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Naveen Prakash Strategy, MBA FT, 2012

The Ready-To-Eat Breakfast Cereal Industry in 1994 (A)


The ready-to-eat (RTE) breakfast cereal industry has been very successful for decades, achieving high returns and growth. By 1994, the US market alone has grown to $8 billion in sales, and 2.82 billion pounds in volume. Despite its high profitability, the industry has grown more concentrated over the years with very few and mostly unsuccessful entry attempts. However, by 1994, the industry started to face new challenges, namely slower demand and gain in market share by private labels. Let s see how the RTE industry managed to maintain such a high profitability for several decades, and analyze the reaction of the incumbents to the new challenges. The RTE Breakfast Cereal Industry in 1994: There are few attributes that strongly distinguish the RTE cereal industry from other packaged food products, and those are key attributes in understanding the profitability of the RTE cereal industry. First, the industry is concentrated in 6 firms: Kellogg, General Mills, Post, Quaker, Nabisco and Ralston Purina, and these firms have maintained an astonishingly stable market share for 40 years (exhibit 1). The market share of these 6 leading firms was close to 100% since the 1950 s until 1990, when private labels started to gain share, which reached 9.2 percent in 1993. Another important attribute of the RTE cereal industry is the amazing proliferation of brands, and the high rates of product introductions. These brands were differentiated along some perceptual, ingredient or taste dimension. A third attribute of the industry is the heavy advertisement and promotion expenditure. The advertising to sales ratio of some firms exceeded 10%, (exhibit 4) which is relatively much higher than other industries. Another characteristic of the industry in 1993 is the heavy use of coupons. Almost 25% of all cereal purchases were made using coupons. Profitability of the RTE Cereal Industry: The profit margins and return on assets for the firms in the cereal industry were much higher than normal. There are several reasons for such high profits. First, it seems that the firms in the industry did not compete on price; rather they competed by following a strategy of product differentiation through innovation and new product introductions. The product differentiation was achieved through research and heavy expenditure on advertising. The fact that the major firms did not seriously compete on price is evidenced by the highly stable market share of the major firms. Second, the industry was highly concentrated. This means that they can get high economic returns as long as they do not compete aggressively. Moreover, due to the small number of competitors it is much easier to coordinate prices through unspoken rules. For example, it was usually the case that Kellog announces price increases and then the other manufacturers follow. Another sign of coordination between major firms is the fact that firms tended to limit retail promotions to one brand at a time. If the industry is so profitable, why it did not attract entry? The key reason for the lack of significant entry until the 1990 s, is that it is extremely difficult to gain a significant market share by a new entrant due to the extremely fragmented market at the product level. With this extremely high proliferation of products, an entrant would be considered lucky if it can capture 1% of the market by introducing a new product. As a matter of fact, Kellogg introduced 30 major new brands in the 80 s and none of them reached 1% of sales by 1993 (exhibit 5). This means that even if an entrant introduces a successful product, the sales of such a product will be about 29 million pounds (1% of the total volume of 2.9 billion pounds, market size page 204) after few years, which is well below the minimum efficient scale of production estimated to be 75 million pounds in the case(page 205). A new entrant needs to introduce at least 3 very successful brands to achieve the (MES) minimum efficient scale. However, the fact that the incumbents brands are so distributed means that it would be easy to kill any new entrant by increasing the advertising expenditure or reducing the price on only the products that are close to the

