The RTE Cereal Industry in 1994

Case Analysis
Competitive Strategy

Presented by:
Raghav Keshav
Why has RTE cereal been such a profitable business?
The RTE cereal market is a classic oligopoly with the four dominant players controlling
85% of the market. The return on sales earned by the incumbents in this market (18%) is
significantly higher compared to rest of the food industry (5%). Efficient markets
typically entice new entrants when the returns are attractive. These returns are gradually
eroded with increased price competition as a result of the entry. The RTE market has
defied this market theory.

There are two main reasons for this. One, any market that yields a high rate of return but
has no new entrants must have significant barriers to entry. The RTE cereal market has
significant entry barriers. Two, barriers to entry does not necessarily mean high profits
for all incumbents in an oligopoly. However, in the RTE cereal, it has. This is
attributable to the fact that players in the oligopoly have demonstrated profit
maximizing behavior and have successfully avoided market share maximization
motivated price wars.

Barriers to entry are discussed below.

Brand Proliferation Strategy: Incumbents have successfully launched a “brand
proliferation” strategy using which every foreseeable market niche is already serviced
with a specific brand. Collectively, there are about 200 + brands offered by the three
leading suppliers. This approach deters new entrants because no market niches are left
out for new providers to exploit. Also, the given market share of any one brand is low in
a market which has such a large number of brands. This also makes it difficult for new
entrants, as the expected market share from a new launch (and hence revenue/profit) is
very low. This would typically not cover the costs associated with initial capital
investment required for the manufacturing facilities.

Advertising & Promotional Spend: Spending on advertising and promotions is about 15%
of sales. Incumbents are spending 300 million annually on advertising and promotions.
The intent is to foster brand loyalty by differentiating similar cereals supplied by
competitors. This high level of spending has increased the average amount that needs to
be spent during a new product introduction in order to catch customers’ attention, hence
adding to list of barriers to entry.

Preferential Privileges in Retail Channel: Incumbents have relationships with the

retailers and get the most desirable shelf space to maximize chances of high sales. Shelf
space is typically allocated based on historical sales volume. This makes it difficult for
new entrants to break into the market, as it is impossible for them to get prime shelf
space.

Capital Intensive: Manufacturing plants cost about $300 million to setup to achieve the
economies of scale required to be profitable. This is certainly a barrier to entry but not a
very strong one as many large companies would have access to this capital (private or
from lending institutions) and would be willing to make the investment, given the high
profitability potential.

The barriers to entry helped maintain the oligopoly. However, a key factor contributing
to high profitability is the implicit collusion amongst members of the oligopoly. The
industry has historically demonstrated a pattern in which Kellogg raises prices and the
rest of the industry follows suit.
What changes have led to the current industry crisis?
Switching cost and trade promotions: Competitors have made heavy use of coupons
based trade promotions. This has reduced switching cost for customers. This has eroded
brand loyalty and has promoted price sensitive shopping behavior.

Price Increases: The price has increased by about 35% over the past 3 years.
Competitors in the RTE cereal market spend heavily on advertising and trade promotions
and have justified the price increases based on the additional advertising expense
companies have incurred. Customers have begun to “feel” the price hikes and are
questioning if the RTE cereals are worth the higher price tags they see on the store
shelves.

Improved product quality amongst private label: Private label manufacturers are
producing a much higher quality product compared to before. The quality is comparable
to the quality of products offered by the name brand suppliers, and, the cost price is about
40% lower. A viable product substitute has emerged in the market.

Emergence of Wal Mart (and other discount retailers): Discount retailers have done
really well and expanded into the groceries area. This has opened up a new retail channel
without the traditional shelf space allocations constraints. The private labels have started
catering to this segment. Discount retailers prefer carrying private label because their
margins are higher on private label compared to name brands.

The emergence of an increasingly value sensitive sentiment amongst customers coupled

with the evolution of an alternative retail channel that knocks down some of the
traditional barriers to entry and carries a low price product alternative has led to the crisis.
The private labels have gained 10% market share in the RTE cereal industry.

A cost structure comparison per pound between the name brand cereals and the private
label providers is presented in the following table. The industry trend seems to be value
consciousness. This trend will favor private label brands in the future.

