Coles and Woolworths are under intense pressure to back down in their milk pricing stand-off after the battle for supply forced dairy giant Fonterra to slash its Australian product range.

Coles conceded that it was getting closer to having to raise retail prices as cracks began to show in the controversial $1/litre pricing policy that has been blamed for farmers abandoning the dairy industry.

Woolworths has admitted the pricing policy is unsustainable.

WA is experiencing its biggest shortfall in milk supply for 50 years as production falls and the population grows strongly.

Processer Lion, which supplies Woolworths in WA, expects to truck in about 5 million litres from interstate this year to top up supplies.

Coles general manager of corporate affairs Robert Hadler said profit margins on milk were paper thin.

Mr Hadler said Coles would not sell milk at a loss, making a retail price rise inevitable.

"At some stage if the farm gate price continues to rise we will have to pass the cost on in the retail price," he said.

Coles has increased the price paid to WA dairy farmers by 6¢ in the past nine months without increasing the retail price of its home brand milk.

New Zealand-based Fonterra announced yesterday that earnings on its Australian brands had fallen by more than 30 per cent.

Referring to the milk supply war, Fonterra chief executive Theo Spierings said: "There's a new reality in Australia. That's why we have to rationalise brands, rationalise our organisation."

Mr Spierings said Fonterra, which does not have a plant in WA, would cut its Australian brands from 21 to "four or five".

Research and development group Western Dairy issued a warning yesterday on moves by Woolworths to sign farmers to direct supply deals.

Western Dairy chairman Dale Hanks said there were obvious dangers in farmers forming co-operatives to supply the supermarket giants.

Mr Hanks, who runs a dairy farm at Harvey, said supermarkets required a flat supply of milk for their home brand labels and there was a risk of any seasonal oversupply becoming virtually worthless.

WA processors Harvey Fresh and Brownes have the ability to put seasonal over-supplies into long-life milk or cheese.

Woolworths and a group of farmers in the Manning Valley in NSW are set to reach a direct supply deal for drinking milk.

The farmers lodged a notice with the Australian Competition and Consumer Commission last week to allow them to collectively bargain with Woolworths.

The model bypasses processors, although they will still process the milk under contract.

The West Australian

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