(AP) In a sour economy, you can pad your budget by cutting out cable, trips to restaurants and vacations. But you can't cut out food.

Americans spend about 12.5 percent of their budgets on food each year, according to the Bureau of Labor Statistics. That means many families' finances are at the mercy of fluctuations in food prices, which soared last year and now are retreating.

What determines just how much you pay at the supermarket for a loaf of bread or a bag of chips?

Here are some questions and answers about the pricing of groceries.

Q: How are food prices set?

A: Food prices are closely linked to the cost of their main ingredients — like dairy, corn and wheat — along with the fuel that's used to transport groceries to your supermarket. All of those items, called commodities, can be volatile since their price is set based on demand and trading on various exchanges. Of course there's also the profit margins for players like the manufacturer, wholesaler and retailer.

Last summer, commodity prices soared to record highs. Crude oil prices climbed to more than $100 a barrel, and corn and wheat prices also peaked. Many factors were at play, including Midwestern floods that devastated corn and soybean crops, and increasing demand as the global economy — back then — was improving.

Some groups, especially food makers, also say a rise in demand for the corn-based fuel additive ethanol pushed up the cost of food, as supply had difficulty keeping up with the demand for corn as an ingredient in both food and fuel. Last month, the nonpartisan Congressional Budget Office said higher use of ethanol accounted for about 10 percent to 15 percent of the rise in food prices between April 2007 and April 2008.

The CBO said in a report that the effect of ethanol on future food prices is not yet clear, since it could lead to an increased supply of corn, which could lower food prices.

Q: How did food makers react to soaring commodity prices?

A: Food companies wanted to protect their profit margins and make sure they weren't losing money, so they boosted prices across many of their product lines. According to the Consumer Price Index, the average cost of food rose 5.9 percent last year, which is faster than previous annual rates in recent years.

Q: Can I have some examples of how grocery prices are set?

A: Let's look at two, very different examples: cheese and cereal.

For most foods, the biggest factor is the price of commodities. For foods like packaged salads or cheese — consisting mainly of a core ingredient, with little else involved — commodity costs can make up between 60 percent and 80 percent of the cost of the product, says Steve McLaughlin, a pricing expert in Bain & Company's retail and consumer products practices.

For foods where more manufacturing is involved, like cereal, commodity costs can account for less than 60 percent of the cost, he notes. The rest of the cost goes into things like manufacturing, packaging, delivery, marketing and innovation — that is, adding value to products by creating new flavors or different sizes, or boosting quality.

Even pricing experts are reluctant to get more specific than that because there is so much variation among products. But McLaughlin did give a general breakdown of the price a grocery store might pay for a typical food product:

  • About 35 percent: Raw materials — though the proportion of the cost coming from this can vary depending on the type of product.
  • About 15 percent: Converting raw materials into food — a cost that includes plants, labor and utilities.
  • About 10 percent: Packaging.
  • Between 5 and 10 percent: Selling and distributing the product.
  • About 10 percent: Advertising, along with research and developent to come up with new products.
  • About 5 to 10 percent: The cost of managing the business.
  • About 15 percent: Operating margins — as in how much profit a company makes on its sales, before interest and taxes.

And don't forget, this is a breakdown of how a food company might price a product it sells to retailers, like grocery stores. When the supermarket sells the item to you, some profit will get added to the price — a profit margin of 20 to 30 percent is typical.

Q: What's happening now with commodities?

A: Those prices have been coming down, partly because the recession is reducing demand. In tough times, companies idle their plants and people cut back on driving and spending. That all means less demand for fuel, and less demand means lower prices.

Corn, wheat, dairy have all fallen too for a variety of reasons, including slumping demand. That means farmers may not produce as much, which could eventually bolster prices by lessening the supply.

Q: What does that mean for food prices?

A: Prices are starting to fall. In the first three months of 2009, food prices fell at an 0.8 percent annual rate, according to the CPI.

Q: But my grocery bill isn't shrinking drastically. Why not?

A: While food ingredients cost less, food companies say they're still not as low as they've been in previous years. In fact, ingredient costs are still expected to be up this year for many major food makers like Kraft Foods and General Mills.

Also, it's unclear how long commodity prices will stay down. Oil prices have been rising to around $60 a barrel since they fell below $35 in February, and higher fuel prices can mean more expensive commodities. Experts say food companies don't want to drop prices just to have to raise them again — that can disrupt business and confuse customers, or even turn them off entirely.

Q: Falling food prices are good news for consumers, right?

A: While lower food prices may help consumers as they try to stretch their budgets, there's a steeper cost to the economy: the risk of deflation.

Price cuts mean less money is being spent, which means companies make less money and, in turn, spend less money. When price declines become widespread and prolonged, you can enter a period of deflation. Economists worry about this because falling prices can hurt the value and prosperity of businesses, which can lead to wage cuts and layoffs.

The last bout of serious deflation in the United States happened in the 1930s — during the Great Depression

Fears about deflation have lessened as a result of interest rate cuts and other moves by the Federal Reserve to encourage spending and investment. Federal Reserve Chairman Ben Bernanke said earlier this week that the risk of deflation is "receding" but it shouldn't "be ignored."

Source: Emily Fredrix, AP Food Industry Writer