F o n t e r r a

PERFORMANCE MEASURES – continued36MILK PRICEAs a co-operative, Fonterra distributes virtually all itsincome to shareholders in the form of payout. Thispayout is paid in proportion to the supply of milksolidsreceived from the shareholders.For performance purposes it is important to divide thissingle payout figure between the payment for the milkand the return on the co-operative’s value add activitiesand investments.Fonterra processes approximately 95 per cent of allNew Zealand milk and accordingly there is not a validmarket based price for liquid milk acquired withinNew Zealand. Further, at this time, it is not appropriateto use prices paid for milk outside New Zealand due tothe significant variances in cost structures between theNew Zealand dairy industry and that in other countriesand the relatively small proportion of New Zealandmilk that is sold fresh in New Zealand. Accordingly themilk price is assessed by a calculation known as theCommodity Milk Price (CMP). This is based upon thecost of milk determined by Duff & Phelps as part oftheir Fair Value Share assessment. The CMP is the pricea hypothetical efficient competitor could afford to payfor milk and is assessed as:Annual revenue that could reasonably be achievedfrom the sale of a balanced portfolio of dairycommodity products, derived from milk, of thequality and quantity supplied to Fonterra inNew Zealand.Less:The assessed operating costs and capital costs(including a fair return on capital) incurred inderiving commodity milk revenue.HISTORICAL CMPAs discussed above the CMP is based upon the cost ofmilk applied by Duff & Phelps in assessing the earningsof the Ingredients business for the purpose of theFair Value Share. The Historical CMP simply takes thatforward looking model used for the valuation andapplies the actual milk volumes, base commodity pricesand exchange rates achieved by Fonterra during theseason (hence it is the Historical CMP).FONTERRA CMPThe Fonterra CMP is calculated in a similar mannerto the Historical CMP. However rather than applyingthe efficient competitor sales mix and operating costsas applied in the Historical CMP, the Fonterra CMPuses Fonterra’s commoditised product mix and costs.It is based upon the actual volume of milksolidsreceived during the year however it assumes thatonly commodity products are manufactured. All milkvolumes actually applied by Fonterra to manufacturenon-commodity and value add products are assumedto be applied to the manufacture of the most similarcommodity products and are assumed to be sold ata base commodity product price. Accordingly theFonterra CMP excludes any returns earned by Fonterrafrom value add activities.ADDITIONAL PERFORMANCE MEASURESThe performance measurements discussed above areconsistent with those provided in previous years.Discussed below are additional performance measuresthat Fonterra will report on going forward.SEPARATION OF MILK COMPONENT AND VALUE ADDCOMPONENT OF PAYOUTOver the last year management has been reviewingFonterra’s performance measures and in particular thecalculation of the price of raw milk. The existing HistoricalCMP and Fonterra CMP models were examined alongwith alternative approaches. The analysis identified thefollowing key issues:There should ideally be one methodology forcalculating the milk price for all purposes includingthe Fair Value Share, management performancemeasurement and statutory financial reporting.The consistency between the milk price determinedby the independent valuer for the Fair ValueShare and the milk price for financial reportingis particularly important to ensure comparabilitybetween the value add earnings inherent in the FairValue Share and those distributed by way of payout.To the extent there is a significant disconnect, issuesaround adequate return on investment will arise.Based upon the work undertaken, the existing CMPmodel (or a derivative of the model) is still consideredthe most appropriate basis for determining the raw milkprice to be used for all purposes. Accordingly, under thenew approach the Valuer will assess the CMP as theycurrently do. However, in determining the optimallong term product mix the Valuer will apply Fonterra’sforecast base commodity product prices rather than theValuer’s modelled mean-reverting forecast prices.