Cola Wars

Q1. If we consider that Coke and Pepsi have been in a very profitable industry, why have very few firms successfully entered this business over the last century?

Answer: The reasons for very few firms successfully entering the business over the last century can be attributed to the fact that the market has been dominated by two players. This was achieved through:

1. Litigation (Page 5): Coke aggressively fought imitations and counterfeit versions through trademark infringements in court during early days. In 1916 alone 153 imitations were barred
2. Brand Loyalty (Page 10): Loyalty is extremely high in this sector. In fact, customers tend to create a clamour if the formulation changes as it could be seen in the case of coke (page 8). Thus, even if a new product were to enter the market it would be extremely difficult to induce a switch. The fact that the market is extremely concentrated (analysis in attachment) makes it very difficult for a new player to make inroads.
3. Huge advertising spends (analysis attached): Pepsi and coke have historically invested highly in advertising. This ensures that a new player without deep pockets entering the space does not get any foothold. Gatorade in recent days has managed to make inroads into the shares; however, one can see from exhibit 8 that they have spent more than Pepsi to get about 1/3rd of the shares currently held by it and on the contrary Dr. Pepper which has reduced its spending has lost out on shares.

One mustn’t attribute the growth of Gatorade entirely to the advertising spends and rather the trend of consumers to move towards healthier drinks.

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Q2. Compare the "concentrate" business to the "bottling" business. Why has their profitability been so different?

Answer: Core Process: Concentrate producers manufactured basic soft drink flavours and sold them to bottlers. The concentrate producer blended raw material ingredients, packaged the mixture in plastic canisters and shipped those containers to the bottler. Bottlers purchased concentrate, added carbonated water and sometimes sweetener, bottled or canned the soft drink, and delivered it to customer accounts. Major concentrate producers used “store door” delivery, whereby soft drinks were delivered directly to individual retail outlets, bypassing retailers’ warehouses. Smaller brands distributed through food store warehouses.

Capital Expenditure: The manufacturing process for concentrate was simple and required little capital investment. A typical concentrate manufacturing plant which could cover a geographic area as large as the United States cost between $50 million to $100 million to build. The bottling process was extremely capital-intensive and involved specialized, high-speed lines. Lines were interchangeable only for packages of similar size and construction, thus each major package type requires separate bottling equipment. Bottling and canning lines cost from $4 million to $10 million each, depending on volume and package type. The cost of a large plant with multiple lines and automated warehousing could reach hundreds of millions of dollars.

Other Costs: A concentrate producer’s most significant costs were for advertising, promotion, market research, and bottler support. Marketing programs were jointly implemented and financed by concentrate producers and bottlers. For bottlers, their main costs components were concentrate and syrup. Other significant expenses included packaging, labour and overheads. Bottlers also had to invest money in trucks and setting up their distribution networks.

Business Aspects: The concentrate producers usually took the lead in developing the programs, particularly in product planning, market research, and advertising. Bottlers assumed a larger role in developing trade and consumer promotions. Concentrate producers employed extensive sales and marketing support staff to work with and help improve the performance of their franchised bottlers. They set standards for their bottlers and suggested operating procedures. They also negotiated directly with their bottlers’ major suppliers (primarily sweetener and packaging vendors) to achieve reliable supply, fast delivery and low prices.

Profitability: Bottlers’ gross profits exceeded 40% but operating margins were usually around 8%, about a third of concentrate producers’ operating margins. (Operating income - $0.30 per case i.e. 32% of net sales) One of the reasons as highlighted above was the huge difference in capital investment. Although Coke and Pepsi had different terms and conditions in their contract with their bottlers but they ensured that they had the bargaining power or the upper hand in setting the concentrate prices. Also over the last two decades, concentrate makers regularly raised concentrate prices, often by more than the increase in inflation [change in CPI (1988 – 2009): 2.9% whereas change in concentrate price – 3.6%]. Bottlers had the final say in decisions about retail pricing. Pressures from concentrate producers on bottlers to spend more on advertising, product and packaging proliferation, widespread retail price discounting – together, these factors resulted in higher capital requirements and thus lower profit margins. Over the time bottlers also had to manage an ever increasing number of SKUs (CSDs and non-CSDs) which led to increased costs (logistics and operations) resulting in lower margins.