DEPARTMENT OF FOOD ECONOMICS
Discussion Paper Series
Economies of Scale and Dairy Product
Manufacturing Enterprises
by
Dr. Michael Keane
Agribusiness Discussion Paper No. 17
January 1998
Department of Food Economics
University College, Cork
Ireland
Economies of Scale and Irish Cheese Manufacture
Table of Contents
Abstract ...........................................................................................................................
Executive Summary ........................................................................................................
Economies of Scale and Dairy Processing - Introduction ..........................................
Economies of Scale - Theoretical Aspects.................................................................
Research on Economies of Scale and Irish Dairy Processing ....................................
Economies of Scale - Empirical Studies ...................................................................
The EU Cheese Industry .................................................................................................
The Irish Cheese Industry ...............................................................................................
Milk Collection Costs and Cheese Manufacturing Costs - Ireland.................................
Discussion and Conclusions ...........................................................................................
References.......................................................................................................................
1
Economies of Scale and Irish Cheese Manufacture
Economies of Scale and Dairy Product
Manufacturing Enterprises
Dr. Michael Keane
Abstract
This paper discusses the issue of economies of scale with particular
reference to Irish cheese manufacture. The economic engineering approach
is used to determine optimum size of cheese manufacturing plants while
taking into account milk collection costs. It was noted that results using this
approach provide for an optimum size which differs greatly from industry
structure in practice. It was speculated that broader industry and market
considerations, involving in particular the prospect of smaller firms obtaining
premia through product variety, may explain the difference.
2
Economies of Scale and Irish Cheese Manufacture
Executive Summary
This paper discusses the issue of economies of scale in relation to Irish and
E.U. cheese manufacture. Theoretical aspects of economies of scale are
discussed and linked to dairy industry economics. It is suggested that the
study of economies of scale in dairy processing plants should be combined
with the effect of scale on milk collection costs in order to determine optimum
scale. The evolution of the E.U. and Irish cheese industry is discussed as well
as past economies of scale studies involving the Irish dairy industry. Detailed
information on milk collection costs was obtained to determine the
relationship between collection costs and distance from processing plant.
Using the economic engineering approach detailed information on cheese
manufacturing costs was also obtained with emphasis on the relationship
between size of plant and unit manufacturing costs. The information on milk
collection and cheese manufacturing cost was combined to determine the
optimum plant size. It was concluded using this approach that there were
considerable economies of scale in cheese manufacture, a result which was
quite similar to that obtained in a similar study in Germany. However it was
noted that this result was widely at variance with E.U. cheese industry
structure in practice. It was concluded that rigid adherence to the economic
engineering approach may be inappropriate in an industry such as the
cheese industry in determining economies of scale. Broader industry and
market considerations, involving in particular the prospect of small
enterprises obtaining premia in the market through product differentiation and
also X-efficiency, may be important factors in explaining the difference
between economic theory and industry practice.
Economies of Scale and Dairy Processing
3
Economies of Scale and Irish Cheese Manufacture
Introduction
The determination of the optimum size of enterprise is a complex issue
involving many considerations. These include the extent of economies of
scale in the activity in which the enterprise is involved and a range of
competitive aspects related to the business environment in which the
enterprise operates. As summarised by Porter (1979) the latter include:
-
Jockeying for position among current competitors in the industry
-
The bargaining power of customers
-
The bargaining power of suppliers
-
The threat of new entrants
-
The threat of substitute products or services
This paper concentrates on one aspect of the determination of optimum size,
the extent of economies of scale at manufacturing plant level in dairy
processing.
Economies of Scale – Theoretical Aspects
The existence of economies of scale depends on the characteristics of the
production function pertaining to different industries. This can be written as y
= Y(K,L) in which y = the level of output per unit time, K = the amount of
capital per unit time, L = the amount of labour per unit time. There are
increasing economies of scale when increasing K and L each by the constant
proportion a will result in a more than proportional increase in y:
k
a y = f(a K, aL).
