Keith DeHaan, Ph.D.

Price discovery and determination of value is an important but very sensitive issue to beef producers. The fact that I am not an economist, I do not work directly in live cattle procurement or represent one of the big four packers may give very little credibility to my discussion on this topic. On the other hand, I have been richly blessed with the opportunity to work across all segments of the beef chain, including beef production prior to the plant, processing at the plant level, and downstream beyond the plant in markets closer to the consumer. From these experiences, the following comments are made.

I will begin with this statement: The beef and pork packing industry is still in a very unsatisfactory condition. There has been no trust formed to advance prices or take advantage of a mythical scarcity to corner the market. The cattle raisers are masters of the situation. That statement was by P.D. Armour in 1895, and it explains how things have not changed in the last 100 years.

Formula based pricing of finished cattle is not new; it has been used for years by several large cattle feeders. However, there has been a rash of different pricing mechanisms and arrangements between the packer and producers introduced in the last few years. The reasons for these are largely because of the economic climate but, also, many producers are fed up with the traditional live cattle market system. What is the packer’s viewpoint and attitude about those pricing mechanisms? They vary, but range from apathy and resistance to cooperation and creativity. The apathy and resistance are there for several reasons. It could be because those pricing mechanisms may not reflect that particular packer’s business or business needs.

Some of the new pricing mechanisms require a great deal of work. It is simple to take the weight of a group of animals, subtract the shrink, and write the check. But, when you have to go through gyrations to tie down individual value, it takes more clerical and plant logistical work. When there is cooperation between the packer and feeder, it is usually because of a win-win situation regardless of the extra work.

When pricing to value or formula pricing cattle, base price discovery generally involves either the USDA report or plant or company average sales on either a live or carcass basis. This can be broken out by region of the country (USDA reports) or by specific plants within a company. The major criticism of this price discovery mechanism is that it is still based on an average live or carcass price. And, the greater the number of cattle represented in this type of formula selling, the fewer cattle remain for use as discoverers of price.

Another mechanism for determination of base price is going beyond the carcass and into the box. This again can either be approached as a USDA report (Meat Price Report or Carlot Trade) or by a specific company or plant’s boxed beef cut-out reports. These give you a value for the carcass minus the drop credit (offal and hide). You get away from a the live average price by using this mechanism and you rely on the company’s ability to sell boxed beef. "Cut-out" is defined as the sum of the individual boxed beef item values. The USDA numbers should represent actual sales reported by packers; however, they have been criticized because of the few numbers they represent. When actual sales figures for boxed beef are used by a company, there is real difficulty in capturing all sales figures in a narrow window of time. There are so many different products selling in different markets and not all of the individual cuts are sold at the same time. So, some meat items are real sales values and some are estimated values.

But, is using what the packer gets paid for his products representative of "true value" and should that be used for price discovery? We keep hearing that true value is determined by the consumer. There are a lot of different profit centers between the packer and consumer attempting to determine value. There are food service purveyors, both in the hotel/ restaurant trade and institutional, wholesalers, retail chains, further processors and the export customer. One could follow sales of all products through these many different channels but it would be a massive task.

Another difficult part of determining value of cattle is that it is difficult to associate all sales back to an animal or group of animals. You can keep the integrity of a producer’s group of animals together through slaughter and into the coolers with no problem, but when they get onto the fabrication floor, they become parts. There you lose the integrity. When you lose integrity, you lose the ability to maintain identity for value purposes. Two ways to approach this difficulty are to (1) process a like-group all at one time and keep all the pertinent data such as yields and prices together, and; (2) sampling. Sampling is assuming a particular lot of cattle is representative of the entire day’s average of similar grading cattle. You can extend the sampling into the sales arena and pick out some cuts going to certain customers and assume those are representative of the entire lot.

To calculate a formulated value for the finished live animal, premiums and discounts are applied to the base price. There is a lot of criticism that the discounts are always higher than the premiums. This is true for one main reason. Bigger numbers (premiums or discounts) are always weighted by their likelihood of occurrence. The bigger the number, the lower probability that it will occur. For example a Yield Grade 4 or 5 discount always seems high; but, the percentage of it occurring is usually below 5%. Theoretically, premiums and discounts should be applied according to how the packer gets rewarded or punished in his market place.

The cowboy math psychology of a grid is "if grading of a producer’s mix of cattle equals the average plant grading, then the grid price usually is equal to the live or rail price of the cattle." In essence, a producer gets rewarded for producing cattle that are superior or punished if the cattle are inferior to the plant average.

How does a packer/processor advise cattle feeders that are contemplating selling cattle on value-based formulas? The first and most important advice is "know what you produce." If a producer does not know his cattle, the selling experience will be a crap-shoot. Secondly, know the formula you are selling on and the kind of cattle that the packer or processor wants. There are some formulas for some branded beef programs that reward lean cattle regardless of the amount of marbling. Others, such as those from our company primarily reward marbling. Formulas from our company will reward low yield grading cattle as well; but, not cattle that do not marble (Select or No Roll). Thirdly, keep the cattle uniform. This might require sorting into or out of the pen, the use of ultrasound equipment or keeping the ages similar.

The following include my experiences (in two separate companies) with value based marketing:

Consistency: The number one reason why I like value-based marketing formulas is because of improved consistency. Our data clearly shows us this. Consistency saves companies money. "Out" cattle (those that fall into the big discounts such as dark cutters and over and under weight carcasses) are expensive. The more inconsistent your product mix is, the more effort and expense required to sell the meat from those animals. Changeover on the fabrication floor between grades cost a lot of money. Returns or refunds, because you have products that did not meet your customer’s expectations, are expensive. It should not be surprising that inconsistency has been labeled as the beef industry’s Archilles heel.

Reduced financial risk on non-conformance: This goes along with consistency. If a packer is paying an average price for an entire pen and there are "out" cattle, the packer absorbs the financial loss. Value based formulas place this risk on the producer, not the packer. The tradeoff is that the packer may not get as much potential income by not taking as much risk. We all know that risk and reward are highly correlated.

Improved quality grades: Our experience is that quality grades improve. More specifically, the percentage of cattle in the upper two-thirds of the Choice quality grade are increased. We have not experienced an increase in percentage of cattle grading Prime, however.

Improved value: Our experience is that the value based formulas we have used have provided our company with fair return for premium investments. When our company offers a premium for whatever reason, we want a return on that investment. It is very important that those returns are there and we monitor them constantly.

I believe that our industry has come a long way on pricing cattle to value in spite of much criticism. But, there remains many improvements yet to be made. Moving beef out of the commodity arena may get rid of many of these criticisms and allow for greater understanding of value. There appears to be rapid evolution of beef processing and packing into more vertical integration along with more vertical or cooperative integration in the production of the animals, as well. It is well known that packers are removing profit centers down stream. Because of this evolution, there will be greater opportunity for more accurate value determinations. Also, there is greater information today and the ability to capture it electronically which should aid in value determinations. Greater sophistication in value determinations and changes occurring in the marketing of beef does mean that owners of beef cattle will need to become more astute marketers in areas they may not be accustomed to.