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Why has RTE cereal been such a profitable business?

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    The RTE cereal market is a classic oligopoly with the four dominant players controlling 85% of the market. The return on sales earned by the incumbents in this market (18%) is significantly higher compared to rest of the food industry (5%). Efficient markets typically entice new entrants when the returns are attractive. These returns are gradually eroded with increased price competition as a result of the entry. The RTE market has defied this market theory. There are two main reasons for this. One, any market that yields a high rate of return but has no new entrants must have significant barriers to entry.

    The RTE cereal market has significant entry barriers. Two, barriers to entry does not necessarily mean high profits for all incumbents in an oligopoly. However, in the RTE cereal, it has. This is attributable to the fact that players in the oligopoly have demonstrated profit maximizing behavior and have successfully avoided market share maximization motivated price wars. Barriers to entry are discussed below. Brand Proliferation Strategy: Incumbents have successfully launched a “brand proliferation” strategy using which every foreseeable market niche is already serviced with a specific brand.

    Collectively, there are about 200 + brands offered by the three leading suppliers. This approach deters new entrants because no market niches are left out for new providers to exploit. Also, the given market share of any one brand is low in a market which has such a large number of brands. This also makes it difficult for new entrants, as the expected market share from a new launch (and hence revenue/profit) is very low. This would typically not cover the costs associated with initial capital investment required for the manufacturing facilities.

    Advertising & Promotional Spend: Spending on advertising and promotions is about 15% of sales. Incumbents are spending 300 million annually on advertising and promotions. The intent is to foster brand loyalty by differentiating similar cereals supplied by competitors. This high level of spending has increased the average amount that needs to be spent during a new product introduction in order to catch customers’ attention, hence adding to list of barriers to entry. Preferential Privileges in Retail Channel: Incumbents have relationships with the retailers and get the most desirable shelf space to maximize chances of high sales.

    Shelf space is typically allocated based on historical sales volume. This makes it difficult for new entrants to break into the market, as it is impossible for them to get prime shelf space. Capital Intensive: Manufacturing plants cost about $300 million to setup to achieve the economies of scale required to be profitable. This is certainly a barrier to entry but not a very strong one as many large companies would have access to this capital (private or from lending institutions) and would be willing to make the investment, given the high profitability potential.

    The barriers to entry helped maintain the oligopoly. However, a key factor contributing to high profitability is the implicit collusion amongst members of the oligopoly. The industry has historically demonstrated a pattern in which Kellogg raises prices and the rest of the industry follows suit. What changes have led to the current industry crisis? Switching cost and trade promotions: Competitors have made heavy use of coupons based trade promotions. This has reduced switching cost for customers. This has eroded brand loyalty and has promoted price sensitive shopping behavior.

    Price Increases: The price has increased by about 35% over the past 3 years. Competitors in the RTE cereal market spend heavily on advertising and trade promotions and have justified the price increases based on the additional advertising expense companies have incurred. Customers have begun to “feel” the price hikes and are questioning if the RTE cereals are worth the higher price tags they see on the store shelves. Improved product quality amongst private label: Private label manufacturers are producing a much higher quality product compared to before.

    The quality is comparable to the quality of products offered by the name brand suppliers, and, the cost price is about 40% lower. A viable product substitute has emerged in the market. Emergence of Wal Mart (and other discount retailers): Discount retailers have done really well and expanded into the groceries area. This has opened up a new retail channel without the traditional shelf space allocations constraints. The private labels have started catering to this segment. Discount retailers prefer carrying private label because their margins are higher on private label compared to name brands.

    The emergence of an increasingly value sensitive sentiment amongst customers coupled with the evolution of an alternative retail channel that knocks down some of the traditional barriers to entry and carries a low price product alternative has led to the crisis. The private labels have gained 10% market share in the RTE cereal industry. A cost structure comparison per pound between the name brand cereals and the private label providers is presented in the following table. The industry trend seems to be value consciousness. This trend will favor private label brands in the future. Name Brand Private Label Comments: Private label cost

    Raw Material $0. 42 $0. 36 15% less mfg cost Packaging $0. 19 $0. 16 15% less packaging cost Labor/indirect mfg $0. 52 $0. 44 15% less mfg cost Distribution $0. 14 $0. 16 10% of wholesale Advertising & Sales $0. 75 $0. 00 Depreciation, overhead $0. 40 $0. 40 Assume same OH/dep EBIT $0. 40 $0. 09 Wholesale Price $2. 82 $1. 61 Retailer Margin $0. 38 $0. 29 15% retailer margin Retail Price $3. 20 $1. 90 What does General Mills hope to accomplish with its April 1994 reduction in trade promotions and prices? Reduce price gap with private label: The name brands have been losing market share to the private labels.