4
Economies of Scale and Irish Cheese Manufacture
with K > 1. Many reasons may be cited for lower long term average costs at
a greater output, Hay and Morris, (1991);
(a)
the division of labour
(b)
indivisible equipment and the principle of multiples
(c)
three dimensional equipment and the relationship between surface
area and capacity
(d)
the economies of massed reserves
(e)
dynamic economies through learning processes
(f)
technological development and scale
Additional economies of scale at the level of the firm involve such factors as
research and development, management, advertising, computer services,
and centralised accounting, Hay and Morris (1991). Further economies of
scale, realised when costs are reduced by producing two or more products
jointly, rather than in separate specialised plants, are also relevant,
particularly in a multiproduct industry such as the dairy industry. Scherer
(1990). Also, large diversified firms “can make their purchasing power felt in
dealing with specialised suppliers (and) financial groups may be better able to
overcome the imperfections of the capital market”, de Jong (1988).
Diseconomies of scale may also exist beyond a certain size, connected with
such factors as increasing problems of information and co-ordination, and
problems of budgetary control. To quote de Jong (1988), “such firms risk
becoming overly bureaucratic so that technological scale advantages are
outweighed by administrative and organisation inefficiencies.
Internal
inefficiency may hamper company performance”. Broader competitive forces
involving, for example, the market power of buyers and suppliers, are also
relevant.
Economists express economies of scale in terms of unit cost curves. Studies
of cost curves in many industries have found a downward sloping short-term
cost curve, as fixed costs can be spread over a larger number of units as
output increases; however if output expansion approaches capacity limits,
the cost curve will bend sharply upwards. The long term average cost curve
is generally found to be more L shaped then U shaped, indicating that beyond
5
Economies of Scale and Irish Cheese Manufacture
a zone of decreasing unit costs, average and marginal long-term unit costs
remain constant, de Jong (1988). In a discussion of cost curves in the long
run, Hay and Morris (1991) point out many of the difficulties in empirical work,
including different depreciation conventions, the difficulty of distinguishing
monopoly profit and differences in cost assignment and rent imputation.
The issue of economies of scale in dairy processing is regularly discussed
internationally, with Krell and Wietbrauk (1993), Caraveli and Traill (1997),
Pitts (1998) as recent examples. In the case of dairy processing, involving a
perishable raw material
which is almost 90% water, produced in widely
dispersed small-scale family farms, it is the author’s view that the issue of
economies of scale at manufacturing level must be combined with that of milk
collection costs. While product distribution costs may also need to be taken
into account in some cases, these costs may generally be ignored for many
processes, as much of dairy product manufacture involves very great weight
reduction, so that distribution costs are minimal relative to milk collection.
Optimum dairy industry structure at manufacturing plant level then normally
involves a balancing of decreasing average processing plant costs with
increasing scale against increasing collection costs. The economic impact of
distance on collection costs has been elaborated on in many texts, Hay and
Morris (1991). Discussed in a specific dairying context by Bressler and King
(1970), it was shown that if the density of production is held constant, the
volume delivered to a plant from a circular area will be a direct function of the
area and hence of the square of the radius. Collection costs will tend to
increase with distance at a constant rate, but because of the quadratic
relation between distance and volume, the marginal costs of collection will
increase with volume at a decreasing rate.
Total collection costs will
therefore be related to the cube of the radius.
Shown in conventional
average and marginal costs terms (Fig.1), plant costs per unit are at their
lowest at point a, whereas combined plant and collection costs are minimised
at a lower volume at point b.
Figure 1 Collection and Plant Costs Expressed in terms of Average Costs per Unit of
Produce Handled
6
Economies of Scale and Irish Cheese Manufacture
ACc
MCc
ACp
MCp
ACa
MCa
=
=
=
=
=
=
Average Costs (processing and assembly combined)
Marginal Costs (processing and assembly combined)
Average Costs (processing)
Marginal Costs (processing)
Average Costs (assembly)
Marginal Costs (assembly)
Source: Bressler and King (1970)
Research on, Economies of Scale and Irish Dairy Processing
The three main methods of economic analysis of industry structure are
empirical cost analysis, budgetary or engineering analysis and the survivor
technique, Hay and Morris (1991).
