Fed Cattle Market Simulator – Grid Pricing
Clement Ward, Derrell Peel, and Kellie Raper
Department of Agricultural Economics
Oklahoma State University
August 2008
Participants in the simulator can price fed cattle on a live weight or dressed weight basis as described in the packer economics paper. However, both packer buyers and feedlot marketing managers may wish to capitalize on the variation in cattle quality within and across pens. They can do that with grid pricing.
Nature of Pricing and Associated Risk – Both with live weight pricing and dressed weight pricing, one price is applied to every animal in the pen regardless of animal quality. As such, more is paid or received for poorer quality cattle and too little is paid or received for better quality cattle. With grid pricing, each animal receives a unique price representative of its carcass quality. Each animal’s price reflects its quality, which economists view as an improvement in pricing accuracy.
Pricing by the three methods – live weight, dressed weight, and grid – alters the risk involved in marketing/purchasing fed cattle. With live weight pricing, packers bear the brunt of the risk. For example, packer buyers must estimate the percentage of cattle in the pen which fall into the different quality and yield grades, and buyers must estimate the dressing percentage. With dressed weight pricing, packers still bear most of the risk, but not all. Now there is no risk for buyers associated with dressing percentage. Feeders are paid based on the actual dressed weight. Thus, now the dressing percentage risk shifts from packer to feeder. Lastly with grid pricing, virtually all risk shifts from packer-buyer to feeder-seller. Buyers need not estimate quality grades and yield grades or dressing percentage. A price is calculated for each animal. Thus, if cattle quality is not what a feeder believes it is, the feeder, not packer, bears the risk.
Grid Pricing Mechanics – Grid pricing could be called dressed weight and carcass merit pricing. Price is established on each individual animal based on carcass merit. Nearly all grids are based on dressed weights for fed cattle.
Most grids consist of a base price with specified premiums and discounts for carcasses above and below the base or standard quality specifications. Grid pricing has been simplified somewhat for the market simulator. There are just three quality grades of cattle (Prime, Choice, and Select) and three groups of yield grades (YG1, YG2-3, and YG4-5). Table 1shows an example grid from the simulator. Premiums and discounts in Table 1 can be put into a matrix format (Table 2). The term grid comes from this matrix framework of premiums and discounts for specified carcass characteristics. Quality grade and yield grade premiums and discounts compared with the base price are shown in the Choice row and Yield Grade 3 column of Table 2.
In the simulator, the premium for Prime quality grade carcasses is fixed at $8.00/cwt. and the premium for yield grade 1 carcasses is fixed at $4.00/cwt. Discounts for Select quality grade and yield grades 4-5 are variable and depend on market conditions. To complete the matrix in Table 2, we assume quality grade and yield grade premiums and discounts are additive. For example, the premium for a Prime grade, yield grade 1 carcass in Table 2 is $12/cwt. That amount is the sum of the $8/cwt. premium for Prime grade carcasses plus the $4/cwt. premium for yield grade 1 carcasses.
Table 1. Example Grid, as Presented by a Packer ($/dressed cwt.)Choice YG3 600-900# / Base Price
Prime-Choice Price Spread / 8.00
Choice-Select Price Spread / -10.00
Light Carcasses (<550 lbs.) / -10.00
Heavy Carcasses (>950 lbs.) / -10.00
Yield Grade 1 / 4.00
Yield Grade 4 / -15.00
Table 2. Example Grid in a Completed Matrix Format ($/dressed cwt.)
Yield Grade
Quality Grade / 1 / 2-3 / 4-5
Prime / 12.00 / 8.00 / -7.00
Choice / 4.00 / Base / -15.00
Select / -6.00 / -10.00 / -25.00
Light Carcasses (<550bs.) / -10.00
Heavy Carcasses (>950 lbs.) / -10.00
Packer grids may identify additional premiums for carcasses meeting specifications for Certified Angus Beef (CAB) or other marketing programs. Likewise, packers may specify discounts for hide damage, injection site blemishes, condemnations and other “out” or unmarketable carcasses (in addition to discounts for light or heavy carcasses as shown in the sample grid).
To compute a grid-based price, the distribution of carcasses by quality grades and yield grades from a sale lot of fed cattle must be known. An example of that distribution for a pen of cattle from the simulator is shown in Table 3for one, 100-head pen of higher quality, lower yielding cattle (high genetic type) weighing 1250 lbs. It also is in a matrix framework.