Naveen Prakash Strategy, MBA FT, 2012 new entries. That is the cost of fighting the new entrant is limited to only the brands near the new entries, and would not affect the revenues of any of the incumbents significantly. Another entry deterrent is the strong relationship that the manufacturers had with the retailers. A new entrant (unless it is the retailer private label) would not be able to get the adequate shelf space to achieve high sales. Although the FTC believed that the major manufacturers deterred entries in an anti-competitive way, the charges were later dropped during the Reagan administration. The effect of the use of coupons on the profitability of the RTE cereal firms is not very clear. It seems that the coupons were meant as a way to increase profit through price discrimination. Consumers who are price sensitive would use the coupons, but other consumers would pay the full price. However, it is not clear that coupons achieved this, since a quarter of the people used coupons and probably most of those would have bought at the higher prices anyway. Moreover, the coupons were very inefficient and introduced extra costs. The threat of private labels: Starting in the 1990 s the industry faced the threat of private labels. As shown in exhibit 1 in the case, private labels grew to 9.2% by volume and about 5% by sales. Private label sales were also predicted to grow further by 2000. Private labels competed mainly on price, which is new to the industry. Even the extremely fragmented industry designed by the incumbents to prevent entry, did not prevent the private labels from gaining market share rapidly. The reason for the rapid gain of market share for private labels is that private labels were attractive to both the consumers and the retailers. To the consumers, they offered an average of 40% discount over branded cereals. To the retailers, they may offer higher profit margins, and in addition they may be a weapon in the hand of the retailers to pressure branded cereal firms to offer them higher margins. Private labels were able to offer the lower prices because they had a much lower cost. For example, a typical Big Three cereal producer spends about 75c per box of cereal in advertising and sales costs. In addition to advertising costs, production and distribution costs for private labels were much less than the big producers. The main reasons are reduced R&D spending, focus on simpler cereals that are cheaper to produce, and rely on third-party distributors. Private labels aggressively focused on reducing costs, without sacrificing quality much. Their message to consumers was: we are the same quality at a much lower price. Moreover, one other factor that helped private labels succeed is that the strategy of coupon use may have backfired, and reduced the value of the brands in the eyes of the consumers. General Mills Decision and its Risks: Facing the threat of private labels, Kellogg continued its regular price increase, but the rest of the industry did not follow this time. Instead, General Mills decided to change its strategy and reduce prices and at the same time reduce the levels of coupons. Probably what General Mills hoped to accomplish is to reduce the gap between its prices and the private labels, so that loyal consumers would not switch. Moreover, General Mills thought that the coupons are very inefficient and add additional unnecessary costs. In addition, it may be the case that many people expected the coupons and would perceive the brands to be expensive otherwise and not buy it without coupons. General Mills didn t intended to start a price war by its decision, with the other big cereal producers. To the contrary, General Mills expected the rest of the big three to follow its decision and present a unified front against the private labels. There are several risks associated with General Mills decision. First, some consumers may have grown accustomed to the coupons and would not pay without the coupons, because they think they may be overpaying. Second, other manufacturers may perceive this move by General Mills as the start of a price war, and may compete more aggressively on price. Moreover, if other big manufacturers do not follow

Naveen Prakash Strategy, MBA FT, 2012 General Mills and adhered to the higher prices, General Mills may be forced to increase prices again which would be unpopular with consumers. Was General Mills Decision Right? In terms of reducing inefficiencies General Mills was right. The coupons just added extra costs to the price which could be eliminated. However, it seems many consumers got accustomed to the coupons and it may be risky to remove them suddenly. It s recommended that GM find some technological way to get rid of the coupons inefficiencies while maintaining their effect. For example, partner with the retailers to develop electronic loyalty programs that give automatic price reductions the more you buy without having to print, distribute, clip, cash and handle coupons. The uniform reduction in prices across the board does not make sense. Since General Mills have so many brands in its portfolio, why not target the price reduction to the brands that are the most threatened by the private labels. These are the simpler, lower cost brands. Industry will probably not follow General Mills strategy because the consumers got so accustomed to the coupons. Re-Evaluation of the industry Although the RTE breakfast cereal industry was very efficient at preventing big entry for decades, and for preserving and growing their profits over the years by competing on new product introductions and product differentiation rather than price, they did not prepare well for the entry of low cost producers. If they had predicted the success of low cost producers, they could have followed the same strategy of product proliferation along the price dimension, in addition to the other dimensions they chose to differentiate their products on. This strategy could have had the dual effect of offering a natural price discrimination strategy that can replace coupons, and could have pre-empted entry by low cost producers since that market segment would have already been crowded. Conclusion The RTE cereal industry managed to maintain high profitability for many decades by making it very unattractive for new entrants by increasing the minimum efficient scale by spending heavily on advertising, and by preventing any new entrant from gaining any significant market share by filling the RTE cereal product space with a large number of differentiated products. The high profitability is also a result of the high coordination between the incumbent firms, and their strategy of not competing on price, but by new product introductions, and heavy advertising. They also do not attack each other products aggressively. A new entrant needs to be an extremely low cost producer, and have a small efficient scale in order to compete in this market. But the new entrant risks destroying the high profitability structure of this market, by introducing price competition and price wars. Private labels have a very good chance at succeeding in this market due to the retailer support, and their strong focus on the cost. Big RTE cereal manufacturers could have protected their industry better from the threat of entry of low cost producers and private labels, by pursuing the same strategy of product proliferation and differentiation, but along the price dimension in addition to the taste and perceptual dimensions. If they have offered cheaper products in addition to their more expensive products, they may have pre-empted the entry of private labels and reduced the private label payoffs. Also it may have been a better means of price discrimination rather than the reliance on the inefficient coupons.