While empirical cost analysis has the
advantage of being based on actual industry data, it is often difficult to obtain
such data due to confidentiality. Studies using the economic engineering and
survivor techniques have been employed on an occasional basis in past
decades in analyses of the Irish Dairy industry, Lynch (1967), O’Dwyer
(1968), O’Dwyer (1970).
economies of scale in the manufacture of creamery butter in Ireland in the
late 1960’s. Completing budgets for five plant sizes, he demonstrated the
existence of economies of scale with unit costs being more than halved in
moving from the smallest to the largest plant. Based on the methodology of
Stollstemier (1963) which again involves the engineering technique, O’Dwyer
(1968) determined the optimum number, location and size of butter and skim
powder plants in Munster and Co. Kilkenny.
The information required
7
Economies of Scale and Irish Cheese Manufacture
included (a) quantity or raw material (milk) at each origin, (b) a transportation
cost matrix for each source-destination pair, and (c) a plant cost function. He
concluded that 23 plants would minimise the total assembly and processing
costs in the area, compared with the 135 plants in operation in the region at
the time, O’Dwyer (1968).
There has also been a very large number of
reports in which structural change and economies of scale have been
discussed in relation to Irish dairy processing, Cook and Sprague (1968),
Keane and Pitts (1981), Boston Consulting Group (1983), ICOS (1985), ICOS
(1987), Keane (1989), Gill and Butler (1989), Pitts (1989), Pitts (1990), DAFF
(1990), Hayes (1991), PA (1992), Pitts (1992), Goe (1993), DAFF (1993),
Zwanenberg (1996), Tozanli (1997). However, no study using the economic
engineering/survivor technique approaches has been completed in recent
years.
One fairly recent study using the benchmarking approach has compared
dairy product manufacturing costs for a number of countries for butter,
cheese, whole milk powder and skim milk powder based on personal
interviews, company and public cost data, Boston Consulting Group (1993).
A summary of the results shows that, when taking “lowest cost in country”,
costs are generally lowest for New Zealand, with Irish costs for butter
manufacture an estimated 25% higher than New Zealand and Irish cheese
manufacturing costs 68% higher (Table 1).
In the absence of detailed
knowledge of sources, comment on the quality of this information is not
possible.
Table 1 Dairy Product Manufacturing (Conversion) Costs, Comparisons, Index
Based on “Lowest Cost In Country”
New Zealand
Ireland
Netherlands
Butter
Cheese
Whole Milk
Powder
Skim Milk
Powder
100
125
117
100
168
123
100
100
102
114
8
Economies of Scale and Irish Cheese Manufacture
Australia
116
181
94
USA
114
90
Source: Derived from Boston Consulting Group (1993)
106
101
Economies of Scale – Empirical Studies
Two key practical aspects of empirical studies of economies of scale are (a)
whether the study should be at manufacturing plant or overall enterprise
level, (b) in relation to dairy processing, whether it should be multi-product or
single product.
Manufacturing Plant or Overall Enterprise Level
Confusion sometimes arises in economies of scale studies regarding the
level at which the study is being conducted i.e. at manufacturing plant or
overall enterprise levels. (A business enterprise may of course involve many
manufacturing plants). For example, the economic engineering approach is
particularly suited to studies of scale at manufacturing plant level, whereas
the survivor technique is normally applied at the overall enterprise level. In
this paper analysis is primarily at the level of manufacturing plant.
Choice of Dairy Product
Many dairy firms are multi-product, as they benefit at both manufacturing,
management and marketing levels from shared services.
The study of
economies of scale at a multi-product level is however quite complex, hence
this study is confined to the single product level. The main manufactured
dairy products are butter and skim milk powder as joint products, and cheese.
Cheese was chosen as the product for study of economies of scale as (a)
average output per plant has always been high for milk powder manufacture
due to the nature of the technology involved, (b) the reduction in the number
of enterprises manufacturing cheese over time has been much lower than
9
Economies of Scale and Irish Cheese Manufacture
that for butter, CEC (1996), making it more interesting and relevant from a
research viewpoint.
The EU Cheese Industry
Based on the triennial studies completed by the European Commission, CEC
(1996), the number of cheese enterprises fell from 2,461 to 1,132 between
1976 and 1994 for the six major Northern European countries for which
consistent data is available over a long period of time, representing a fall of
54% (Table 2).
