of steadily reducing tariffs. A fundamental underlying reason for the already agreed 15% intervention price reduction 2005/6-2007/8, and an option of further reductions to 2015 as discussed later, is the apparent necessity to adjust the CAP price support system to fit in with GATT/WTO trade agreements. In this context, the WTO trade round negotiations, and in particular, the negotiations on tariffs are vital in determining the future shape of EU dairy policy in terms of both the level of internal price support achievable, and the price and volume of import access and status of export refunds. Already, informal opening positions on tariffs have been adopted by the leading players and the course of this debate will do much to shape future global dairy policy EU dairy policy Dairy policy for the years up to 2007/8 has been agreed under the Berlin agreement as follows: Intervention prices unchanged to 2005, but reducing by 15% in three equal steps from 2005/6 to 2007/8 Direct payments rising in three equal steps from 2005/6 to 2007/8 Quota increases by 2.4% at EU level from commencement of Agenda 2000, with a flat rate increase of 1.5% to come in 2005/6 to 2007/8. While Agenda 2000 is likely to hold firm, there has been recent proposals by the EU Commission in its Mid Term Review in relation to bringing the 2005/6-2007/8 changes forward. In July 2002, the European Commission document Report on Milk Quotas provided a comprehensive review of dairy policy to date, and went on to outline a set of four policy options for the period beyond 2007/8, i.e. for the years 2008/9 to 2014/5. The results of a study of the consequences of implementing these options were outlined, including the estimated effect on milk product consumption, production, trade and prices, producer milk prices and the EU budget. The four policy options considered in the European Commission document for the period 2008/9 to 2014/5 are as follows: A: Status Quo: No policy change from final year of Agenda 2000, i.e. 2007/8 policy unchanged to 2014/2015. B: Repeat Agenda 2000: A further lowering of intervention prices by an average of 10% in three steps, combined with a 3% rise in quotas and a further increase in direct payments. C: A two-tier quota regime (A and C quota): The A quota would equate to the level of unsubsidised internal consumption, together with a more open unsubsidised C quota for exports, combined with the continuation of the Agenda 2000 direct payments at 2007/8 levels to 2014/15. D: Abandonment of Quotas: Quota abandonment from 2007/8, with a doubling of Agenda 2000 direct payments (decoupled). While this document launches an extended discussion on policy to 2015, one may already infer from it that Option B for the period is close to Commission thinking currently, not least because it may 16

4 fit well with the WTO trade round. However, there are some commentators who see this option as a step towards a longer-term move in the direction of Option D. This transition is predicted to be slow, and in response to increasing pressure from the WTO. Recent developments Under the mid term review of Agenda 2000 the European Commission is seeking deeper cuts in EU support prices during the period of The Commission has brought forward agenda 2000 proposals by one year from 2005 to This involves a 28% cut in the target price over five years starting from 2004 compared with a 17% cut over three years commencing in An increase in milk quota of 1% in 2007 and 2008 is proposed as well as compensation on the same basis as agenda 2000, at less than 60% of the price cuts, with the quota system being extended for a further six years to It is also proposed to tilt the intervention cuts more towards butter with intervention price cuts for butter of 7% per annum between 2004 and 2008, compared with SMP price cuts of 3.5% per annum. At the same time it is proposed that the automatic butter intervention would be stopped once purchases exceed 30,000 during the March August each year (there would be no intervention outside of the March August period) and be replaced with a tendering system. This would operate in a similar way to the existing scheme for SMP, where the current annual buying limit is 109,000T. The Commission has also published its proposals for WTO negotiations calling for improved market opening and reduction in trade distorting support commencing in 2006 for 6 years. The key elements of the proposals include: Opening markets for farm imports by cutting tariffs by an average of 36% Scaling back all forms of export subsidies by 45% Further cutting trade distorting domestic farm support by 55% EU enlargement The major issues are the size of quota for the applicants, the future dairy market balance of the 10 (ultimately 12), and food safety/hygiene issues. While Poland, especially, has a large dairy industry with much potential, the quota system and structural problems will constrain output. Also, the 75 million population of the 10 CEEC countries, together with increasing prosperity, will represent a growing market. The current negotiations between the applicant countries and the Commission highlighted the issue of dairy quotas. The Commission agreed a revised offer to the CEEC countries in Copenhagen, with increased quota allowances for all. Table 1 EU Enlargement Quota Allowances 000 tonnes Cyprus Czech Estonia Hngry Lith Latvia Malta Poland Slovakia Sloveni a Original offer CEEC requests Revised Add Source: Agra-Europe Dec 2002 Recent European Commission estimates 4 indicated that the 10 applicants might go from being net exporters of 2.3 million tonnes milk equivalent in 2001, to 1.3 million tonnes net importers in Despite this, competing exports, especially at the commodity end, from Poland and the Baltic States will continue. The intensity of competition will depend on the final agreement on quota size and the rate of growth in domestic demand. Overall, the 10 with quota constraints should not be a major threat in the short-term, and the major restructuring required, and growing domestic demand, could present opportunities for the Irish industry. Chapter 2 contains a more detailed assessment of the market opportunities within emerging EU markets. 4 Prospects for Agriculture in CEEB , EU Commission 17