Name Brand Private Label Comments: Private label cost

Raw Material $0.42 $0.36 15% less mfg cost
Packaging $0.19 $0.16 15% less packaging cost
Labor/indirect mfg $0.52 $0.44 15% less mfg cost
Distribution $0.14 $0.16 10% of wholesale
Advertising & Sales $0.75 $0.00
Depreciation, overhead $0.40 $0.40 Assume same OH/dep
EBIT $0.40 $0.09
Wholesale Price $2.82 $1.61
Retailer Margin $0.38 $0.29 15% retailer margin
Retail Price $3.20 $1.90
What does General Mills hope to accomplish with its April 1994 reduction in trade
promotions and prices?

Reduce price gap with private label: The name brands have been losing market share to
the private labels. The private labels have been competing on price and have been
successful in gaining the price sensitive customers’ business. General Mills (GM) hopes
to gain back some of the market share that has been lost to the private labels by cutting
price.

Increase profits!: The net effect of reducing price and minimizing trade promotions is an
increase in profit, even before the desired effect of increased market share via reduced
price is achieved. GM wants to send a signal to the market and hopes that the
competitors follow suit. Analysis to quantify the benefit is provided. The following
analysis makes a simplifying assumption that the $175 million saved by way of cuts in
trade promotion are not spent in other forms of advertising. Also assumed is that the
relative market share of the members in the oligopoly is unchanged.

Lost profit because of reduced cost (11% price drop for 40% of sales) is shown
below.
(40% of Revenues * 0.11)/Pounds sold
= (0.4*2473.70*0.11)/684.8
=$0.16/lb

Increased profit based on the $175 million reduction in promotions is shown

below.
Increased Revenue/Lb

Old New
Advertising Expense (mil) $239.70 $64.70
Sales (million lb) 684.8571429 684.8571429
Advertising/Pound ($/lb) $0.35 $0.09
Savings/lb $0.26

The net effect of the promotions cut and price drop is $0.10 / lb increase in
profit. This is roughly $68 million in increased profit!

Reduce emphasis on trade promotions: Trade promotions are expensive as they involve
administrative expense, coupon printing expense, etc. Also, coupons based trade
promotions reduce switching cost and are destructive to brand loyalty building activities.
GM hopes to spend on direct advertising, which typically enhances brand loyalty, rather
than spend advertising budget on coupons that are targeted at price sensitive customers.
What are the risks associated with this action? How do you expect General Mills’
competitors to respond?

Competitors have 2 options. Description and analysis of each option is provided below.
Option 1 – Follow Suit: Competitors could follow GM’s lead i.e. cut prices by 11% and
reduce spending on trade promotions. This would lead to increased profits for each
player as shown below (approximate).

Market Share Increased Profit

Kellogg 36.5% $102 million
General Mills 24.3% $68.1 million
Philip Morris 15% $42 million
Quaker 7.5% $21 million

Option 2 – Do Nothing: Retain existing pricing and promotion strategy. Hope to gain
market share from GM customers that perceive the reduction of GM’s cereal prices
insufficient compared to the benefit gained from GM’s coupon rebates. Highly price
sensitive customers that would bother to compare the price reduction benefit vs. original
benefit availed using coupons would fit this profile.

Competitors will decide between the two options based on their assessment of how price
sensitive the market is. For example, Quaker will select option 2 if it believes that profits
will increase by at least $21 million via increased market share of customers switching
from GM to Quaker. This will be achieved if Quaker can sell an additional 53 million
pounds of cereal (EBIT of 0.4/lb). This translates to increase in market share of 1.8% (53
million/2820 million).

Based on the historical track record of this industry and on the low effort, high benefit
nature of option 1, I expect the competitors to follow suit. The risk is that competitors
may misconstrue GM’s move to be the beginning of a price war and may cut their prices
significantly.

Was General Mills move the right one?

In light of the market conditions and the competitive environment, General Mills did the
right thing. The customers were signaling that the high prices in effect thus far would not
be sustainable in the future. GM had to cut prices to stop market share loss and had to
become more efficient in the current environment. The coupon based promotion model
was incredible expensive and had to be limited in the future. Also, reduction in trade
promotions helped offset some of the lot profit because of reduced prices.

It is unclear if the price reduction percentage was sufficient to stop market share loss to
the private labels. The price differential between GM’s cereals and private labels is still
significant even after the price cut. The price cut might help gain back some customers
who were on the fence, however, this increase will turn out to be relatively minor. The
price cut, however, might help gain market share from the other brand name cereal
makers.

This signals the beginning of price competition in a market that has refrained from profit
erosion via price undercutting. Market forces in efficient markets force this behavior.
GM (and other competitors in the market) will be forced to go down the path GM chose
sooner or later. Better sooner than later.