The reduction in the number of cheese enterprises was
considerable in all countries with the exception of Ireland (Table 2). Average
cheese output per enterprise increased very substantially for all countries.
However in 1994 there was huge variation between countries in average
output per enterprise, ranging from about 44,000 tonnes per enterprise in the
Netherlands to less than 1,000 tonnes per enterprise in Belgium (Table 3).
Table 2 Changes in Industry Structure, Cheese
1976
1985
1994
No. Enterprises
Belgium
110
85
79
Denmark
202
70
39
Germany
537
361
248
France
1,551
1,189
739
Ireland
12
13
12
10
Economies of Scale and Irish Cheese Manufacture
Netherlands
49
26
15
2,461
1,744
1,132
100
71
46
1976
1985
1994
Belgium
373
576
885
Denmark
777
3,650
7,350
Germany
1,210
2,529
5,642
France
612
1,070
2,105
Ireland
4,083
6,046
7,722
Netherlands
7,735
20,192
43,980
Total (6 countries)
Index
Source: Derived from CEC (1996)
Table 3 Average Output per Enterprise, Tonnes
Source: Derived from CEC (1996)
More detailed analysis of cheese manufacture by dairy enterprise structure
shows that 90% of enterprises in the six major countries in 1994 had an
output of less than 10,000 tonnes p.a. while 82% had an output less than
4,000 tonnes (Figure 2).
11
Economies of Scale and Irish Cheese Manufacture
Figure 2 Manufacturing Enterprises by Size in EU (6), 1994
600
500
400
300
200
100
0
<0.1
0.1-1.0
1.0-5.0
5.0-10.0
>10.0
1,000 tonnes p.a.
Derived from [4]
The Irish Cheese Industry
The development of the Irish cheese industry in the twentieth century has
been outlined by authors such as McCarthy (1992) and Foley (1993). The
period 1910-21 is generally regarded as the first era of commercial
production, with the number of factories rising to about 200 in 1919 with
exports of over 14,000 tonnes to Britain, McCarthy (1992). This industry
declined greatly in the 1920’s, as creameries reverted to butter production
following the end of World War I, associated with a major price decline for
cheese arising from the decontrolling of price by the British Food Controller in
1919. There were some developments in cheese-making from the 1930’s to
the 1960’s pioneered by Mitchelstown Co-op and the Golden Vale
Federation, such that by 1966, 21 factories were producing a total of about
17,000 tonnes p.a. (Table 4).
12
Economies of Scale and Irish Cheese Manufacture
There was a substantial decline in the number of factory cheese enterprises
in Ireland between the
mid 1960’s and mid 1970’s, though much less
dramatic than for butter. Despite recommendations for major further
rationalisation in cheddar manufacture, such as the report of the Boston
Consulting Group (1983), structural change since then has been quite limited.
With overall factory cheese output increasing over five-fold between 1966
and 1996, there was more than a ten-fold increase in output per enterprise
(Table 4).
Table 4: Cheese Output and Enterprises - Ireland
Year
Output, ‘000 tonnes
Cheese Enterprises
1966
1976
1986
1996
17
49
63
92
21
12
11
10
Source: Irish Dairy Board
Milk Collection Costs and Cheese Manufacturing Costs – Ireland
Milk collection and cheese manufacturing costs are first considered
separately and then combined to provide overall estimates of economies of
scale at manufacturing level.
Cheese Manufacturing Costs
A profile of cheese manufacturing costs related to scale was established
through personal interview with cheese manufacturers and associated
institutions. Following the discussions, detailed information was available on
cheese manufacturing costs, including itemised costs for the various fixed
13
Economies of Scale and Irish Cheese Manufacture
and variable cost components.
From this information, incremental and
average cost curves for cheese manufacture were derived. Both curves were
decreasing at a decreasing rate, as might have been expected, indicating
considerable economies of scale up to about 20,000 tonnes p.a. with limited
further reductions beyond this size. (Figure 3).
