Is Vertical Integration Necessary in the Soft Drink Industry?

Benjamin Martin
March 30, 2004
EWMBA 299E – Competitive Strategy
Prof: Meghan Busse
 The carbonated soft drink (CSD) industry, from concentrate producers down to the retail

selling of the end product is ripe for vertical market failures because one stage of the process

retains significant market power. This paper will give an overview of some financial statistics

comparing two different stages of production process, the concentrate production and the bottling,

or end-packaging, of the product. The paper will then go on to discuss the causes of the vertical

market failures and what is being done by the concentrate producers and bottlers to mitigate them.

Finally, the paper will discuss the pros and cons of vertical integration as a possible solution to the

vertical market failures.

Economics: Concentrate Producers vs. Bottlers

The concentrate producers have significant strategic advantages over the bottlers that allow

them to have lower cost of sales as a percentage of sales, 17%, relative to the bottlers, 65%. The

advantages are simply the facts that the concentrate producers actually own the copyrights and the

product that the end consumers want and that the market is dominated by two players, Coca-Cola

and PepsiCo. This concentration has given producers a significant amount of power in the contract

negotiations with bottlers and has allowed them to essentially dictate the prices at which they sell

the concentrate to the bottlers. The bottlers, on the other hand, have no real strategic advantage.

They are caught in the middle between the concentrate producers and the retailers. The market

power of the concentrate producers squeezes them from the supply side and years of “Cola Wars”,

from the Pepsi Challenge to Britney vs. Harry Potter, have kept pressure on retail prices, squeezing

the profits from the bottlers.

Aside from the cost difference of the ingredients that are used by the concentrate producers

and the bottlers, also affecting the gross margins is the cost of packaging. For concentrate
producers, the cost is relatively small since the concentrate is shipped in bulk to the bottlers and

concentrate is, well, concentrated. However, the bottlers have to sell the products in their end

packaging which is typically small containers and the end product is diluted from the concentrate,

both increasing volume and driving up their costs.

Another disparity between concentrate producers and bottlers is the selling and delivery

costs. Concentrate producers also have low selling and delivery costs because the concentrate is

low volume relative to the end product, hence lowering transportation costs relative to bottlers. In

addition, they only have to deliver to a few locations, the bottling plants. In contrast, bottlers have

higher volume to transport, the end product diluted from the concentrate, and they have to

distribute to the many retail locations that sell the end product. The bottlers try to maximize the

sales in these retail stores by giving high quality of service to retailers (Direct Store Door

Delivery), but this is an expensive service to provide. This combination of service quality and

bulky transport raises costs for the bottlers

The concentrate producers, owning the trademark and the product, take on the major

responsibility of marketing and advertising, so naturally their costs as a percentage of sales would

be quite a bit higher, 39%, as compared to 2% for the bottlers. The reason for the disparity is

because the concentrate producer has the brand to protect and takes the lead on most marketing

and advertising of the end product. In addition, the concentrate producers also assist the bottlers

with sales and marketing support staff, because the end product is their main source of revenue and

it cannot be easily replaced. On the flip side, the bottler does not have the same magnitude of

incentive for the survival of the brand. They do want to maximize sales, but they are not

necessarily tied to a particular brand and they can just compete with other bottlers and get a

contract with a different concentrate producer.

Vertical Market Failures

The market between the concentrate producers and bottlers is prone to vertical market

failures because there are very few concentrate producers and many bottlers. This can lead to a

market dominated by the concentrate producers, who can manipulate the transactions between the

two parties. The contracts between the concentrate producers and bottlers, although written in

favorable terms for the concentrate producers, are meant to be long-term and predictable, in

attempt to standardize the numerous transactions that would take place without them.

Without the standardization of contract terms, including concentrate price, each time an

order of concentrate was ready to be bottled, the price and terms would have to be settled. Since

selling soft drinks (and the newer products) is a semi-continuous process (i.e. people are

continuously buying these products) the process from making concentrate to bottling should be

somewhat continuous. The concentrate producers benefit by not having to negotiate each time

they need to have concentrate packaged, lowering transaction costs. To aid the bottlers, they need

a fairly continuous stream of concentrate to bottle, otherwise they will take on other contracts and

bottle those products, generating switching costs, when they go back to bottling the original

concentrate. There could also be impact to the transaction from external forces. The bottler could

want to delay the bottling because they have to complete another contract first so they may stall

negotiations or ask for a better price because they have enough work from other contracts and

don’t necessarily need this contract.