    The private labels have been competing on price and have been successful in gaining the price sensitive customers’ business. General Mills (GM) hopes to gain back some of the market share that has been lost to the private labels by cutting price. Increase profits! : The net effect of reducing price and minimizing trade promotions is an increase in profit, even before the desired effect of increased market share via reduced price is achieved. GM wants to send a signal to the market and hopes that the competitors follow suit. Analysis to quantify the benefit is provided.

    The following analysis makes a simplifying assumption that the $175 million saved by way of cuts in trade promotion are not spent in other forms of advertising. Also assumed is that the relative market share of the members in the oligopoly is unchanged. Lost profit because of reduced cost (11% price drop for 40% of sales) is shown below. (40% of Revenues * 0. 11)/Pounds sold = (0. 4*2473. 70*0. 11)/684. 8 =$0. 16/lb Increased profit based on the $175 million reduction in promotions is shown below. Increased Revenue/Lb Old New Advertising Expense (mil) $239. 70 $64. 70 Sales (million lb) 684. 8571429 684. 8571429

    Advertising/Pound ($/lb) $0. 35 $0. 09 Savings/lb $0. 26 The net effect of the promotions cut and price drop is $0. 10 / lb increase in profit. This is roughly $68 million in increased profit! Reduce emphasis on trade promotions: Trade promotions are expensive as they involve administrative expense, coupon printing expense, etc. Also, coupons based trade promotions reduce switching cost and are destructive to brand loyalty building activities. GM hopes to spend on direct advertising, which typically enhances brand loyalty, rather than spend advertising budget on coupons that are targeted at price sensitive customers.

    What are the risks associated with this action? How do you expect General Mills’ competitors to respond? Competitors have 2 options. Description and analysis of each option is provided below. Option 1 – Follow Suit: Competitors could follow GM’s lead i. e. cut prices by 11% and reduce spending on trade promotions. This would lead to increased profits for each player as shown below (approximate). Market Share Increased Profit Kellogg 36. 5% $102 million General Mills 24. 3% $68. 1 million Philip Morris 15% $42 million Quaker 7. 5% $21 million Option 2 – Do Nothing: Retain existing pricing and promotion strategy.

    Hope to gain market share from GM customers that perceive the reduction of GM’s cereal prices insufficient compared to the benefit gained from GM’s coupon rebates. Highly price sensitive customers that would bother to compare the price reduction benefit vs. original benefit availed using coupons would fit this profile. Competitors will decide between the two options based on their assessment of how price sensitive the market is. For example, Quaker will select option 2 if it believes that profits will increase by at least $21 million via increased market share of customers switching from GM to Quaker.

    This will be achieved if Quaker can sell an additional 53 million pounds of cereal (EBIT of 0. 4/lb). This translates to increase in market share of 1. 8% (53 million/2820 million). Based on the historical track record of this industry and on the low effort, high benefit nature of option 1, I expect the competitors to follow suit. The risk is that competitors may misconstrue GM’s move to be the beginning of a price war and may cut their prices significantly. Was General Mills move the right one? In light of the market conditions and the competitive environment, General Mills did the right thing.

    The customers were signaling that the high prices in effect thus far would not be sustainable in the future. GM had to cut prices to stop market share loss and had to become more efficient in the current environment. The coupon based promotion model was incredible expensive and had to be limited in the future. Also, reduction in trade promotions helped offset some of the lot profit because of reduced prices. It is unclear if the price reduction percentage was sufficient to stop market share loss to the private labels. The price differential between GM’s cereals and private labels is still significant even after the price cut.

    The price cut might help gain back some customers who were on the fence, however, this increase will turn out to be relatively minor. The price cut, however, might help gain market share from the other brand name cereal makers. This signals the beginning of price competition in a market that has refrained from profit erosion via price undercutting. Market forces in efficient markets force this behavior. GM (and other competitors in the market) will be forced to go down the path GM chose sooner or later. Better sooner than later.

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