In this paper, I will address the carbonated soft drink industry's vertical integration, profitability, consolidation, key opportunities and challenges as well as the application of Michael Porter's 5-Force Model.
Vertical Integration of Concentrate Producers and Bottlers
Vertical integration occurs either when a firm takes over the manufacturing of its inputs or when it takes over the functions of its customers (Grant, 2008). In the case of the carbonated soft drink (CSD) industry, the vertical integration of concentrate produces and bottlers comes about when a firm takes control of the product finalization process and distribution channels through which the CSD product is sold. Vertical integration can provide competitive advantages to firms by subduing threats from new entrants or substitute products and power over the suppliers and buyers of the products.
When evaluating the profitability of concentrate producers and bottlers to determine the advantages of vertical integration we utilized profit pool mapping. Profit pool mapping involves defining the pool’s boundaries, estimating the pool’s overall size in order to determine the industry’s total revenues, estimating the profit for each value chain activity, and comparing the aggregation of profits in each activity with the total of the industry (Grant, 2008, p. 116).
Define the Pool’s Boundaries
In the CSD industry the question is whether the concentrate manufacturers should engage in vertical integration with the bottlers. Doing so would result in one firm controlling the bottling process, the distribution channels, and the end product sales.
Estimate the Pool’s Overall Size
Overall, the concentrate producers in the CSD industry earn an approximate pre-tax income of $0.25 per case and the bottlers earn $0.52 per case (Yoffie & Wang, 2002, p. 20). Although the pre-tax income of bottlers is higher, concentrate producers are more profitable because their pre-tax income is 35% of their sales versus the bottler’s 9% because of the high costs in the bottling industry.
Estimate Profit for each Value Chain Activity
co*ke’s concentrate production is 10.6% of their total consolidated sales of $20,458,000 and the bottling is 1.6% of $14,750,000 of sales. On the other hand, Pepsi’s concentrate production is 10.7% of $20,438,000 of consolidated sales and the bottlers earn 13.9% of $7,982,000 of sales.
Compare the Aggregation of Profits
The aggregation of these profits into one consolidated organization, instead of having separate entities, would definitely benefit both concentrate producers and bottlers because this would increase profits for both organizations and increase their control as suppliers. Since concentrate producers are so much more profitable than bottlers, vertically integration would also benefit both firms by ensuring that the efficiencies gained from integration would be passed on to the consumer by way of lower prices because each separate firm would not be adding its own profit margin at the end of each manufacturing stage. In turn, lower prices would increase sales which would work to increase revenue and profits for the bottlers and concentrate producers.
Profitability of Concentrate Producers and Bottlers
Taking a deeper look into the profitability of concentrate producers and bottlers, concentrate producers tend to be more profitable because the majority of their capital investment is primarily focused on promoting, advertising, and market research of their brand of which half of these costs are financed by bottlers. Concentrate producers share the burden of most of their costs with their bottlers and generate most of their income from a set price paid by bottlers regardless of price increase (Yoffie & Wang, 2002, p. 2). On the other hand, bottlers have multiple areas to finance with capital investments. Not only do bottlers help finance concentrate producers on advertising and brand promotion, they spend from $4 million to $10 million each year for bottling and canning lines and $75 million to operate a large bottling plant (Yoffie & Wang, 2002, p. 3). Additionally, bottlers need major supply inputs such a bottling plants, trucks for distribution, cans, plastic bottles, glass, and other raw materials. Bottlers directly deliver products to retail stores and are responsible for space availability in all locations. They also have to maintain a strong relationship with the retailers to ensure their brands are highly promoted and marketed which can be costly at times. All of these activities increase a bottler’s costs which decreases profitability.