5 2. Dairy production 2.1 Introduction The importance of the Irish dairy sector has long been recognised by successive Governments, who have been supportive in facilitating the development and expansion of the industry. State agencies such as the Department of Agriculture, Teagasc, Enterprise Ireland and Bord Bia work closely with the industry. In addition to the state agencies, the university sector, particularly UCC and UCD, have been important in advancing education and research in the dairy sector at both production and processing levels, and have been instrumental in developing a cadre of technically proficient talent to the industry. Irish dairy farmers are considered to be both technically competent and commercially focused, with major changes having taken place in the structure of the industry at production level Significantly, over the last five years, the percentage of farmers producing over 275,000 litres has risen from 10% to 15% of the total number of producers. This scale has facilitated increased investment at farm level, and the adoption of a more commercial focus. Ireland has enjoyed a comparative advantage in the production of milk within the EU This competitive advantage is due to the grass-based feeding system for its dairy herd. This is facilitated by the country s moderate climate, which makes it very suitable for grass production. The grass-based feeding system has been more cost efficient than the mainly grain-fed systems used in continental EU countries. The pasture-based feeding system also has the advantage of being able to be portrayed as a more natural production for dairy cows and milk production. Ireland has been able to build on this comparative advantage to develop an industry in which over 80% of its processed output is exported. However, dairy farmers are facing some significant challenges and issues at a structural level There is widespread concern about the future viability of dairy farming in a sector facing increasing costs, static or falling prices for their milk, and major restrictions on their ability to improve efficiencies by increasing scale and maximising production from their farm units. This is highlighted by the difficulties that are being encountered in attracting sufficient numbers of young farmers into the sector, and the constraints on the more progressive and efficient farmers to increase scale. This has been a result of a number of factors, including the restrictive nature of the quota system, an increase of 40% in industrial wages over the last decade widening the gap between industrial and agricultural incomes, and Ireland s cultural attachment to land ownership, resulting in uneconomic land prices that increases the costs of production and also acts as an expansion constraint for farmers. With the cost of hiring labour or farm relief also rising, it is likely that retaining and attracting dairy farmers will remain a challenge. There is a strong focus within Irish dairy farming on the price that is paid for milk, with considerable attention being paid to the annual milk price audit and monthly league tables. While the importance of the milk price is understandable, given the pressures on farm incomes, it can however inhibit longer term strategic planning for the industry as a whole. The dairy industry is critically dependent on its ability to produce products that are in demand and that are competitive on international markets. This requires continuous and significant investment aimed at improving the quality, attractiveness and value-added content of its products. It also requires an unrelenting focus on improving efficiency and productivity at every level of the production chain, from pasture to the product purchaser. An over concentration on the issue of current milk prices may detract from the need for medium to longer term strategic planning and investment. The Irish dairy processing sector faces international competitors who have adopted strategies of dramatically increasing their scale, and their levels of investment in R&D and in plant. Irish dairy farmers need the processing sector to be internationally competitive, and to increase the levels of returns it achieves for Irish dairy products. Going forward, it may be necessary to review and change the way in which milk production is organised in Ireland This would involve addressing issues such as changes in the scale of production, management of the location of the milk pool, and providing appropriate encouragement to the next generation of farmers. These changes are discussed in chapter 3. 18

6 2.2 Profile of the production sector The number of milk producers has continued to fall since 1984 There has been a continual reduction in the number of producers involved in milk production in Ireland since the introduction of the quota regime in 1984, when there were 68,000 dairy farmers. Over the last decade, the numbers have fallen by 50%, from 57,000 to, around just 28,000 in According to the Department of Agriculture projections, a similar rate of reduction during the next decade will result in a dairy industry containing 14,000 producers in The quota regime has also meant that the level of total milk deliveries has remained relatively constant over the last decade, reaching 5,338,000 tonnes in The level of milk deliveries in Ireland s main EU competitors Denmark and the Netherlands has also remained static due to the cap on production at 4,418,000 tonnes and 10,683,000 tonnes respectively, in In contrast, New Zealand, which does not have a cap on production restriction, increased the volume of milk deliveries from 1991 to 2001 by 74%, reaching 12,322,000 tonnes in As the number of producers has fallen, producer size has risen Since 1996, the percentage of total quota held by farmers with a quota under 180,000 litres has fallen from 51% to 34%, with a consequential rise from 49% to 66% in the percentage with a quota over 180,000 litres. The absolute number of farmers has also followed this trend, with the percentage of total producers with under 180,000 litres falling from 79% to 59%. While the number of producers has decreased significantly, the average quantity of milk deliveries by producers has consequently increased The average delivery by milk producers has risen from 76,000 litres in 1984 to 180,000 litres in The average number of cows per farm has increased by 89% over the last decade, from 24.2 in 1991 to 45.7 in Over the same time period, average milk yield has risen by only 14%, to 4,375 kg per annum in Figure 1 Distribution of dairy farmers by quota size 79% 59% 26% 12% 10% 15% Under 180,000 litres 180,000 litres to 275,000 litres Over 275,000 litres Source: Department of Agriculture and Food, However, while the scale of Irish producers has increased, the rate of this change is significantly slower than its EU competitors Ireland still has a relatively large number of small producers, and the average quota size for the country is 189 tonnes (40,000 gallons), compared to an average quota of 362 tonnes (77,000 gallons) in Northern Ireland. 19