Figure 3 Cheese Manufacture: Estimated Costs
25
Pence Per Gallon
20
15
10
A verage C ost
5
M arginal C ost
0
5
10
15
20
25
30
35
40
T housand T onnes
Milk Collection Costs
Detailed information on milk collection costs was obtained from Irish dairy
industry sources for tanker loads which were collected in regions which
ranged from very close to the processing plant to up to one hundred miles
distant. In all 60 observations were made. From the observations it was
possible to estimate an incremental cost curve (Figures 4,5). Reviewing the
scatter diagrams, it was clear that a simple linear function would be
appropriate, despite the fact that the theoretical functional form for such a
relationship is curvilinear as in Figure 1. It was not surprising to find that a
linear function was appropriate, as despite the theoretical expectation, linear
functions often fit well in such work when observations are limited to a given
relevant range.
Figure 4 Incremental Milk Transport Cost
14
Economies of Scale and Irish Cheese Manufacture
Figure 5 Average Milk Transport Cost
15
Economies of Scale and Irish Cheese Manufacture
Million Gals p.a.
Combined Manufacturing and Collection Costs
The previous estimates of cheese manufacturing and milk collection costs
were then combined to establish the overall average and incremental cost
curves. In the case of cheese manufacture this involved conversion from
tonnages to volumes of milk equivalent. The estimates show that while the
addition of milk collection costs has flattened the economies of scale curve
slightly, estimated scale economies up to 20,000 tonnes p.a. remain
considerable (Figure 6).
The associated overall incremental cost curve
continued to decline at a decreasing rate, although one could anticipate that it
might begin to turn upwards a little beyond the range of milk volumes
considered.
Figure 6 Combined Costs, Cheese Manufacturing plus Milk Transport
30
25
Pence Per Gallon
20
15
10
5
A v e ra g e C o s t
M a r g in a l C o s t
0
10
20
30
40
50
60
70
80
M illio n G a llo n s P .A .
Comparison with Other Studies
The above analysis would seem to indicate that there are considerable
economies of scale in factory cheese production.
The analysis may be
16
Economies of Scale and Irish Cheese Manufacture
compared with similar studies in other countries. One research contribution
in particular which seems relevant is based on the model of costs of
operations in the dairy industry as completed on an ongoing basis by the
Federal Dairy Research Institute in Kiel, Germany. Some recent results from
this research have been discussed by Pitts (1998). One set of results shows
the budgeted costs of manufacturing Gouda cheese where volumes
produced range from 1,000 to 30,000 tonnes p.a., with associated plant
capacity utilisation ranging from 21% to 100%. Results for a mid-range set of
estimates, based on 2 shifts and 65% capacity utilisation, show considerable
economies of scale (Figure 7). These results can readily be compared with
the Irish results earlier, as both have estimated costs for a 20,000 tonnes p.a.
output and this output level can be set at 100 for comparative purposes. The
comparison showed that the pattern of estimated economies of scale is quite
similar in both the Irish and German studies (Figure 7), with both studies
clearly indicating that there are considerable economies of scale in cheese
manufacture.
Figure
7
Comparative
Manufacture
Economies
of
Scale
Estimates
for
Cheese
160
150
140
Index
130
120
110
100
90
80
I
70
Germany
60
0
2
4
6
Discussion and Conclusions
8
10
12
14
16
18
20
Thousand Tonnes
As shown above, studies at manufacturing plant level have indicated that
there are considerable economies of scale up to about 20,000 tonnes cheese
per annum in both Ireland and Germany (Figure 7).
However, despite
considerable change over the years, the actual structure of the cheese
industry shows that 90% of all cheese enterprises in six major European dairy
17
Economies of Scale and Irish Cheese Manufacture
countries had less than 10,000 tonnes output in 1994 (Fig 2). Obviously
there is a total contradiction between these two observations. Based on the
economies of scale studies one would expect the large enterprises to
dominate the industry. This leads to discussion of comparative performance
relative to scale of enterprise in practice.
Reviews of actual performance in dairy manufacturing related to scale of
enterprise
requires
agreement
firstly
on
appropriate
indicators
of
performance. While detailed discussion is beyond the scope of this paper
(see O’Connell (1997)), one important indicator is the price paid to farmer
suppliers of milk, given that much of the European Dairy industry is owned by
milk producer co-operatives.