Evaluating Industry Attractiveness for Concentrate Producers and Bottlers
Aside from profitability, the attractiveness of an industry depends on the structure of the industry’s internal and external environments. By applying Porter's Five Forces model for both concentrate producers and bottlers we are able to evaluate the inherent attractiveness of each industry. According to Grant (2008), high capital requirements can be one of the most discouraging factors when a company is considering market entry into an industry (p. 74). The high capital requirements necessary to operate a bottling plant makes the structure of the concentrate producer industry much more attractive. While bottlers do tend to have a large amount of power over buyers because they maintain valuable distribution channels, competition in the industry is high. Aside from lower capital requirements the concentrate producers have more control over their costs than bottlers which contributes to the profitability and inherent attractiveness of the industry. A detailed comparison of each industry using Porter’s Five Forces can be found in Exhibit One.
Consolidation of CSD Industry
In addition to studying the industries of bottlers and concentrate producers, it is also important to explore the CSD industry as a whole. According to Jain (2002), a consolidated industry is one where a small number of firms control a large share of the industry’s sales. Data on market share in the CSD industry shows that this industry has been extremely consolidated for many years with two firms, Pepsi and co*ke, holding the majority of market share in the industry. By using the four-firm concentration ratio (CR4) historical market share data shows that the CSD industry has gone from being 67.6% consolidated in 1966 to 93.5% consolidated in 2000 which is an increase of 38% over 34 years. Appendix Two shows CR4 calculations for the CSD industry for several years and demonstrates graphically that consolidation in the industry has shown an increasing trend since 1966. According to Jain (2002), a CR4 greater than or equal to 40% represents a consolidated industry and a CR4 around 70% or 80% signifies that an industry is highly consolidated. As the CR4 data in Appendix Two shows, the CSD industry was almost to the point of high consolidation in 1966 and easily met and exceeded that level over time which is proof of increasing consolidation in the CSD industry.
Aside from numerical data, the structure of the CSD industry also exhibits several common characteristics of a consolidated industry. For example, consolidated industries tend to have high barriers to entry (Jain, 2002). The CSD industry is one that requires high amounts of capital in order to ensure quality marketing and gain access to important distribution channels. In 1999 and 2000 co*ke spent $148.9 million and $207.3 million respectively in order to keep its co*ke Classic brand in the public eye and in key distribution locations (Yoffie & Wang, 2002, p. 17). Few new entrants could raise the amount of capital necessary to gain access to marketing and distribution channels large enough to be competitive with current organizations. Additionally, the $58 million increase in co*ke’s advertising in only one year is proof that capital requirements are increasing which in turn increases entry barriers and industry consolidation. Two other important characteristics of consolidated industries are differentiated products and high brand preferences (Jain, 2002). The industry’s top two competitors, co*ke and Pepsi, offer product lines that almost mirror each other which results in little differentiation between products. Despite the small amount of product differentiation strong brand loyalty exists in the CSD industry and further exacerbates the consolidation of the industry. co*ke and Pepsi’s position as the top two holders of market share since 1966, despite the development of other products like Dr Pepper and 7UP, is proof of the extreme loyalty that exists to these two brand names (Yoffie & Wang, 2002, p. 18). High loyalty to these two brands has made it difficult for other firms to gain meaningful market share and continues the trend of consolidation in the CSD industry.
The CSD industry’s high CR4 and structural characteristics have made this industry an oligopoly where the strategies of the major competitors tend to shift with one another. co*ke’s and Pepsi’s competitive strategies have tended to mirror each other over the years in an action and reaction manner where when one company made a shift in strategy the other company was sure to follow. For example, in 1980 when co*ke switched its concentrate sweetener from sugar to high fructose corn syrup because the syrup was much cheaper than sugar Pepsi was soon to follow (Yoffie & Wang, 2002, p. 8). As long as the competitive strategies of these companies continue to mirror each other competition in the CSD industry will remain high. co*ke’s and Pepsi’s inabilities to break free from their dependence on one another will force them to continually be competing for the same market share in the CSD industry and any other industries these companies choose to enter.