7 In Denmark, a country with a milk production level of 4,418,000 tonnes in 2001, the number of dairy farmers has fallen from 20,000 in 1991 to 8,911 in 2001, while the average quota per farm has increased from 234 tonnes (50,000 gallons) in 1991 to around 500 tonnes (107,000 gallons) in 2001, an increase of 114%. Likewise, in the Netherlands, dairy farmer numbers have declined from around 47,000 in 1991 to about 28,000 in 2001, and the average quota size has increased from 234 tonnes (50,000 gallons) in 1991 to 394 tonnes (84,000 gallons) in The approaches and attitudes to quota policy and how quota is managed differ between countries. However, the practical effect of these policies and approaches has meant that in Northern Ireland, Denmark and the Netherlands, farmers have been able to substantially increase their quota size, while it remains quite difficult for Irish farmers to significantly increase their milk quota under the current management arrangements of the quota system. Figure 2 Number of dairy farmers ,000 46,977 38,557 37,122 35,027 32,850 35,383 31,650 29,467 29,071 27,926 28,174 20,000 14,685 14,741 14,673 14,362 13,861 12,282 11,371 10,568 9,767 13,892 8,911 Source: Eurostat, Ireland Netherlands Denmark New Zealand Concern has been expressed about the future viability of the smaller dairy farming enterprises, which are facing a price-cost squeeze Research by Boyle (2002) on the competitiveness of Irish agriculture, found that in relation to dairy farming, Ireland lacks the necessary scale to adequately remunerate owner labour and assets. Likewise, research by Teagasc (Hennessy 2001), suggests that dairy farmers are facing a price-cost squeeze. High rates of inflation will increase production costs, with fixed costs projected to rise by 15 to 20% impacting negatively on farm net margin. Thus, the Teagasc research indicates that farmers will have to respond by increasing efficiency, enlarging operations, or a combination of both. The same research goes on to analyse the impact of milk quota elimination on farms and estimate the level of production required to maintain living standards. It concludes that substantial expansion of production is required if farmers wish to maintain real incomes. For example, the typical farm supplying just under 80 tonnes in 1999 would need to increase production by 85% to 140% (by 68 tonnes to 112 tonnes) to maintain real income. Even at 200 tonnes, this is only at 40% of the average size of Danish dairy farmers. The seasonality of milk supply is a major feature of production in Ireland With the exception of liquid milk producers, Irish dairy farmers have continually adjusted the date of calving, so that through compact calving the total herd calves around the time of lowest milk production cost. While this maximises production cost efficiency from a grass-based production perspective, it also results in increasing supply levels in the peak months of March to June. The table below illustrates how seasonality has actually gradually disimproved over the decade. In 2001, the peak month production 20

8 (May), as measured by milk deliveries, was six times the lowest month s production (January). This ratio has gradually disimproved over the last decade, having gone as low as 4.7 in Table 2 Seasonality of milk supply ( 000 tonnes) Peak month milk deliveries Low month milk deliveries Peak to trough ratio Source: Department of Agriculture and Food (2002) Figure 3 Monthly deliveries of milk tonnes Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Source: Department of Agriculture and Food (2002) and CSO (2002) Ireland s main EU competitors do not have a seasonality problem Ireland s main EU competitors, Denmark and the Netherlands, have both managed to improve their peak to trough ratios, while Ireland s has gone in the other direction. It is also worth noting that milk supply in Northern Ireland is considerably less seasonal, indeed its peak to trough ratio has fallen from 1.7 in 1996 to 1.6 in Table 3 Peak to trough ratios Ireland Denmark Netherlands New Zealand n/a n/a Source: IDB, Eurostat, Dexel, (2002) This seasonality leads to poor capacity utilisation in the Irish processing sector, adding to the operating costs of processors Ireland s capacity utilisation (measured by 12 times peak month production as a percentage of current total production) has only registered a slight increase from 57.9% in 1986 to 60.8% in This compares to capacity utilisation levels of 92.3% for Denmark and 92.9% for the Netherlands, facilitated by their low peak trough ratios of 1.21 and

9 Seasonality also causes a mismatch between market need, which for many products is for fairly constant all year round supply Crucially, Ireland s seasonality also restricts the types of products that can be produced, and continues to act as a significant constraint on the Irish industry. If seasonality remains it will continue to constrict the ability to produce certain products that require year round milk supply. The opportunity and viability of altering the product mix to higher value products and, consequently, the ability to pay an additional premium to compensate somewhat for the increased production costs associated with off-peak milk, is discussed in chapter 3. The fat and protein levels of Irish milk is below that of its main competitors Both the fat and protein content of Irish milk has improved over the last decade. The average fat content of Irish milk has risen from 3.55% to 3.80%, while the average protein content has risen from 3.20% to 3.28%. However, as the table below illustrates, the constituent fat and protein levels in Irish milk are below not only the EU average, but also well below its competitors such as Denmark, Holland and New Zealand 5. Table 4 Protein and Fat Levels (2001) 2001 Ireland Denmark Netherlands New Zealand EU Average % Protein % Fat Source: Eurostat, ZMP National Statistics (2002) Lower fat and protein levels add to the costs of Irish processors, who have to process greater volumes of milk to obtain value ingredients Keane and Fingleton have developed a measure of competitiveness using cost per kg milk solids (% fat and % protein combined). Their research, set out in the table below, found that over the last decade, Ireland has become less competitive relative to its main EU competitors. For example, Ireland s production costs using this measure were 52% lower than Denmark in 1989, but this had fallen to only 34% lower by Table 5 Production cash costs ( per kg milk solids 6 ) Ireland Denmark Netherlands New Zealand Source: Keane 2002 (Derived from Boyle 2002) The dramatic rise in New Zealand production costs can be explained, in part, by exchange rate changes over the period. There is an inconsistency and variability of milk produced from grass-based production The predominance of grass-based production, and the seasonality of that production in Ireland, results in inconsistency and variability in the milk produced. This inhibits the processors as they attempt to meet the demands of their customers, and the market, for standard products all year round. The table below 5 The breed of cow used for milk production has an influence on the fat level. In the case of New Zealand they have predominantly gone for a Jersey breed or a cross breed of Jersey & Friesian) which produces a higher fat content level but at lower milk yield per cow than that obtained by Irish dairy farmers. The NZ industry works on milk solids payment system, where value is got from the % of protein and % of fat, but there is a discount applied for volume. This explains why the industry has moved towards a higher milk fat and lower volume cow. 6 Milk solids = % fat and % protein combined 22

