Coca-Cola vs.

Pepsi-Cola

Introduction The soft drink industry has been a profitable one in spite of the cola wars between the two largest players. Several factors contribute to this profitability, and these factors also help to show why the profitability of the concentrate production side of the industry has been so much greater than the bottling side. Over the years the concentrate producers have experimented with different levels of vertical integration, and although it has not necessarily been clear which have been more successful historically, some decision criteria can be developed to help determine if and when complete vertical integration is necessary. Profitability in the soft drink industry As analysis using Porters five forces shows why the soft drink industry has been so profitable. Suppliers and buyers have not had more power over the industry than it has had over them. Internal rivalry, while seeming intense, has not eroded the profitability of the industry because of its concentration and the fact that the two major players have primarily competed on the basis of advertising and promotion and not price. Entry is difficult both for reasons of scale and the strong brand identity of the current major players. Substitutes have not been close enough to take away significant market share, although the emergence of new substitutes may pose the largest threat to the industrys profitability. Suppliers and Buyers Suppliers to the soft drink industry are, for the most part, providing commodity products and thus have little power over the industry. Sugar, bottles and cans are homogeneous goods which can be obtained from many sources, and the aluminum can industry has been plagued by excess supply. The one necessary ingredient which is unique is the artificial sweetener; aspartame is clearly preferred by consumers of diet beverages and for a time was under patent protection and therefore only available from one supplier. However, the patent expired and another producer entered, reducing the market power of NutraSweet. Buyers can be considered at the consumer or the retail level. For consumers, taste will be an important part of the preference for a particular soft drink; thus although there is no monetary switching

cost, there may be a loss of enjoyment associated with a less-preferred brand. Because of this, consumers have historically been brand-loyal and not based purchase decisions on price. Retail outlets have not been able to exhibit much buyer power over the industry, although they can do so more easily than consumers. Traditionally these outlets have been fragmented and have been reliant on the major soft drink brands to increase store traffic. However, at the time of the case there has already been evidence of some buyer power on the part of grocery stores, as they successfully resisted an attempt to price the varieties with more costly inputs higher. As grocery chains increasingly consolidate and as discount outlets continue to grow, buyer power on the part of retailers is likely to increase. Substitutes While the U.S. soft drink market was growing, substitutes did little to interfere. Soft drinks are sufficiently unique that when a consumer wants a soft drink another product is not likely to satisfy. Other cold drinks such as water, juices and iced tea offer similar refreshing qualities, yet they do not have the same taste or properties. Hot beverages and alcoholic beverages are not desirable or appropriate for many of the occasions when one would want a soft drink. The one category which threatens soft drink producers is the new age product which offers (or implies) more natural ingredients and/or health benefits. The soft drink industrys initial answers to these beverages, in the form of Tab Clear and Crystal Pepsi, are not going to compete effectively with the new age products. Entry Significant barriers exist to entering the soft drink industry. Bottling operations have a fairly high minimum efficient scale and require fixed assets which are specific not only to the process of bottling but also to a specific type of packaging. Exit costs are thus also high. Bottling operations do exist which in theory could be contracted out, but they are tied up in long-term contracts with the major players and thus can only contract with other producers in a limited way. Perhaps the most significant barrier to entry, however, is the strong brand identity associated with the best-selling soft drinks. Placing another cola on the market is not an attractive value proposition. Internal rivalry The concentration in the industry (Coke and Pepsi have 73% in 1994) would suggest that internal rivalry is somewhat less than if there were many players of equal size. Although the competition between Coke and Pepsi has become more fierce over time, they traditionally competed primarily on advertising,

promotion and new products rather than price (although the explosion of new brands did eventually lead to some price competition). The products are similar but not homogeneous and buyers are fairly brand loyal. Retail buyers have significant costs for switching from the major brands since those are

responsible for bringing people into the store. Flattening and potentially declining U.S. demand may be a factor which increases internal rivalry and encourages more price competition and thus erosion of profits. The greater profitability of concentrate producers over bottlers The concentrate producers are in the most advantageous positions relative to Porters five forces. Their suppliers are the commodity producers mentioned above and have little power. They enjoy protection from the barriers to entry which result from the high fixed costs and MES associated with bottling, yet their own fixed asset base is quite low and so they are removed from the resulting asset specificity and exit costs. Concentrate is the substance which makes the resulting soft drink what it is, so there is no good substitute for the bottlers who purchase the concentrate. The bottlers could switch to another brand, but because of the territorial limits the major concentrate producers have been allowed to impose, the bottler could not easily switch to an analogous product of the competitor as there is probably already another bottler in the region producing it. Smaller concentrate producers with less brand identity will not be able to supply concentrate for a product that can generate the same sales volume, so these are not good substitutes. Bottlers can exert some buyer power, since they provide an asset which is specific to a given geographic area. It would be costly for the concentrate producer to reproduce this and is the reason the bottler exists as an independent entity in the first place. However, there are many bottlers and few concentrate producers, and the function of the bottler can be easily imitated while Coke and Pepsi are unique. Thus the concentrate producers have monopoly power over their brand, while the bottlers are providing a commodity service. The value added by the bottler is much less than that of the concentrate producer and this difference results in the different profits each player is able to capture. Long-term nature of the contracts Agreements between concentrate producers and bottlers have taken the form of long-term contracts or franchises. Due to the significant investment in specific assets needed to run a bottling operation, long-term contracts are necessary to induce investment. Once the facility is built the fixed costs will be sunk and the bottler will be willing to produce at any price that covers marginal cost. The bottler knows that the concentrate producer knows this; therefore, before investment, a long-term contract

