Strategy and General Management Deliverable #1 – Cola Wars

Team 26 Members – Sunny Mohanty, Maria Eduardo Faria Goes, Rita Franco, Angela
Vargas, Revol Tamba, Viet Nguyen Hoang

1. Why historically has the soft drink industry been so profitable? How has competition
between Coke and Pepsi affected the industry’s profits?

To answer this question, it would be of great help to analyse 5 major buckets. These 5
buckets play a significant part in the high profitability of the Soft Drink Industry. The 5
buckets are:

High Barriers to Entry – The Industry majorly comprises of Concentrate Producers and
Bottlers, both of which are profitable. These two major players are highly interdependent
too, sharing costs for procurement, production, marketing and distribution and had many
overlapping functions. Any new entrant had to significantly invest in concentrate production
as well as bottling. Additionally, CPs had the right to stipulate contracts with bottlers for
exclusive territories. The main players in the industry commanded strong brand loyalty too,
making it even more difficult for a new entrant to make substantial profits.

Rivalry between Competitors – The revenues are highly concentrated in this industry with
Coca Cola and Pepsi ruling the industry with approximately 73% of the market share as in
1994 leading to the conclusion that the industry can be thought of as a duopoly. They
realised that their market would get saturated and the competition between them in terms
of marketing to acquire customers and new markets has ensured that the CSD industry has
stayed profitable.

Substitutes – There were no major substitutes to pose a threat to the major players in this
industry, but slowly bottled water and teas started popping up that posed a threat to the
profits of the industry. But the players responded proactively by diversifying their offerings.
They followed a three-pronged approach to this diversification by alliances, acquisitions and
internal product development to compete and safeguard their profits.

Supplier Power – The main raw materials required for the manufacture of colas were
aluminium and sugar. Sugar could be purchased from several suppliers easily, and in the case
that it became expensive, CPs could easily switch to High Fructose Corn Syrup as they have
done in the past. Aluminium has also been very inexpensive and there have been only two
major consumers from the Soft Drink industry who also negotiated terms with the suppliers
on their bottler’s behalf. This left suppliers with very low bargaining power against Pepsi and
Coca Cola and enabled these two entities to set the price for sourcing raw materials in a way
that led to larger profits for themselves.

Buyer Power – Soft Drinks were mainly sold through supermarkets and were one of the 5
most selling product lines fetching them 15%-20% profits and supermarkets used to be a
fragmented industry thus giving them very little bargaining power against CPs especially
when they depended on them to draw traffic. Apart from this, CPs sold through a DSD model
that was hugely profitable for them and enabled them to have strong relations with their
retailers and distributors thus deterring any new entrant/substitute from using such
channels. In the food business, both CPs had exclusive contracts with restaurants to serve
their drinks. The vending machine business was also hugely profitable for CPs as they had no
one to bargain with and could set their prices.

In addition to all this, High consumer consumption, low cost of production, strong marketing
power and strong brand loyalty have helped this industry stay profitable.

Coke and Pepsi have managed to create a duopoly in the CSD industry and have managed to
employ business practices to ensure the industry’s profitability. They have managed not only
to capture the US market but globally have been able to continuously get more and more
customers to consume their products due to strong and effective marketing power. Also due
to their ability to lower production costs and diversify their product line, they have been
able to keep their customers amidst rising competition from other drinks. Their process of
entering contracts with their bottlers at a fixed price of concentrate has helped them
maintain large profit margins irrespective of inflation and rising costs. They also invested
towards maintaining operational efficiency for their bottlers and negotiated on their behalf
with suppliers for low-cost materials. They have also managed to acquire smaller companies
offering substitute products to keep their customer base and not to engage in price wars
that might affect the industry’s profits.

To conclude, as the article itself mentioned: “The more successful they are, the sharper we
have to be” (Roger Enrico, former Pepsi-Cola CEO) we can understand that because Coca-
Cola and Pepsi are direct competitors, each one pushes harder the other one, making its
business the most effective as it can be, and always seeking for more market share and
increase in volume and revenues/profits.

2. Compare the economics of concentrate business to that of the bottling business:

Exhibit [4] shows that the concentrate business is more profitable than the bottling business,
where cost of goods sold for concentrate manufacturers accounts for 22% of net sales, while
for bottlers the same items account for 58%. There is also a big difference between the two
in terms of operating income. Concentrate producers see 32% of net sales as operating
income, while bottlers get four times less, just 8% of net sales. The difference in profitability
between the two can be explained by the following reasons. First, CP contracts gave them
strong powers to negotiate and fix prices for concentrate purchase with little room for
renegotiation and bottlers were not allowed to offer services to competitor brands too,
which limited their product offerings. As a result, these exclusivity rights have enabled CPs to
develop high-gross-margin products. Second, the operations of CPs required low investment
in factories and equipment as well as labour, with the significant amount of their spendings
geared towards marketing. The bottling process, on the other hand, was capital intensive
due to high packaging costs and large investments in large facilities, trucks, and distribution
networks. CPs then began to buy the business of their major bottlers and consolidated their
bottling process; and this led to a higher degree of dependence of small bottlers on CPs,
leading them to accept high prices set by the CPs.
 Below are the differences between the economics of these two:

Concentrated Bottling
Initial Investment Low Investment ($5-$10 High Investment ($20-$50
million) (1 plant/US million) (80-85 plants/US
market) market)
Cost of goods sold as a % 22% 58%
of net sales
Operating Income as a % 32% 8%
of net sales
Relationship Independent Dependent on Concentrate
producers

3. How can Coke and Pepsi sustain their profits in the wake of flattening demand and
the growing popularity of non CSDs?

To sustain profitability, we would suggest that Coke and Pepsi follow a strategy of
diversification of their offerings. They should begin positioning themselves in other drink
markets apart from the CSD market. Since there has been a rise in health-related concerns,
they can position themselves in the energy drinks and sports drinks markets as well as the
bottled water industry. This needs to be done with a focus on informed acquisitions of
existing companies in these new segments and/or by investing in the development of such
products that are differentiated from other existing products in the market.

Apart from this, Coke and Pepsi can look to invest in complement products such as chips and
push to have these items sold strategically by having them placed next to CSDs in retail
stores. They can also look at how they can make the customer buying experience easier and
more comfortable and diversify into online direct sales of their products to end consumers;
also, aggressively expanding their network of vending machines into locations with higher
footfall or consumer ‘hotspots’.