In the years between 1975 and 1993, the Coca Cola Company had an average return on equity of 30.5%. Similarly, PepsiCo Inc. had an average return on equity of 21.2%. While these figures likely include soft drink take-back operations (it's hard to tell from the information available in the Yoffee and Foley case), it's clear that the soft drink industry is extremely profitable—profitable, that is, for producing concentrates like Coca -Cola and Pepsi. Say no to plagiarism. Get a tailor-made essay on "Why Violent Video Games Shouldn't Be Banned"? Get an original essay For other members of the soft drink supply chain, the soft drink industry is not as attractive. The pre-tax profit for a typical bottler, for example, is less than a third of that of a standard concentrate producer. This discrepancy between the profitability of concentrate producers and that of bottling companies arises from the competitive structure of the two separate industries. Concentrate Suppliers: A Structural Analysis Using a basic structural analysis of the soft drink concentrates market, it is easy to see why the industry is so profitable. First, there are few direct competitors within this market: Coca-Cola and Pepsi make up 72% of the entire market, with only a handful of additional suppliers making up the remaining 28%. Furthermore, competition between these companies is limited by strong brand recognition, especially for Coca-Cola and Pepsi. Because major players can rely on their strong, differentiated brands, they are able to price their products substantially above long-term average costs1. Second, the industry's basic cost structure – low fixed costs versus high variable costs – helps concentrate manufacturers to avoid falling into harsh price competition2. The tendency to compete on price is further limited by the nearly century-long competition between Coke and Pepsi, a history that has allowed them to learn how to avoid destroying profits in mutually damaging price wars. Third, concentrate suppliers have a strong strategic advantage over… versus their suppliers. Because concentrate producers purchase undifferentiated raw materials from a large number of supplier companies, they are able to avoid losing a significant portion of the value they create in upstream market transactions. The result of this strategic advantage is that the average concentrate supplier spends only approximately 17% on the direct costs of producing concentrate. This allows Coke and Pepsi to invest in other aspects of the business – brand recognition, retailer relationships and market research – that will help perpetuate these strategic asymmetries and allow concentrate suppliers to continue to capture the lion's share of the value created by the entire soft drink. industry. 1 Smaller brands charge substantially less than Coca-Cola and Pepsi. In fact, the profitability of each manufacturer is directly proportional to the strength of its brands. A comparison of the net profitability of Dr. Pepper, Seven-Up, and Royal Crown in Exhibit 2 shows that the profitability of Royal Crown – a company with a substantially less recognized brand than Dr. Pepper or Seven-Up – has historically remained behind that of Dr. Pepe and Seven-Up. 2 The typical concentrate production facility costs $5-10 million and could supply the entire country. This compares to capital investment of $3.2 billionnecessary so that bottlers can satisfy commensurate demand. Likewise, concentrate suppliers have a strong strategic advantage vis-à-vis their customers. The large number of undifferentiated bottling companies allows concentrate suppliers to seek the highest prices for concentrate, securing the most favorable returns in long-term contracts. This allows concentrate suppliers to avoid losing a significant percentage of the value they create in their downstream market transactions. Finally, although producing physical soft drink concentrate is a trivial industrial exercise, the importance of brand recognition has created high barriers to entry. Indeed, Saloner, Shepard, and Podolny specifically cite Coca-Cola and Pepsi as having a “promotional advantage from cumulative investment.” This brand recognition helps Coca-Cola and Pepsi perpetuate all of these strategic advantages by increasing long-term barriers to entry into the concentrate market, thus preserving Coca-Cola and Pepsi's ability to expropriate the vast majority of value created along the way. the entire value chain. Interestingly, concentrate suppliers have managed to isolate the one aspect of the soft drinks market that can provide continued positive returns. While we're used to thinking of soft drink production as being made up of several industries along a multi-step value chain, the only reason it appears that way is because Coca-Cola and Pepsi have been very adept at outsourcing virtually all of them. the aspects of the business that do so. do not provide positive long-term returns. In fact, it is likely that the only reason Coca-Cola and Pepsi continue to produce soft