1. 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 Porter’s 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 industry’s 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
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2. 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 industry’s 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,
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3. 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 Porter’s 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
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4. 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 competitor’s 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
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5. 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 competitor’s 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.
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6. 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.
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