While the competitive strategies of these companies do tend to move together they do so unilaterally which can seriously impact the profitability of co*ke and Pepsi as well as the entire industry. For example, in 1999 co*ke enacted a major price increase for its co*ke Classic brand and Pepsi followed with a price increase shortly after both of which caused a decrease in consumer purchases and return to shareholders (Yoffie & Wang, 2002, p. 11, 19). Since co*ke and Pepsi are the major players in the CSD industry any decrease in profit or return to shareholders for these two companies will also negatively impact the profitability of the entire industry. Despite unilateral shifts in competitive strategy between co*ke and Pepsi the CSD industry has remained profitable over the years. Looking toward the future, if co*ke and Pepsi continue their competitive feud with one another eventually one company could make a unilateral shift in price that would destroy the profitability of the entire industry. In order to maintain the profitability of the CSD industry co*ke and Pepsi should start competing on non-price based factors like product differentiation and avoid unilateral price changes (Jain, 2002). In doing so neither company would disturb the consolidated structure of the industry and both companies could remain profitable thus greatly contributing to the increased profitability of the entire CSD industry over time.
CSD Industry Economies of Scale in Advertising
As previously mentioned, advertising costs in the CSD industry are extremely high which makes economies of scale an important concept in this industry. Economies of scale occur when the average costs associated with achieving or producing something diminish with higher frequencies or units produced. Such efficiencies create absolute cost barriers to entry and are typically associated with actual production costs since a threshold level of production must be achieved to lower costs sufficiently to be profitable or effective relative to competitors (Grant, 2008, p. 74). In the CSD industry, effective advertising requires a high commitment of capital to achieve visibility with consumers in order to drive sales increases and gain market share. This economy of scale in advertising allows larger firms to realize higher per-dollar returns on their investments.
The two major players in the CSD industry have made massive investments in their brands over the span of decades, sometimes almost doubling advertising spending in the span of one or two years as co*ke and Pepsi did between 1981 and 1984 (Yoffie & Wang, 2002, p. 8). Such investments achieve the simple economies of scale through purchasing power and volume discounts for advertising space, depth of market research available, and actual creative production efficiency. The innovative nationwide campaigns developed through such investments, including the famous “Pepsi Challenge”, the reformulation of the co*ke and co*ke Classic brands, and themes such as the “Pepsi Generation” or “co*ke is it,” were implemented on a scale that elevated both brands in the minds of consumers almost to the level of pop culture and positioned them among the most visible and valuable corporate food and beverage brands (Yoffie & Wang, 2002, p. 22). This brand value and associated market share are the cumulative effects of years of advertising investment that co*ke and Pepsi have made as early entrants in the industry. As a result, a new entrant to the industry looking to achieve similar market share would need to both match the current levels of advertising spending by these giants and invest heavily to overcome the inherent advantages gained from co*ke’s and Pepsi’s past investments. These economies of scale in advertising represent a prohibitive barrier to entry in the CSD industry.
Current Conditions of Advertising in the CSD Industry
A review of advertising spending and its relationship to market share illustrates the impact of economies of scale, the stranglehold they create for the CSD industry’s oligopolies, and the threshold of efficiency in advertising. Despite significantly different levels of advertising among the top ten brands in the CSD industry there was no change in market share among the top ten between 1999 and 2000 as they retained the same 72.9% of the overall market share (Yoffie & Wang, 2002, p. 17). Diet co*ke, Diet Pepsi, and Barg’s reduced spending but retained or gained market share which was likely a result of equity built in their brands. However, massive increases by both co*ke Classic and Pepsi of 39% and 43% respectively resulted in a gain of just 1% of market share for co*ke, while Pepsi declined 2% (Yoffie & Wang, 2002, p. 17). This trend would indicate that a “dilemma” game is being played out whereby both competitors invest to match each other well past the point of audience saturation and diminished return (Grant, 2008, p. 103). 7Up, Dr Pepper, and Mountain Dew similarly increased their advertising budgets from 1999 to 2000 which resulted in relatively small or no gain in market share, indicating that they too have reached this dilemma with their competitors. Overall, between 1999 and 2000 the top ten brands increased advertising spending by 24.5% relative to an 8% increase for the total market in order to solely retain their market share.
