Compare the economics of the concentrate business to that of the bottling business: Why is the profitability so different? The returns received by concentrate producers differ from those received by bottlers for several reasons … Concentrate producers:
Capital investment. Concentrate production business is less capital intensive than bottling. It requires less funds to be invested in machinery, labor and modernization. “A typical concentrate manufacturing plant cost about $25 million to $50 million to build, and one plant could serve the entire United States” (Yoffie, 2007). The number of significant costs is small. The major ones are: advertising, Market Research and product development. However, concentrate producers tended to employ large number of people to work with bottlers and their suppliers to ensure quality control and efficiency of production as well as reliable supply of raw materials (e.g. cans) and low prices (Yoffie, 2007). Franchising. The concentrate producers work using the principle of franchising. It means that bottlers pay them in order to become part of the bottling network and are granted “the sales operation in an exclusive geographic territory…(Yoffie, 2007)” Concentrate price. Coca-Cola was able to determine its concentrate prices since 1987 when the Master Bottling Contract was established. Pepsi’s Master Bottling contract was a bit different to Coke’s as it obliged bottlers “to purchase raw materials from Pepsi at prices, and on terms and conditions, determined by Pepsi”. They based the price of the concentrate on CPI and negotiated it with bottlers. “From the 1980s to the early 2000s, concentrate makers regularly raised concentrate prices, even as inflation-adjusted retail prices for CSD products trended downward”, – another reason for greater returns in concentrate production business. As brand promotion was very strong and formula was always kept a secret the whole thing with concentrate was kind of exclusive, so it greatly added towards the price of the concentrate itself and, as the result, towards the returns of concentrate producers (Yoffie, 2007). Raw materials. Concentrate producers required fewer raw materials and their major spending were on caramel coloring, citric acid, caffeine and natural flavorings. Bottlers, on the other hand, required large number of production materials. Their major inputs were:
packaging (e.g. cans, glass bottles etc.), as well as sweeteners (e.g. aspartame). This process helped concentrate makers reduce the outflow of money which increased their profitability (Yoffie, 2007). Bottlers:
Dependency. Bottlers were always very dependent on concentrate producers as they were obliged to buy raw materials from them (Pepsi Master Bottling Agreement). They were also very dependent on suppliers of packaging, flavours and sweeteners. As the price of the concentrate rose, bottlers could not react in the same way and increased the price of the final product as they were being squeezed by other suppliers of different beverages. These factors contributed to lower returns in bottling business. Bottling is a much more capital intensive industry than concentrate production. It requires huge investment and on-going improvement and modernization of bottling lines. Large bottling plant with “a capacity of 40 million cases, could range as high as $75 million” (Yoffie, 2007). High competition. The number of bottlers is much greater than the number of concentrate producers, so the competition took place between them was fierce. There were approximately 2000 bottlers in 1970s and the figure dropped to less than 300 by 2004. Ongoing modernization and increasing capacity was required from bottlers (which were often small and family-owned) and not all of them could meet those requirements, so their number dropped. High competition ensures that returns are really low, only enough to survive Investments. Besides investments in modernization, bottlers bought trucks for transporting and established the distribution channels. It all required some investments as well. “Bottlers’ gross profits routinely exceeded 40%, but operating margins were usually in the 7% to 9% range (Comparative Costs of a Typical U.S. Concentrate Bottler and Producer). Stability. The returns received by bottlers are less than returns received by concentrate producers due to the risk levels as well. The concentrate producers are responsible for brand promotion and invest heavily in trademark to stimulate sales. High returns are what they get as the result. However, bottlers have little risk in their operations as they are given the famous name well-known all over the world. This development provides them with stable returns, and low risk.
How has the competition between Coke and Pepsi affected the industry’s
profit? The competition between Coke and Pepsi reached its peak to become a real war battle by the year 1980. This war had affected the industry profit for both concentrate producers and bottlers, while the effect of bottlers was much higher. After the successful “Pepsi Challenge” (blind taste tests: sales shot up) in 1974, Coke countered with rebates, retail price cuts and significant concentrate price increases. Pepsi followed of a 15% price increase of its own. During the early 1990’s bottlers of Coke and Pepsi employed low price strategies in the supermarket channel in order to compete with store brands. The concentrate producers were always able to increase their profits by increasing the concentrate price, while the bottlers, especially the small-sized, had to suffer from the war dramatically by decreasing their profits. This had a negative effect on the profitability of the bottlers (Operating income in 2009: concentrate producers 32%, bottlers 8%). During this period net profit for bottlers was in the low single digits. The war forced bottlers to increase their advertising and packaging proliferation, giving discounts for shelf space and spending high capital on new products. Pepsi and Coke were however able to maintain the profitability through sustained growth, for example the successful launch of Diet Coke by Coca Cola or the entry of Pepsi into the food business, which both contributed powerful to the companies and as a result to the industry’s profit.