10 illustrates the variance that exists in both protein and fat levels by comparing the months with the lowest and highest levels for 1991 and Table 6 Irish protein and fat levels (1991 vs 2001) 1991 % difference 2001 % difference Lowest monthly protein level % 3.02 Highest monthly protein level % Lowest monthly fat level % Highest monthly fat level Source: CSO (2002) 19.3% The table shows that over the last decade, Ireland has continued to have a difference of roughly 19% between peak and low months for both fat and protein. This compares with average variations of about 5% in Denmark and 8% in the Netherlands between peak and low months for fat and protein percentage. This difference would suggest that dairy processors in these two countries would have less variation in raw product than Ireland. This should in turn result in more uniform plant extraction rates, and lessens the need for seasonal adjustments to plants to optimise product yields. There has been erosion of Ireland s competitiveness in recent years The Irish climate, with its moderate winters, enables farmers to feed their cows on grassland pasture for an extended period, and to utilise silage from the peak grass-growing period as winter feed. This reduces the feed costs for Irish farmers in comparison to their main EU competitors. Teagasc estimates that over 80% of milk produced in Ireland, and almost all used in dairy products, is produced almost exclusively from grazed grass. Research by Boyle et al 7, on the competitiveness of Irish dairy farming, found that Ireland s cost advantage over seven other EU countries (Germany, France, Italy, Belgium, the Netherlands, Denmark and the UK), has gradually fallen over the period from 1989 to This loss of competitiveness is due in part to the introduction of maize subsidies and reductions in world grain prices, both of which favour non-grass based production. However, Ireland s high rate of inflation has also been a contributory factor. The table below provides data on simple cash costs of Irish producers, but also provides data on economic costs and costs measured as a percentage of output. Economic costs take into account noncash costs such as family labour, equity capital and owned land. Expressing costs as a percentage of output value takes into account the prices received for products sold, and thus factors in higher processing costs and poorer market returns (poorer product portfolio) due to seasonality and low and variable milk solids. Table 7 Irish milk production costs Milk production cash costs ( per 100 kgs milk) 15 (82) 16 (82) 18 (90) Milk production cash costs (as a % of output value) 52 (89) 61 (95) 66 (100) Milk production economic costs ( per 100 kgs milk) 31 (96) 37 (103) 37 (105) Milk production economic costs (as a % of output value) 111 (108) 139 (119) 140 (121) Source: Boyle et al. (2002), (Number in bracket is Ireland as a % of EU average) Ireland s cash costs per 100kgs of product volume have increased from being 82% of the average in 1989, to 90% at the end of the 1990s Measuring total economic costs per kg, Boyle found that Ireland s economic costs per 100kg milk have risen from 96% of the average in 1989 to 105% in Boyle suggests that measuring costs as a 7 The Competitiveness of Irish Agriculture Updated Edition 2002, Boyle, Brown & O Regan 23

11 percentage of output value is a more comprehensive overall measure of competitiveness. In an Irish dairying context, it reflects the idea that while milk production costs may be low relative to other EU countries, the seasonality and low milk solids content of milk results in high processing costs and poorer market returns. Using both cash costs and economic cost measures as a percentage of output value, Boyle again found that Ireland has become steadily less competitive relative to EU rivals over the 1990s, with cash costs rising from 89% of the EU average to 100%, and economic costs rising from 108% to 121% of the EU average. By analysing Ireland s costs relative to the other seven EU countries in Boyle s research (as indicated by the figures in brackets), it is clear that all measures indicate that Ireland has become less competitive over the decade. Given that dairy producers are likely to face continued price pressure, these rising production costs are now placing producers in a difficult position and one that must be addressed to ensure future viability. 2.3 Issues that need to be addressed at production level There is a need to ensure that there is a viable future for farmers who remain in dairying The average size of Irish dairy farms is considerably below that in competing countries. The price cost squeeze facing the production sector will accelerate the exodus from dairying, as the value of EU price supports are reduced in the coming years. While the processing sector needs to strive to improve the return it obtains for its output by increasing the value-added content of its products, the value of the increased returns achieved may not be sufficient for the future viability of many dairy farmers, given the strong competitive challenges in the international market place. To obtain a viable income from dairying in the future, farmers will have to respond by a combination of increasing efficiency and substantially enlarging their operations. This will be difficult to achieve in the absence of a radical change in policy on the management of the milk quotas, where currently only small increments in certain locations are available, and the relatively high cost of land. The seasonality of milk supply needs to be addressed Seasonality is a major issue facing the industry, but it is also one that has existed for a long period. How the industry deals with the country s seasonal milk production will determine, in large part, the type of products produced by the industry and the markets served. Addressing this issue will require cooperation between farmers and processors, and is likely to involve fundamental structural reform. If the industry does not address this issue, it must accept the consequences of the reduced number of opportunities available, and confine itself to products that are low in moisture and capable of storage. Improving fat and protein levels and consistency Ireland s low fat and protein levels, and the inconsistency of these levels throughout the year, act as significant disadvantages to the Irish dairy industry as a whole. While initiatives such as the campaign run by Teagasc, have resulted in an improvement over the last decade of 7% in fat content and 2.5% in protein content, Ireland remains well behind countries such as Denmark, Holland and New Zealand. The dairy industry needs to address this issue that many consider to be a fundamental weakness. While the low fat and protein levels add to processors costs, the inconsistency of these levels can cause problems when marketing and selling products. Fundamentally, when processors cannot produce a consistent product year round, they face major problems selling certain products where consistency of texture, flavour, functionality and year round supply are essential. Maintaining Ireland s competitiveness There are a number of factors that have reduced, and continue to reduce, Ireland s competitive advantage. These factors include the rate of farmer rationalisation and the relatively small scale of dairy farms, both of which are in contrast to Ireland s major competitors. The Irish industry is also facing severe price pressure due to poor market conditions, while also encountering rising costs of operations. 24

