AgDM newsletter article, June 1998
By John Lawrence, Extension Livestock Economist and Director of the Iowa Beef Center, 515.294.6290, firstname.lastname@example.org
Traditionally, the pork processing sector has been a highly competitive, low margin business.† Firms slaughtering and processing hogs into relatively undifferentiated fresh wholesale pork products, and into processed products where few firms have successfully differentiated their products, find it very difficult to consistently reap high profit levels.
Packer cost structure
The cost of acquiring hogs typically comprises 70 percent of the costs of a slaughter-processing company.† Labor costs typically comprise about 50 percent of the remaining variable and overhead costs.†
The cost of acquiring hogs typically comprises 70 percent of the cost of a slaughter-processing company.
How intensively a plant is used can have a significant affect on unit costs.† Average estimates of fixed plant and equipment costs are $6 per head for single-shift and $3 for double-shift plants.† So there is a clear rationale for double shift plants where other factors do not offset these economies of size.
Per unit costs decline as volume and market shares of the largest firms increase.† If another plant is added to an existing operation, administrative overhead costs typically increase less than volume.† So the cost per hog decreases.† However, the cost impact will vary depending on the number of plants and the extent of under-utilized capacity in the administrative and staff functions.
An important cost difference between plants is the extent to which there is further processing and fabrication of pork products.† More deboning and further processing involves much higher labor costs.
Effect of capacity utilization on competition
Plant utilization is a key element of packer profits.† Capacity utilization rates can have a significant effect on cost per head and pricing behavior in the market for hogs.† Most of the variable costs of operating a plant become fixed within the first four days of the week.† So the added cost of processing hogs on the fifth day is relatively low.††
Most of the variable costs of operating the plant become fixed within the first four days of the week.
The cyclical nature of hog production is an important factor in plant utilization.† Because packer capacity has to be large enough to handle the seasonal and cyclical peaks of hog production, there are other periods when plants are not running at capacity.† When the number of hogs purchased is below 80-90 percent of plant capacity, packers are often willing to bid significantly higher prices (or haul hogs further distances) since the added cost of killing and processing them is low relative to the expected price of the end product.
The excess capacity usually found in this industry, in combination with the small added costs of processing more hogs, provides a strong incentive for a firm to bid aggressively for more hogs.† If each firm follows this strategy, hog prices will surge, causing the farm-to-market margins to drop sharply.
This strategy will tend to discourage collusion.† If packers colluded to share the available supply of hogs, all of the plants would be below capacity and profits would decline.† The full benefits only accrue to those plants that achieve 100 percent capacity utilization.†
The need to fill capacity is also a significant incentive for vertical integration into hog production through arrangement such as long-term supply contracts with hog producers.† Vertical integration reduces a packerís susceptibility to the vagaries of spot market hog supplies.
A significant change in the pork slaughter-processing sector is a trend to increased integration.†
However, other attempts at integrated pork production have been less successful.†
Long-term marketing contracts
In addition to integrated and tightly coordinated production and processing systems, there are increasing linkages between traditional processors and producers in the form of long-term marketing contracts. Currently, all major packers serving Iowa are offering or considering some type of long-term marketing agreement with producers with a variety of alternative pricing methods.† These contracts typically are written for five years or longer and can provide advantages for both producers and processors.††
Producers are assured market access and may be provided cash-flow assistance to protect them during periods of extremely low prices.† The processor is assured a steady supply of known quality hogs and may pay less for hogs during periods of high prices.† The contracts provide a method of improving communication between producer and processor on issues of scheduling and quality.†
The primary concern of producers is the potential decline in the number of buyers at the local level.† Iowa currently has a very competitive market for hogs.† A 1994 study found approximately 200 buying stations and plants in Iowa.† A representative producer in each quadrant of the state had five or more different companies bidding for hogs in a 50-mile radius.
Although the market is competitive now, there are concerns about the future.† If plants close due to a shortage of local supplies or if packers meet the majority of their needs with long-term contracts, the market environment may be less favorable for the remaining producers.†
Although the market is competitive now, there are concerns about the future.
There is limited evidence to suggest that a plant closing will have a significant impact on hog prices in the long run.† Previous research has shown that, although prices may weaken initially when a plant closes, prices do return to pre-closing levels as competitors move into the market.
Another study reported that producers near a plant closing benefited less from a rising market than other producers.† If Iowa loses a large share of its packer capacity and there arenít buyers nearby to fill the void, prices could decline relative to other states.
Looking to the future
Increased packer concentration seems likely in response to the impact of economies of size, both within plants and in multi-plant operations.† Stronger long-term vertical linkages will continue to increase in importance.† These linkages will reduce quality and quantity risks that are quite costly to packers, and will provide assured market access and increased quality and quantity consistency incentives to producers.† Overall efficiency is likely to be enhanced, but market power issues will be raised more frequently if current trends continue.