The desire to match direct competitors’ advertising efforts in the absence of collusion can result in reduced efficiencies and increased costs in the advertising side of the CSD industry. Aside from the purpose of gaining market share increases in advertising from the top ten brands between 1999 and 2000 could have also been an attempt by the CSD industry to counter erosion by other non-CSD beverages such as teas, waters, and sports drinks that have gained in consumption in the last decade and occupy a growing share of the total beverage market (Yoffie & Wang, 2002, p. 16). Such reduced efficiencies may also be episodic, or cyclical, as the absence of significant industry competitor with co*ke and Pepsi may result in a mutual reduction of spending and return to greater efficiencies in advertising for both companies.
Key Opportunities and Challenges in the CSD Industry
Advertising is not the only major factor that impacts the opportunities and challenges of the CSD industry. In the late 1990s and in early 2000 the CSD industry faced a number of other challenges and opportunities. Using Porter’s Five Forces model we will identify key challenges and opportunities in this industry.
Intensity of Rivalry
Due to the consolidated structure of the CSD industry intense rivalry is a major challenge. The industry’s major competitors have to compete not only with each other but also with smaller firms and generic store brands. Furthermore, because total costs in this industry are high and mostly fixed companies must produce near capacity in order to attain the lowest per unit costs. These high levels of production can lead to a fight for market share and result in increased rivalry (Grant, 2008). Additionally, intense rivalry exists in the CSD industry because consumers can freely switch from one product to another and are extremely sensitive to price changes.
Barriers to Entry
Another major challenge facing the CSD industry is high barriers to entry for all companies involved. While the capital requirements are relatively moderate, the marketing expenses are high. Additionally, distribution channels are highly controlled and have limited capacity which leaves firms constantly competing for the best positioning in stores, restaurants, and other vending locations. Retaliation is also high in the CSD industry. Major players in the CSD industry have historically engaged in legal action and price wars in order to deter new entrants and keep current competitors from gaining market share (Yoffie & Wang, 2002).
Threat of Substitutes
While the threat of substitutes is generally high in the CSD industry because there is little differentiation between products this has actually acted as an opportunity because it has forced firms to look for ways to continually reinvent themselves in order to remain competitive. For example, both co*ke and Pepsi have diversified into non-cola products and have explored international opportunities. These factors have allowed for the diversification and bolstered profitability of CSD firms (Yoffie & Wang, 2002).
Power of Suppliers
The power that CSD firms has as buyers in this industry also acts as an opportunity. Since the agreements between CSD firms and their suppliers are often governed by contractual or franchise agreements that include allowances for price adjustments this gives CSD firms the ability to better control their costs and respond to price increases in materials. Additionally, since CSD firms also have the ability to form long-term relationships with their suppliers they are able to better predict future profitability because costs can become fixed.
Power of Buyers
The power of buyers in the CSD industry is a major challenge for CSD firms. Since companies rely heavily on brand identity and advertising to build and maintain market share the CSD industry is at the mercy of the tastes and preferences of buyers. High consumer price sensitivity also increases the power of buyers in this industry because similar substitutes are readily available and switching costs are non-existent.
Please see Appendix (1) below for more details regarding the 5-Force Model.
co*ke’s and Pepsi’s Responses to Challenges and Opportunities
co*ke and Pepsi have responded to the challenges and opportunities that exist in the CSD industry in similar ways. In response to the intense rivalry that exists in the industry both co*ke and Pepsi have been forced to spend significant resources to promote their products, launch marketing campaigns, and offer discounts and commercial promotions. Doing so has created a weakness for both companies due to increased costs and has threatened the industry by increasing barriers to entry.
co*ke’s and Pepsi’s responses to the barriers of entry in the CSD industry have also been similar to each other. For example, in order to gain better access to distribution channels, co*ke and Pepsi acquired bottlers and created bottling subsidiaries (Yoffie & Wang, 2002, p. 10). Both companies saw an opportunity in the market to consolidate bottlers and took advantage of that opportunity in order to gain more control over distribution networks. In turn, this also increased both companies’ powers as buyers over the suppliers which had traditionally held most of the power in the industry. However, in responding to the entry barrier of retaliation both firms have weakened their financial positions by engaging in expensive lawsuits in order to keep one company from increasing its market share.