assuring a price above marginal cost is necessary. For the same reason, long-term contracts are necessary to make sure that bottlers continue to invest in additional plant and equipment to maintain peak efficiency. Underinvestment on the part of its franchisees has been a problem for concentrate producers, and this may be a signal that the contracts need to be revised to better align investment incentives. Should concentrate producers vertically integrate into bottling? The structure of the current contracts, particularly the feature of territorial exclusivity, makes the relationship between concentrate producers and bottlers fairly vertical already; each concentrate producer has a single bottler covering a given region. Because bottlers are not competing with one another, they are free to cooperate as if they were part of the same company, and to the extent that it is profitable for them they already seem to do so. Evidence of this is found by the example of bottlers which can afford to adopt packaging innovations providing the product to nearby bottlers that cannot. On the other hand, under current contracts bottlers are allowed to choose production of a competitors non-cola product over the analogous franchise product; complete vertical integration would ensure that bottlers produced only the products of the owner. The answer to whether actual ownership of bottlers is necessary is not obvious, and this is evidenced by the fact that concentrate producers went through several cycles of buying and selling their bottlers. Three types of issues can be considered in evaluating this question technical and agency efficiency, transactions costs and efficient investment, and market power and strategic effects. Technical and agency efficiency Technical efficiency does not seem to be an area for potential improvement by vertical integration. It is possible that bottlers could more easily work together and learn more efficient production techniques from one another if they were part of the same company, but as mentioned above, they already have an incentive to cooperate in this way. The costs of providing incentives to bottlers, or bottler relations, are significant for the concentrate producers. However, it is not clear that buying up bottlers, with the associated transaction and coordination costs, would be a lower cost strategy. For example, the retail relationships managed by bottlers may be somewhat difficult and costly to monitor, but if the concentrate producer bought the bottler the monitoring would not necessarily be easier, and a similar incentive system of reward based on sales minus costs would probably be introduced. The general goals which the concentrate producers would like the bottlers to meet are not complicated and it should be

feasible to align incentives through contracts. One exception to this which Pepsi encountered was in international markets, where the needed management skills could not be found in locally owned bottlers. This is more a case of market failure than provision of incentives, and exceptions such as these may require the concentrate producer to own some bottlers. Transactions costs and efficient investment With the exception of contract negotiation, transactions costs which would be avoided by vertical integration would likely be counterbalanced by internal coordination costs. Contract renegotiation is infrequent and not dissimilar to the internal salary negotiations that would occur on a more frequent basis. Efficient investment, on the other hand, is an area in which the concentrate producers have discovered problems, and the lack of investment has been a reason for concentrate producers to buy up bottlers in the past. Since current contracts do not specify performance requirements, new terms would need to be introduced to solve this problem. However, concentrate producers are in the more powerful position and have already been able to amend bottler contracts to pass on higher input costs as well as some marketing costs. Thus, adding a performance requirement to the contract which would induce the proper amount of investment in plant and equipment should be feasible. Market power and strategic effects Potential market failure or foreclosure provide the most compelling reasons for concentrate producers to buy bottlers. The international market mentioned previously is one example where market failure has been observed, and vertical integration provided a clear advantage by allowing the CP to bring in its own management. In the mature U.S. bottler industry, market failure of this nature is much less likely. The potential for foreclosure on a particular brand is something concentrate producers should consider. Since current contracts allow bottlers to choose a competitors non-cola product over the analogous product of the CP, a particular non-cola brand could be completely shut out of a market. If bottlers remain independent, this issue of product mix will become more important as bottlers consolidate and control larger portions of the market. A requirement to carry only the products of the concentrate producer, or simply not those of a major competitor, may be difficult to incorporate into contracts if bottlers have found the product mixing strategy to be profitable; however, this restriction should theoretically be possible to accomplish through contract agreement and should not require purchase.

The most compelling reason to vertically integrate would be if the concentrate producers anticipate market failure in some way that would shut them out of bottling altogether. This is unlikely, as the strong performance of the large concentrate producers with consumers will always attract some bottler to the market. Additionally, the large number of bottlers across the country makes it unlikely that a concentrate producer would be shut out of a large enough portion of the market that other bottlers could not adjust reasonably quickly in order to meet demand. If bottlers consolidate such that the industry is much more highly concentrated, the concentrate producers may wish to re-evaluate and integrate forward at that time.