12 3. Dairy processing structure and efficiency 3.1 Profile of the processing sector Level of industry consolidation While the structure of the Irish dairy processing sector has changed considerably over the last decade, it remains fragmented in nature when compared to its major competitors At present, six companies process 80% of the milk pool of million tonnes, with this number rising to eight processing 90% of the milk pool. Data for 2001 gathered from processors for this study 8, indicate that the four largest processors account for 73% of sales, with the remaining nine processors accounting for just 27%. The pace of overall rationalisation in the Irish industry has been much slower than that of its competitors Despite the reduction in the number of processing companies and plants that has already occurred, the Irish dairy processing industry remains fragmented, and individual processors are of a considerably smaller scale than processors in competing countries such as Denmark, Holland and New Zealand. Evidence of the fragmented nature of the industry is illustrated by comparing the number of processors that account for 80% of the milk pool in these countries. Table 8 Number of companies processing 80% of the milk pool Year 2001 Ireland Denmark Netherlands New Zealand Number of companies processing 80% of the milk Source: Promar and Prospectus research In 2001, the four largest Irish processors handled 3.81 million tonnes of raw milk, compared to Arla s 3.97 million tonnes in Denmark, Friesland Coberco s 5.20 million tonnes, and Fonterra s 13.5 million tonnes during the same period. The consolidation within the Danish, Dutch and New Zealand dairy industries has been achieved through the adoption of deliberate strategies to create large-scale international dairy operations. Due to capped production, the European operators have looked to gain economies of scale through the construction of larger plants to replace smaller, older, less efficient sites. The recent announcement that Denmark s second largest co-operative, Hellevad Omegns, is to merge with Arla, will see Arla processing 91% of the country s total milk pool. In conjunction with this expansion of operations, the company has earmarked 9 plants for closure within the next two years, while at the same time upgrading existing plants to increase throughput and constructing higher capacity new facilities. Like the Danes, the Dutch have also consolidated their processing industry in recent years, resulting in the two major players, Friesland Coberco and Campina, accounting for 82% of all milk processed. These two players have presided over an industry that has seen the number of processing sites decline from 95 to 63 in the period between 1990 and Meanwhile, the consolidation of the New Zealand dairy industry has, in the main, been at a company, rather than a plant level. (The formation of Fonterra actually came from a base of 15 separate dairy cooperatives as recently as 1992.) This is due to the fact that New Zealand does not have constrained production systems, and new processing plants are generally built to process additional volumes of milk produced. This had led to the development of super-sites that process up to 15m litres of milk per day, that operate together with older, smaller plants. The relatively large number of processors in the Irish industry leads to duplication of effort, particularly of support services such as IT, human resources, finance and management, testing, product development and marketing, and inefficiencies in assembly and processing. 8 As part of this study, a detailed questionnaire was completed by 13 dairy processors representing the vast bulk of the milk processed in Ireland. The processors were Arrabawn, Carbery, Connacht Gold, Dairygold, Donegal, Glanbia, Kerry, Lakelands, Newmarket, North Cork, Town of Monaghan, Tipperary and Wexford 25

13 3.1.2 Plant product output volumes Apart from butter, the number of processing plants in Ireland has not changed very much since 1991 There is limited data available in relation to processing plants, but the table below provides an overview of how the number of processing plants has changed over the last decade. This data is based on information from various sources, including ICOS and data provided by processors for this study, thus it includes smaller plants producing limited quantities of some products. Table 9 Number of Irish processing plants, by product output Cheese Butter Powder Casein n/a n/a n/a 7 7 Source: ICOS, ZMP, Promar and Prospectus Research (2002) Average production in both cheese and butter plants has risen considerably over the last decade The most noticeable change in the main product plants has been the reduction in the number of butter plants, falling from 20 plants in 1991 to 11 plants currently, with butter production falling by just 8.6% during the same period. It is also worth noting that while the number of cheese plants has only risen from 9 to 10 over the last decade, production of cheese has risen by 67% in this period. While the number of companies processing the majority of the milk pool provides an indication of the level of concentration and the scale of individual companies that exists within an industry, it is also necessary to investigate other measures of scale. One such measure of scale is the average size of plants, as measured by the average annual production of each product by each plant. Changes in production are taken into account by determining the average plant output as measured by the average annual production for each plant. Table 10 Average output of plants - Ireland (average annual production 000 tonnes) /2 Cheese Butter Powder 9 (WMP & SMP) Casein Source: ICOS, ZMP, Promar and Prospectus Research (2002) A significant proportion of the increased average butter production per plant has occurred in the last three to four years, driven by the reduction in the number of plants from 15 to 11. Average cheese production has increased to 12,000 tonnes due to greater use of existing capacity. The figures for powder production are in stark contrast to cheese and butter, with average production falling from 17,200 tonnes in 1991 to just 9,900 tonnes in However, these powder production figures relate to SMP and WMP production only and do not take into account the use of these plants for the production of other products such as whey powder and fat filled milk powder (no official published production figures are available for these products). Using the data provided by processors for this study on the production of these other products it is clear that processors have switched to producing powders other than SMP and WMP. Indeed, when whey powder and fat filled milk powder production are included (using data from processors) the average output from powder plants is just under 19,000 tonnes per annum. The average production of casein has remained steady at just under 7,000 tonnes for the last number of years. 9 SMP and WMP only. As published industry data is not available for other products such as whey powder or fat filled milk powder, it is not possible to provide an accurate average output figure with these products included. As resul t the apparent drop in average powder output is deceptive, as it does not include whey or fat-filled powder from these plants. 26