As consumers began purchasing more substitute products co*ke and Pepsi responded to the slowed growth in the CSD industry by diversifying their brand holdings. As consumer trends shifted from carbonated drinks to lemon-lime drinks, tea-based drinks, and other non-carbonated drinks, co*ke and Pepsi followed an aggressive strategy to acquire brands such as Tropicana (Pepsi), Gatorade (Pepsi), Aquafina (Pepsi), and Dasani (co*ke) (Yoffie & Wang, 2002, p. 12-13). This diversification enabled co*ke and Pepsi to counter the slow growth in the CSD industry and increase their market share and profitability.
In order to remain profitable both co*ke and Pepsi also had to respond to the high power of their buyers. Both companies did a great job of responding to changing consumer preferences by introducing bottled water brands as the consumption of bottled water began to rise and offering diet versions of their products. Additionally, both companies recognized the importance of brand loyalty by spending millions of dollars on campaigns to convince consumers that one brand was better than the other. However, co*ke and Pepsi did make a mistake in responding to high consumer price sensitivity in 1999 by increasing prices which temporarily decreased consumption (Yoffie & Wang, 2002, p. 11). Eventually both brands did realize that the higher prices were hurting sales and agreed to lower prices.
Future Profitability of co*ke and Pepsi
As domestic demand for CSD beverages plateaus alternative beverages could provide a growth engine for both co*ke and Pepsi (Yoffie & Wang, 2002, p.12). With a health conscious society on the rise, both companies can continue to expand product offerings that are tailored to different market segments in order to maintain profitability. Even though both companies are constantly battling one another they each create a competitive situation that gives consumers more choices domestically as well as internationally. As the cola wars continue both companies will need to look for ways to make their products more affordable such as using refundable glass packaging and cheaper bottles and by exploring untapped international markets.
Recommendations for Success
I believe that both co*ke and Pepsi will continue to be formidable forces in the CSD industry and will continue to sustain profitability without threat from new entrants due to significant barriers to entry (Grant, 2008, p.72). As consumers' needs change they are demanding healthy drinks and snacks which are creating a paradigm in the CSD industry. This shift produces tremendous opportunities for both co*ke and Pepsi to diversify their product offerings in an effort to capture more of the changing market share. Pepsi and co*ke may also want to look into competing in markets where the other company has no interests in order to lessen their dependence on one another and diversify their holdings so that each company can grow.
In order to expand internationally we believe that management at Pepsi and co*ke should have clearly defined strategies and targeted plans in order to effectively utilize their resources in the international market and any shifts in strategies should be made simultaneously in order to avoid replicating the price wars and cut throat activities that occurred in the United States. With a population of 5,996,000 people in 1999 there are enough emerging markets across the globe so that both companies can compete in foreign direct investment through the use of Greenfield investment or through local partnerships that will help to mitigate costs and minimize barriers to entry and country risks (Yoffie & Wang, 2002, p.23). Pepsi’s and co*ke’s management must also actively give back to society through environmental efforts, like recycling, in order to ensure long term corporate and environmental sustainability as well. Both companies are poised for continued growth if they invest wisely, focus on the consumers and markets that they serve, and continually scan the environment for new opportunities.
References
Grant, R.M. (2008). Contemporary strategy analysis (6th ed.). Malden, MA: Blackwell.
Jain, V. K. (2002). Note on industry structure.
Yoffie, D. B., & Wang, Y. (2002). Cola wars continue: co*ke and Pepsi in the twenty-first century. Harvard Business School Press. HBS 9-702-442.
Appendix(1) - Five Forces Analysis of Concentrate Producers and Bottlers
