This paper estimates technical inefficiency in milk production of smallholder dairy farmers in the highlands of Ethiopia and identifies factors associated with the observed inefficiency using a stochastic frontier production function approach. The analysis utilizes cross-section data collected from 1277 farmers. The result indicates a mean technical efficiency of 55%, suggesting sizeable technical inefficiency in milk production. The results further show that household wealth, education level and access to markets and institutions are the main drivers of technical efficiency in dairy production. Evidently by improving smallholder access to market and institutions as well as investing on adult education, it is possible to bring considerable gain in milk production.