14 It is necessary to look beyond average plant output and take into account the impact of large or small plants It is important to look beyond simple industry average outputs of individual products. The data on plant size supplied by processors for this study, provides a more detailed picture of the current structure of the industry. The table below illustrates the average output of the two largest plants, based on the data supplied by processors. Table 11 Largest Irish plants Butter Cheese Powder 4 (SMP & WMP) Casein Ireland - average output of the two largest plants ( 000 tonnes) Promar and Prospectus Research (2002) The respective plants accounted for 52% of the total butter production in 2001, 40% of the cheese, 36% of the total powder and 59% of total casein production. This suggests that there are already a number of plants within the country of comparable competitive scale. However, there are also some plants producing very small amounts of product. There are also certain product types where scale of production is not the critical factor, but rather product innovation and specialisation, and the ability to produce product output levels that are appropriate to meet the demand for their specific product or market niche. This is particularly true for the production of specialist cheeses and other high value-added products. Denmark has seen strong growth in the number of small specialist operators in parallel with the process of major consolidation of the industry, with one player processing 90% of milk. In the area of the production of commodity type products such as powder, bulk cheese and butter, however, the trend is for larger scale plants to achieve economies of scale and greater efficiency. In determining an appropriate future plant configuration for the industry in chapter 3, consideration is given to both the published data and the information provided by processors for this study, particularly in relation to the production of products such as whey powders and fat filled milk powders. The average output of Irish cheese plants is less than half that in the Netherlands The tables below provide the average plant size for cheese, butter and powder plants in Ireland, Denmark, the Netherlands and New Zealand. Table 12 Average plant size Cheese 000 tonnes Ireland Denmark Netherlands New Zealand n/a n/a n/a n/a 31.3 Source: ICOS, ZMP, IDB, Promar and Prospectus Research, (2002) The figures for average cheese plant size illustrate that while production output in Ireland has increased by 50% over the last decade, both Denmark and the Netherlands have increased by roughly double this, at 94% and 106% respectively. In absolute terms, Ireland, at an average of 12,000 tonnes per plant, is well behind the output levels of both the Netherlands (24,700 tonnes) and New Zealand (31,300 tonnes), although as indicated above, the largest Irish plants are similar in scale to these countries average plant output. While the figures 10 Excludes private dairy production 11 All data for the Netherlands for 1991 and 1994 actually refers to 1990 and 1995 respectively

15 appear to indicate a smaller scale exists in Denmark, a more detailed analysis suggests that this is not quite the case. Of the 62 Danish cheese plants that existed in 2001, The 14 largest plants accounted for 75% of cheese production, giving an average output of 17,000 tonnes for these plants, with the remaining 48 plants producing only 25% of the total cheese produced. An indication of the specialised nature of some of the smaller plants can be obtained from the fact that 18 Danish cheese plants produced less that 400 tonnes in While it is difficult to determine the scale of production for bulk cheeses in Ireland, the data suggests that Ireland currently has a smaller scale of bulk cheese production than its major competitors. In chapter 3, section 3.2, consideration is given to research by Teagasc on the efficiency of cheese production in Ireland along with other factors to consider in determining the most efficient scale for the Irish industry. The output from Irish butter plants is also considerably below that of their main competitors Table 13 Average plant size Butter 000 tonnes Ireland Denmark Netherlands New Zealand n/a n/a n/a n/a 35.2 Source: ICOS, ZMP, IDB, Promar and Prospectus Research (2002) The average Irish butter plant output, at 11,600 tonnes per plant, is well behind both the Netherlands at 21,700 tonnes and New Zealand at 35,200 tonnes. The average production per plant for Denmark of 5,700 tonnes is again misleading, given that 3 of the 30 butter plants account for 84% of the total butter production, with an average size of 12,941 tonnes for these three plants, but the largest being quoted as having a capacity of 50,000 tonnes. The figures for average powder plant output demonstrate that a gap exists between the plant product output levels in Ireland, and the plant product output levels in all three countries that Ireland has been benchmarked against Table 14 Average plant output Powder tonnes Ireland Denmark Netherlands New Zealand n/a n/a n/a n/a 69.6 Source: ICOS, ZMP, IDB, Promar and Prospectus Research (2002) The average powder (SMP and WMP only) production per plant in Ireland is just over half of Denmark and the Netherlands, and one seventh of New Zealand s. Although published data isn t available for whey powders in all countries, we have used the estimates available 17 to determine the average plant output including SMP, WMP and whey powders. In 2001, the average output of SMP, WMP and whey powder per plant in Ireland was 19,000 tonnes compared to 23,400 tonnes in Denmark, 35,900 tonnes in the Netherlands and 71,900 tonnes in New Zealand. The data above suggests that the current configuration 13 Excludes private dairy production 14 Average production of SMP and WMP only it is not possible to directly compare average production of all powders using official data as only published data on SMP and WMP is available in all countries Whey powder estimates: Irish data based on information provided by processors for this study and includes whey powder and fat filled milk powders, Danish data from FAOSTAT, Netherlands data from Productschap Zuivel, New Zealand data from Statistics New Zealand 28