In the simulator, packers and feeders typically negotiate the base price. For packers, bids include the projected price of boxed beef, byproducts value, and slaughter-processing costs. The base price could be discovered by a formula tied to the boxed beef price, futures market price, or some other arrangement. Once the base price is known for the grid in Table 1 (i.e., the “base” price cell in Table 2), the net price can be computed for a pen of cattle. Premiums or discounts for the distribution of carcasses in the
Table 3. Example Distribution of Carcasses in Matrix Format (% of pen total)Yield Grade
Quality Grade / 1 / 2-3 / 4-5
Prime / 5 / 8 / 1
Choice / 21 / 35 / 4
Select / 10 / 16 / 2
Light Carcasses (<550bs.) / 0
Heavy Carcasses (>950 lbs.) / 0
pen are found by multiplying the percent of carcasses in each matrix cell in Table 3 times each premium and discount cell in Table 2. That sum for all cells is added to the base price. This process is illustrated here.
STEP 1. Negotiate the base price.$120.00/cwt.
STEP 2. Calculate the net premium or discount.
Multiply the percentage of carcasses in each cell of the distribution of carcasses times the respective premium or discount cell in the premium-discount grid. Note percentages are converted to decimal form.
[($12 x 0.05) + ($8 x 0.08) + (-$7 x 0.01) + ($4 x 0.21) + ($0 x 0.35) + (-$15 x 0.04) +
(-$6 x 0.10) + (-$10 x 0.16) + (-$25 x 0.02) +] + [(-$10 x 0.00) + (-$10 x 0.00)] = -$1.29/cwt.
STEP 3. Add the base price in STEP 1 to the total net premium or discount in STEP 2.
$120 - $1.29 = Grid price$118.71/dressed cwt.
Note the cell in Table 3 showing the “base price” yields no premium or discount in STEP 2, i.e., ($0 x 0.35). The two expressions in parentheses inside the last pair of brackets in STEP 2 are the discounts for light and heavy carcasses [(-$10 x 0.00) + (-$10 x 0.00)]. However, there are no light or heavy carcasses for 1250 pound cattle.
Premiums and discounts are important. However, negotiating a base price is probably more critical to paying a lower net price (for packers) or receiving a higher net price (for feeders) from a grid than are the specific premiums and discounts. The base price affects all cattle in the sale lot, whereas premiums and discounts affect only selected carcasses.
In the simulator, the software computes the premiums and discounts when packers and feeders choose to purchase/sell fed cattle with a grid. The software calculates the premium-discount matrix (Table 2) using fixed premiums and discounts and market determined premiums and discounts. It calculates the carcass distribution matrix (Table 3) using carcass characteristics associated with each weight and genetic type of cattle. Carcass characteristics are shown in the packer economics paper and are given to all feedlot and packer teams. Lastly, the software uses the base price which is negotiated and entered by seller and buyer.
Grid Pricing Guidelines – Deciding when to price fed cattle on a live or dressed weight basis and on a grid basis is difficult. Generally, one would expect better quality cattle (high genetic type) should bring more with a grid, capitalizing on the quality grade premiums. And the corollary would be expected, one would expect to market lower quality cattle (low genetic type) on a live weight basis. As a general rule this may hold true. However, results can differ for several reasons.
First, a premium or discount may be built into the base price which could alter the above “normally expected” outcome. Second, market conditions may make Select grade discounts and yield grade 4-5 discounts such that the normally expected outcome changes. Lastly, composition of the pen, based on cattle weight, may alter the outcome.
The two figures below identify the nature of the discounts for Select grade and yield grades 4-5 carcasses in the simulator. The Select grade discount is greater for lighter carcasses, such as when fed cattle marketings are smaller. Large discounts signal feeders to keep cattle to heavier weights to increase the percentage of Choice grade carcasses, and thereby reduce the discount.
Discounts for yield grades 4-5 carcasses can be interpreted similarly but with one notable difference. The largest discounts for yield grades 4-5 carcasses are when cattle weights are heavy, as when supplies are plentiful. In this case, the market is sending a signal to feeders to market cattle at lighter weights to reduce the percentage of overfinished cattle.
Note the contrary market reactions to marketing heavier or lighter cattle. Heavier cattle increase the percentage of yield grade 4-5 cattle and discounts increase. Heavier cattle also increase the percentage of Choice grade cattle and the Select discount narrows, meaning less premium for Choice grade cattle. Thus, keeping cattle to heavier weights has a simultaneous positive and negative effect in addition to the cost of gain effect discussed in the feedlot economics paper.
Summary Advice – Putting forth concrete guidelines for grid pricing is very difficult. Packer and feeder teams are encouraged to try purchasing/marketing fed cattle with grid and alternative pricing methods in the simulator to determine what is effective and what is not.
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