These are at least two creditable annual
producer milk price comparisons which have been ongoing within the EU for
a number of years, Irish Farmers Journal (1998), Aarts (1997).
Based on a very preliminary analysis of these milk price comparisons, there
seems to be little evidence that large enterprises are paying consistently
higher prices to producers than smaller enterprises.
Hence smaller
enterprises in general seem to be successfully using various means to
obviate their inability to benefit from economies of scale.
In reviewing means by which smaller enterprises may counteract economies
of scale problems, at least two possibilities may be suggested, product
differentiation and X-efficiency.
Product Differentiation
In discussing product differentiation one must at the outset acknowledge the
characteristics of a product such as cheese. Cheese is a biological product
in which consumers perceive a very wide range of subtle flavour differences.
Thus there is a very wide variety of cheese products, with some countries
having a very large number of small artisan-type enterprises, each producing
its own unique variety. Even though Irish cheese production is mainly larger
scale factory production for a mass consumer market (mainly factory
cheddar), a parallel industry involving farmhouse cheese production has
18
Economies of Scale and Irish Cheese Manufacture
expanded considerably in recent years, Kenneally (1996). Thus the nature of
the product lends itself to great variety, with limitations to scale due to size of
market in relation to many of these varieties.
In this context one must acknowledge the limitations of the economic
engineering approach to economies of scale at plant level in relation to
determining the optimum size of enterprise.
An enterprise operates in a
business environment in which many opportunities and threats exist. In many
cases, opportunities can be exploited by providing products for market
segments where substantial premia can be obtained, even though production
for these market segments may not be suited to large scale manufacture. In
most industries, small firms providing products for “niche” markets survive in
parallel with large firms meeting the needs of the mass market. There is no
reason to believe that this should not also happen in dairying, and despite the
changing structure of the EU cheese industry over the years as shown
earlier, this feature is very much in evidence.
X-Efficiency
There are various studies by economists who suggest that large firms may
sometimes not fully realise potential gains. In economic theory a common
assumption of production analysis is that enterprises operate on the frontier
of efficient techniques, at a technique determined by least cost.
This
assumption has been challenged, with the term x-effeciency being coined to
express the potential gains in performance that enterprises could achieve
without changing inputs as such.
Reasons given for less than optimum
performance include internal factors, involving labour contracts and
motivation, and external factors related to competition, Hay and Morris
(1991).
With regard to external factors it is argued that “the lack of
competition in the market leads to slack within the firm, or ….. the firms
standard for its costs will probably not be the absolute level of costs it could
attain, but rather to keep its costs in line with those of the industry as a
whole”, Hay and Morris (1991)
Irish Dairy Processing and the Future
19
Economies of Scale and Irish Cheese Manufacture
In considering the optimum future structure for Irish Dairy Processing, it is
clear that there is a need for a small number of very large enterprises which
can compete at a global level. As stated by Rabobank (1998), “gradual trade
liberalisation, investments in technology and the globalisation of food retail,
food services and food industries are creating a need for strong, globally
orientated food companies with a solid financial base”.
The successful
development of enterprises such as the Kerry Group, AWG, Dairygold,
Golden Vale and the Irish Dairy Board represent a very positive Irish
response to this need.
At the smaller dairy enterprise level, the key to
survival, given the presence of major economies of scale for standard
products, would seem to be the development of specialised products for
niche markets while ensuring that absolute efficiency is achieved at their
given scale. Premia earned for specialised products may help to counteract
the disadvantages of being unable to benefit from economies of scale. From
a strategic viewpoint, the weakest position for dairy enterprises to be in is to
be of small scale and to be producing standard mass-market products where
major economies of scale are present and no premia are possible. Such
enterprises will be vulnerable unless they pursue the development of
differentiating features to provide premia to counteract their scale problem or
achieve superior levels of efficiency at their given scale.
From a
methodological viewpoint, the overall conclusion is that while economic
engineering type studies may reveal substantial economies of scale, broader
industry considerations, involving such factors as the opportunity to obtain
premia through product variety and consideration of x-efficiency, should be
taken into account before any definitive conclusions on scale can be drawn.
20
Economies of Scale and Irish Cheese Manufacture
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