drink concentrates is that it is easier to promote the brand if they can claim to produce "the essence of the product". In purely economic terms, however, the concentrate is simply an additional product input, while the brand is the essence of the product. Bottlers: A Structural Analysis In contrast, the soft drinks bottling sector shows every sign of long-term unprofitability. Bottlers face stiff competition in a highly fragmented competitive landscape: in 1994 there were between 80 and 85 bottlers nationwide, each producing an undifferentiated product. Furthermore, as of 1994, there are few – if any – barriers to entry. In direct contrast to Coca-Cola and Pepsi's strategic advantage over their upstream suppliers, bottlers face a far less hospitable environment in their commodity market. Not only are there only a few concentrate suppliers, but two manufacturers - Coca-Cola and Pepsi - together make up nearly 60% of the soft drink concentrate market. This is compounded by the extent to which the bottling company's customers have acquired increasing market power. WalMart's enormous size compared to other retailers and effective use of its own brand of soft drinks has put increasing pressure on the prices bottlers can charge their retail customers. This pressure is exacerbated by the bottling industry's underlying cost structure where high fixed costs relative to variable costs increase incentives for short-term pricing below average total costs. The result of all these factors is an industry that earns zero long-term economic profits. Historical relationship between bottlers and concentrate producers Coca-Cola and Pepsi have long relied on exclusive bottling franchises as their primary method ofbottling and distribution of their products. In the early 1980s, Coca-Cola and Pepsi owned only 20%-30% of their bottling companies; the rest were privately or publicly owned franchises. Historical relationships between concentrate suppliers and bottlers have evolved as a result of the underlying economics of the soft drinks business. Using Stuckey and White's analysis, the industry exhibits characteristics of an industry plagued by vertical market failure. In this case, however, the benefits of these market dynamics accrue to concentrate suppliers. Since there are many buyers (bottlers) and few sellers (concentrate suppliers), sellers dominate the market. (This is illustrated in the diagram below.) Since most of the value within the value chain lies in the brand recognition associated with concentrate production, Coca-Cola and Pepsi clearly benefit from outsourcing bottling and manufacturing. distribution. Nonetheless, concentrate suppliers clearly need to ensure that their brands are not compromised by the way bottlers and distributors market and sell their products. Franchise agreements have allowed concentrate manufacturers to control their brands without diluting their capital and management resources. The specific terms of these franchise agreements demonstrate the extent to which concentrate suppliers have managed to take advantage of market dynamics and assert control over the entire soft drinks value chain. Concentrate manufacturers have used their sales and marketing organizations to promote soft drink sales. They also establish production standards to control the quality of soft drinks. They even went so far as to mandate direct store door (DSD) delivery, effectively redistributing value within the supply chain from bottlers to retailers. The nature of this relationship, however, is not entirely expropriatory. Coca-Cola and Pepsi have clearly recognized the extent to which strategic asymmetries surrounding the bottling industry could well lead to long-term negative economic profits and above-average bottling and distribution of soft drink products. In order to promote the long-term health of the bottling industry, Coca-Cola and Pepsi lobbied extensively for the Soft Drink Interbrand Competition Act of 1980, a federal regulation that preserved the right of concentrate manufacturers to grant exclusive territories. In essence, this legislation promoted the strategic advantage of bottlers over retail stores by transferring value from retail stores to bottlers. Vertical Integration: Rationale and Rhetoric Given the benefits provided by the franchising system, it is difficult to understand why Coca-Cola and Pepsi would want to vertically integrate into bottling. Yet this is exactly what they started doing starting in the mid-1980s. According to Yoffie and Foley, between 1980 and 1993, Coca-Cola and Pepsi nearly doubled their reliance on company-owned bottlers. The "analyst's reasons" for such expansion, however, make little economic sense. The weakened bottlers needed capital infusion and so looked for buyers. While it is perhaps correct to say that the profitability of the bottling industry was declining in the late 1970s and early 1980s, this can only be seen as an effect of franchising agreements, arrangements put in place and enforced by suppliers of.