Cola Wars: Profitability of the soft-drink industry

Historically, the soft drink industry has been extremely profitable. Long time industry leaders Coca-Cola and Pepsi-Cola largely drive the profits in the industry, relying on Porter’s five forces model to explain the attractiveness of the soft drink market. These forces allowed Coke and Pepsi to maintain large growth until 1999, and also explain the challenges that each company is currently facing. The relative duopoly that Coke and Pepsi share in the industry allows for higher profits, while also maintaining enough competition to promote firm improvement.

The first of Porter’s forces is the threat of new entrants. Coke and Pepsi have been largely successful because of many barriers to entry that limits the risk of entry by potential competitors. Coke and Pepsi both have strong brand loyalty, made possible by their long history and adherence to tradition. When Coke strayed from its Coca-Cola Classic formula, its customers demanded a return to the original recipe. Pepsi and Coke also share an absolute cost advantage over others in the industry.

They developed superior production operations by buying up bottling companies and performing the service in-house.

These companies also have large economies of scale, as they both operate internationally and together control 84% of the market worldwide. Additionally, government regulations have prevented competitors from mimicking Coke’s secret formula, as evidenced by their relentless defense of their brand in court. All of these factors have made it difficult for competitors to enter the soft drink industry.

The second of Porter’s forces is rivalry amongst established companies.

The competitive structure of the industry has allowed Coke and Pepsi to sustain high profits. The industry is essentially an oligopoly, with Coke and Pepsi dominating the market. The firms are hurt by having similar products that are relatively undifferentiated. However, diversification of product lines into carbonated and non-carbonated beverages has created some product differences. High industry growth from 1975 to 1995 also provided a reprieve from the competitor pressure. Franchising and long-term contracts created higher switching costs, historically limiting the effects of rivalry on the two firms.

Porter’s third force is the bargaining power of buyers. This has always been low in the industry, and continues to diminish over time. The low number of suppliers does not afford buyers much room to negotiate. Furthermore, the abundance of distributor options prevented the bottling plants from applying pressure on Coke and Pepsi. Exhibit 8 also shows that both Coke and Pepsi were among the top five consumer brands most important to retailers, suggesting that they were on the losing end of the transaction relationship.

Porter’s fourth force is the bargaining power of suppliers. Coke and Pepsi have always set their price. Bottlers were forced to buy concentrate at set prices, usually negotiated in the favor of Coke and Pepsi. The small number of suppliers limited alternatives that could provide the necessary concentrate to bottling groups. Coke and Pepsi have continuously renegotiated contract terms to decrease their costs and enhance profitability. These contracts eventually eliminated marketing cost obligations for concentrate producers as well. Suppliers became so powerful that they eventually bought their own bottling plants.

Porter’s fifth force is the threat of substitutes. Initially, other products that could fulfill the same objective of soft drinks (quench thirst) were very weak. According to exhibit 1, carbonated soft drinks were the most-consumed beverage in America through the 1970s and 1980s. Since then, bottled water has become increasingly powerful, cutting into U.S. consumption. A growing health awareness has led to higher demand for non-carbonated soft drinks. Coke and Pepsi have largely met this threat by diversifying into other product lines such as water, juice, tea, and sports drinks.

A significant factor that has also allowed the soft drink industry to prosper is the success of the fast-food industry. By partnering with restaurants such as Taco Bell, McDonalds, Burger King, and Pizza Hut, soft drinks have
become a complement to this other profitable sector. Pepsi has taken advantage of this trend in its merger with Frito-Lay.

While these five factors all contributed to making the soft drink industry very profitable, the industry is more recently facing challenges that could lead to declining profitability. Industry demand is steadily decreasing, as the United States – the largest consumer of soft drinks in the world – becomes more health conscious. Furthermore, buyers are now threatening to produce soft drinks themselves, such as in-store brands at Walmart. This has increased the bargaining power of the buyer.

Though the future profitability of the soft drink industry may be declining in America, Coke and Pepsi have taken substantial actions to spread their brands worldwide. Each has a long-term growth strategy to saturate new markets, whether domestically or abroad. Coke has already taken control of many international markets, while Pepsi claims that its progression to the snack industry provides synergy in its business. It is undeniable that the competition between Coke and Pepsi has resulted in a multitude of strategies employed by both sides.