16 of Irish processing plants fails to gain the economies of scale, such as reduced capital and labour costs, that are being achieved by its competitors. This is of particular importance in the production of base products such as butter, powder and bulk cheeses, where cost competitiveness is essential Efficiency of processors The downward price pressure facing commodity products over the medium to long term, is driving processors of these products to focus on scale and efficiency To compete effectively in commodity markets, the Irish industry will have to be cost competitive, and will need to obtain the benefits that are available from economies of scale. Scale will also be a key factor in enabling processors to meet the requirements of the buyers of commodity products for their suppliers to be able to supply large volumes. To achieve this scale will require significant capital investment and co - ordination between processors at an industry level, to avoid unnecessary duplication of effort and investment. While a more pragmatic approach has been adopted within the Irish industry over the last decade, with greater co-operation taking place between processors regarding cost management (for example, in the area of milk assembly), its fragmented structure and lack of scale still poses major challenges for the industry in the future. A number of processors have achieved progress in operating at outputs levels, which bring them advantages from economies of scale. However, there are still a relatively high number of processors producing small quantities of base products and these operators will find it increasingly difficult to survive unless they switch their activities to more specialised and valueadded products. Data provided by processors indicates that larger scale processors achieve higher margins While many factors influence the margins achieved by processors, the most important factors are the price paid for milk, the product mix of the processor, and the efficiency of the processor s production operations. While some exceptions exist, the data provided by processors for this study identifies a strong correlation between scale of the operation and margin achieved, with larger scale processors achieving higher margins. This is in line with conventional wisdom that suggests that increasing the scale of production results in greater efficiencies up to a certain optimal level, after which benefits gained are less than the additional costs incurred. Research by Teagasc 18, illustrated in the graph below, found that the greatest increases in efficiency for Irish processors came from moving from small to medium scale operations. The larger processors have the ability to produce larger quantities of product with improved efficiency that contributes to better margins. Figure 4 Plant scale and fixed costs for powder production Fixed costs Scale (tonnes/h) While some smaller processors are delivering higher margins, this is often linked to the production of higher margin products, rather than more efficient production. The link between scale and margins is made more difficult to determine due to the differing approaches and policies of co-ops and plcs. This difference is between providing returns through a higher milk price, or through increased profits that are either reinvested in the business or distributed to shareholders. A more detailed discussion of the need for scale in the context of the overall future direction of the Irish industry is included in Chapter O Callaghan et al, A Cost Model Approach to Capital Re-Investment Choices for Competitive Milk Powder Manufacture in Ireland,

17 3.1.4 Plant capacity utilisation In order to compare the efficiency of Irish processors with other countries, a number of measures have been used. Capacity utilisation provides an indication of how efficiently plant and equipment is utilised, while raw milk processed per employee captures the efficiency of employee input. It should be noted, however, that measures that rely on reported employee numbers must be used cautiously, given the potential distortions caused by part time employees, and the differences in time of year the data is gathered. Table 15 Capacity utilisation 19 (%) Ireland Denmark The Netherlands New Zealand n/a n/a Source: Derived from CSO data, Eurostat (2002) The capacity utilisation figures demonstrate the negative impact that seasonal milk supply has on the processing sector in both New Zealand and Ireland While difficult to quantify accurately, it is clear that there is a cost associated with lower capacity utilisation that is borne by the processors. Put simply, those with higher capacity utilisation levels are able to make their investment in plant and equipment work harder for them, and produce greater quantities of product. While Ireland s lower capacity utilisation enables processors to switch between products in response to short term market trends, it does put Ireland at a disadvantage relative to countries such as Denmark and the Netherlands, which continue to operate plants all year round at close to full capacity. To counter the advantage of those with higher capacity utilisation levels, those with lower levels need to have lower input costs and/or lower overhead processing costs (labour, energy, etc), and/or higher value yielding products, or a combination of all three. New Zealand has countered its lower utilisation levels by having significantly lower input costs, and going for plant scale to handle peak volumes and obtain economies of scale from larger plants. Ireland has also used lower input costs to help maintain competitiveness, but with increasing domestic cost pressures and a difficult trading environment, this approach will become harder to sustain going forward, and the processing sector will have to turn its attention to improving cost efficiencies, and improving the value-added content of its output. This will require some movement on addressing the low capacity utilisation levels Raw milk processed per employee Interpretation of the data on raw milk processed per employee, included in the table below, must take into account the potential discrepancies caused by the collection and make up of employee numbers in each country. However, given the increasing production and large scale of plants in New Zealand, it is not surprising that they consistently process larger volumes of milk per employee. The higher volumes of milk processed in the Netherlands is consistent with the fact that it has some of the largest plants in Europe. Thus, Ireland at 560 tonnes per employee in 2000, is only ahead of Denmark using this measure of efficiency. Given the level of consolidation that has occurred within the Danish industry in recent years, one would have expected a higher productivity but using official Danish figures for the number of employees in dairy processing the raw milk tonnage processed per employee is significantly below that of Irish employees. 19 The capacity utilisation measure used here is defined as (annual milk deliveries)/peak month production x 12 30

18 Table 16 Raw milk processed per employee (tonnes) Ireland Denmark 20 Netherlands New Zealand n/a n/a n/a N/a N/a N/a , , , , ,120 Source: CSO, Danmarks Statistik, Nederlandse Zuivel Organisatie (NZO), Statistics New Zealand, ZMP (2002) Role for smaller niche processors While much attention and focus is given to the larger players that dominate the dairy sector in countries such as Denmark and New Zealand, the smaller niche processors also play an important role in the industries of those countries. Examples of two processors that have succeeded through innovation and specialisation are included below. Tatua Dairy Co-operative While arguably operating in the shadow of Fonterra, this small 135 supplier co-op is one of New Zealand s dairy industry success stories. Established in 1914, in the past decade the company has paid a premium price to its shareholders for milk by processing it into high value dairy ingredients. Based in the Waikato, the historic home of the New Zealand dairy industry, the company has followed a technology-led approach to the manufacture of dairy ingredients from 100 million litres of shareholder s milk annually, and selling these to customers world-wide. 90% of all its manufactured goods are exported. Total annual company turnover in 2001 was 54m. The company states that its success is based around a customer and technology-led approach to generate new product solutions. These solutions see the company re-invest in NPD and research above the New Zealand dairy industry standards. Most of the products are sold through direct trading relationships between the company and its clients. Interestingly, this was also the case prior to the formation of Fonterra, when the New Zealand Dairy Board controlled the export of all dairy products. Thise Mejeri, Jutland Founded in 1988, this small niche player has created a market position through providing higher value branded consumer goods, including organic and Channel Island milk products. Based in the Northern part of Jutland, Thise Dairy markets a wide variety of dairy products through the large supermarket chains, including Irma in Copenhagen. The company is seen as an innovator, and has recently launched a number of new products using Channel Island (Jersey and Guernsey cow s milk). In addition to the Danish market, the company also exports goods to Sweden, France and the UK, having recently gaining a listing with Sainsbury s for its organic spreads under the supermarket s own-label. The success of Thise can be attributed to its commitment to innovation, and filling a market void left for niche products caused through the consolidation of the Danish dairy industry, driven in the main by Arla (MD Foods) Infant formula manufacturers Presence of international infant formula food manufacturers in the Irish market Over the last two decades, Ireland has become one of the world s leading producers of infant nutritionals. The presence in Ireland of some of the world s leading infant nutrition manufacturers Wyeth, Abbott and Numico provides an important outlet for milk powder. The recent investment of 88m by Abbott Ireland in its Cootehill facility, doubling its capacity, is a positive sign for the industry, and was achieved against 20 Full-time equivalents except 1991; excludes ice-cream plants