The stability of the long-term contract has other advantages for both sides. It gives the

bottlers exclusive territorial rights, reducing inter-brand competition, and gives bottlers a relatively

predictable volume of business. The contracts also remove the incentive for the concentrate
producers to abusively manipulate the transactions as can happen in a market dominated by few

sellers as mentioned above.

One area where the contracts fail to improve the conditions between the concentrate

producers and bottlers is aligning incentives between the two parties. Although both sides want to

maximize profits, doing so independently may lead to different allocations of marketing,

advertising and capital spending that affect product sales volume for both existing and new

products. On several occasions, Coca-Cola and PepsiCo have made significant capital investments

on behalf of the bottlers to put in specialized equipment so the bottlers can package new products.

Without these investments, the concentrate producers would have had significant difficulty rolling

out new products.

In other cases, some bottlers didn’t invest in many of the hot fill or reverse osmosis

equipment required for new tea and water products because they did not think it was in their best

interest. Instead, they bought these products from the regional plant owned by a concentrate

producer or another bottler and distributed them along with the products they packaged. These

kinds of actions can cause strain on relationships, increase overall costs and strain the concentrate

producers’ capital.

The contracts allow the bottlers to have final say in retail price, new packaging (but they

could only use authorized packaging), selling and advertising in its territory. This also can cause

friction between concentrate producers and bottlers because of misaligned incentives. In the past

Coca-Cola has had trouble convincing some bottlers to join advertising campaigns and have had to

chip in to get the bottlers to go along. Coca-Cola was not obligated to share marketing expenses

but did so to ensure quality and proper distribution of marketing for their products. Again, this can

cause strain on the relationships between bottlers and concentrate producers.

Vertical Integration

The issues discussed above have led Coca-Cola and PepsiCo to partially vertically integrate

in to bottling. Coca-Cola started CCE, Coca-Cola Enterprises, and established it as an independent

bottling subsidiary of Coca-Cola. The parent company would buy struggling bottlers and resell

them to CCE. Pepsi followed a similar pattern. They acquired about half of their bottlers and held

equity stakes in the rest. In the 90’s PepsiCo also created PBG, Pepsi Bottling Group, as an

independent anchor bottler for the parent company.

There is not sufficient reason for concentrate producers to vertically integrate any further

than taking equity stakes in bottlers or helping out the bottlers when they have problems as they

have already done. Although the issues raised earlier in this paper do exist, the failures in the

market are not best handled by vertical integration. The transaction frequency, potentially causing

high transaction costs and unreliability, have been taken care of through the use of the master

bottling contracts that provide long term stability of production volumes and price. These long

term contracts also solve a potential problem of not having an outlet of bottling and retail

distribution.

Another issues solved by the contracts is the market power in the industry being with the

two large concentrate producers. This power gives them the ability to extract the economic surplus

from the bottlers. If the concentrate producers were to vertically integrate, the surplus they would

be taking is from themselves. Given that bottlers’ margins are already squeezed on both sides,

there is no additional economic surplus for the concentrate producers to gain by vertical

integration.

The strongest argument for vertical integration is to align incentives of all parties involved

in the entire production process. Being separate companies, the concentrate producers and the
bottlers will each employ different strategies that will maximize their own return. These strategies

could be harmful to the other party in the vertical production chain. Conflicts could arise because

a local bottler may choose a different strategy in pricing, marketing or quality of service that

optimizes their profit while hindering the profits of the concentrate producer’s. For example, the

bottling contracts provide the bottlers with the final say in pricing, regional advertising and service

to retailers. The concentrate producers would like to have full control over these since they own

the brand and have the most to lose, potentially a significant amount of market share in a particular

region, if the brand is eroded poor service or lack of regional advertising by a particular bottler.

Vertical integration, either by purchasing bottlers or creating a wholly owned subsidiary,

would align the incentives of each party that is involved in the production process. However,

vertically integrating brings its own set of issues. The concentrate producers would lose

substantial flexibility in ramping up or stopping production because they would be constrained by

the switching costs. By outsourcing this function, they have the ability to add additional capacity

or reducing capacity quickly by signing or terminating contracts. Another related drawback is they

would bear the bulk of the capital costs if they were to own the bottling processes.

For the carbonated soft drink industry (including new non-CSD products) quasi-integration

strategies they have employed so far, such as franchising, taking an equity stake or outsourcing

completely, are superior to vertical integration. The concentrate producers retain the production

flexibility, do not bear the majority of capital costs and leave the bottling and distribution the

supposed experts, the bottlers. The most significant issue they have to conquer is to align the

incentives of the production chain, as discussed above. The concentrate producers must find a way

to align the incentives of the producers so they retain more control over the bottlers yet influence

the bottlers to go along with marketing campaigns or other initiatives they are undertaking.