Glanbia is to acquire Dairygold's liquid milk business for €10 million, subject to approval by the Competition Authority.
The extra 6.15 million gallons of milk will increase Glanbia's sales in this area by 10 per cent.
The companies have also entered into agreements to co-operate on the milk manufacturing side, with Glanbia manufacturing some of Dairygold's butter products and processing some of Dairygold's whey while Dairygold will manufacture some of Glanbia's dairy products from 2006.
Mr Jerry Henchy, chief executive of Dairygold described the deal as a "very positive move" in the Irish dairy sector.
Calls for consolidation of the industry have been made for many years, but progress to achieve meaningful rationalisation has been slow partly as takeovers and mergers have failed to provide the expected economies of scale.
Mr Henchy said the deal was a "pragmatic solution" where the two companies will share facilities and production assets.