19 strong competition from other countries. Indeed, the success of the infant nutrition business in Ireland is an indication of the dairy processing sector s ability to produce the highest quality dairy products that meet the needs of demanding multinational organisations. An indication of the importance of this sector is provided by estimated labour and raw material costs of 226m per annum, with 840 people employed. Up to now, the infant formula manufacturers based in Ireland produced relatively basic products, a large proportion of which was exported outside the EU, with export refunds being important for their international competitiveness. However, in recent years and with increasing potential going forward, the enhancement and extension of these products provides excellent potential to increase the value of these products to the industry. There are also opportunities for processors to work in partnership with the infant formula manufacturers to provide enhanced ingredient solutions. For example, enriched or fortified ingredients to improve the nutrition, well-being and/or health of a wider range of consumers, from infants to the elderly. The spin-offs from these partnerships are not only increased value for the products they supply, but also open up opportunities for the processors to utilise the technologies and skills acquired, to identify other applications and demand niches for enriched ingredients. Recent announcements of significant major expansions in this sector augurs well for the continued expansion and increasing valueadded content of its output. 3.2 Processing structure and efficiency issues Aging plant in need of replacement in the medium term There has been ongoing investment by processors in plant since the last round of significant capital investment, supported by FEOGA funding, in the 1980s. However, there are indications that another round of major capital investment may be required to replace existing plant in the medium term. Over 70% of the processors surveyed as part of this study indicated that part of their current technology was either in need of upgrade, or only adequate for current needs. Some processors are already beginning to find it difficult to meet certain product specifications of their customers with existing equipment. Irish processors selling within EU markets will continue to face pressure from buyers for greater product customisation. Many processors are therefore, likely to need to invest in plant and equipment to hold onto their customers. A number of processors could well come under pressure to upgrade facilities and face difficulty securing and/or affording the funding necessary for the capital investment due to low profitability levels and cash reserves. Increasing costs and compliance requirements placed on processors to meet environmental, food safety and quality demands Processors are likely to continue to face increasing pressure from numerous sources to improve their quality assurance systems so that they will be able to meet the increasing levels of environmental and food safety standards. There are concerns not just about water and energy consumption, but also about effluent discharge and by-product management, in particular. This pressure is not only coming at an EU level through enforcement of existing regulations, but is also being driven down the food chain by consumers and retailers, bringing issues such as traceability to the forefront of the debate. The changes required to meet these environmental, quality and safety requirements will impose major costs on both producers and processors. While some processors have invested in these improvements on an on-going basis, it is likely that some processors will need to make significant investments, imposing a significant cost that will be difficult to absorb. In planning for the future, the Irish dairy industry must continue to be vigilant and to be more proactive in its approach to food safety, quality and environmental standards. There are great risks in this whole area and just one incident could cause significant damage to the entire food industry and the reputation of Ireland as a quality and safe supplier of food products. 32

20 3.3 Product mix of the Irish dairy processing sector Product sales values Fresh milk products, butter and cheese accounted for over 50% of total sales of the thirteen dairy processors in 2001 The table below is based on data supplied by processors, and shows the average sales turnover breakdown for the thirteen processors for the main product types in Table 17 Percentage of total sales turnover (2001) Product type % of total sales turnover Fresh milk products (liquid milk, cream, yoghurt) 17% Butter 19% Cheese 18% Casein 14% SMP 7% WMP 7% Whey powder 2% Whey protein 2% Other (e.g. unprocessed milk, whole & skim milk, choc 14% crumb, functional foods, lactose, alcohol etc) Source: Promar / Prospectus research There were significant variances in the market prices obtained by different processors for their products in 2001 Based on data supplied by processors, the following average prices were obtained for the main product types (excluding fresh products). Product type Table 18 Prices obtained for main product types (2001) Average price per tonne (domestic and export sales combined) Butter 3,030 Cheese 3,620 SMP 2,310 Casein 7,110 WMP 2,420 Whey powder 710 Whey protein 1,540 Source: Promar / Prospectus research There are a number of factors, which can influence the variances in the price achieved by different processors for the same product type. These include the level of product branding, product differentiation (properties, packaging, portions, etc.), the level of value-added to the base product, the proportion of domestic sales to export sales, the distribution channels used, the impact of seasonality (particularly, the time of year products are sold on markets), and the nature of the relationship between the processor and buyer Profitability The table below outlines the relative profitability of the main products. This table is based on gross margin data provided by processors as part of this study. It provides a broad picture of the relative profitability within Ireland s product mix. 33