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Ready-To-Eat Breakfast Cereal Industry Assignment

The Ready-to-Eat (RTE) cereal industry started in 1894 when Dr. John Kellogg and his brother, W.K. Kellogg, endeavored to make whole grains appetizing to Dr. Kellogg’s vegetarian clients in his Michigan sanitarium. From this beginning, W.K. went on to invent the corn flake at later founded the Kellogg Company.

In the same year, Henry Perky promoted his shredded wheat cereal at the World’s Fair in Boston; he later sold his company to Nabisco, and the shredded cereal became the flagship brand. Philip Morris would later acquired the RTE brands from Nabisco and Post, whose main cereal was Post’s Grape Nuts was introduced by a patient of Dr. Kellogg.

With the strong entry of Quaker Oats into the RTE markets in 1904, Kellogg, Philip Morris, and Quaker accounted for 59% of the RTE volume.

The evolution of the RTE cereal industry

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Why has the RTE cereal been such a profitable business? What changes have lead to the current industry crisis?

Since 1904, the RTE cereal industry has been characterized as highly concentrated with a few dominant players commanding most of the sales volume. Enjoying friendly competition and consistent growth (3% CAGR), cereal manufacturers posted profit margins of 15-30%. The industry faced little competition from new entrants and became increasingly concentrated by the 1970s.

However, at this time, the Big Three (then Kellogg, General Mills, and General Foods) were facing increased scrutiny from the Federal Trade Commission (FTC) for possible implementation of anti-competitive practices and deterring new entrants. Significant barriers to entry seemed to include:

? Technology: While pieces of the cereal production process were simple, the extrusion process was complex, requiring significant engineering and production expertise. This step in the process provided manufacturers with a competitive advantage that new entrants could find difficult to duplicate.

? Economies of scale: Efficiencies in production were achieved when a single cereal production line could be consolidated and fed to a larger multiple production line. Because of this, the RTE cereal plant was estimated to need to be a capacity of 75 million pounds per a year to achieve minimum efficient scale.

? Capital intensity: As manufacturers sought to achieve economies of scale, a plant with capacity of 75 million pounds per a year could require an initial investment of over $100 million and employment of approximately 125 people. As new, smaller entrants may look to enter the space, the significant upfront investment could make it difficult to get off the ground.

? Distribution: Manufacturers owned their own distribution channels and centers where the major supermarket changes would pick up their own orders; supermarkets represented the majority of the manufacturers’ volume. The remaining sales would be made through wholesalers and brokers who would sell to smaller outlets. When introducing a new brand in supermarkets, firms would have to pay slotting allowances (as costly as $1 million) to secure shelf space.

With incumbents already dominating much of the space, new entrants had less flexibility to reshuffle brands by replacing failed brands with new ones. Additionally, the major manufacturers had large sales teams who were able to work closely with supermarkets to customize distribution and product placement for the needs of each customer.

? Data: In 1990s, firms began to use scanner data to better manage inventories and costs to the specific demands of the customers within in each sales region. Availability of customer data allowed the major firms to be better respond to changing customer preferences.

By the mid-1990s, the cereal industry started to see some changes that affected the industry dynamic and the power of the Big Three.

? Increasing use of promotions: The cereal industry allots a higher-than-average advertising budget, with an advertising/sales ratio as high as 18.5% in the 1960s before falling to 10.2% in 1993. Characterized by consistent price increases, the major firms employed the use of coupons to appeal to customers and capture market share. With coupon printing and distribution topping +$600 million, this type of promotion became increasingly prevalent and critical to the buying experience. Consumers would continually brand switch and brands/firms were gaining no significant market share. The “price-promotion spiral” drove prices up 15.6% by 1993 (up from 1990), outstripping the price increases of other consumer goods.

? New product introductions: The major firms continued to make R&D investment into new brand introductions or brand extensions. Additionally, there was the rise of co-branded products, which partnered with another brand name (such as Reese’s Peanut Butter Puffs distributed by General Mills and multi-grain cereals from Healthy Choice and Kellogg’s). With an increasing number of brands hitting the market, the industry became more fragmented. Soon no one brand accounted for more than a single market share point.

? The growth of non-supermarkets: Discount retailers like Wal-mart began to expand their stores into “supercenters” that included a supermarket in one store along with the general discount retail and specialty retail. Additionally, drug and convenience stores also had an increasing share of food sales. The majors’ distribution channels to these outlets were significantly smaller and less prominent. Further, shelf space at large stores was easier to secure than at traditional supermarkets, and smaller labels could do so without paying a hefty “slotting allowance” as required by supermarkets. This combination of factors allowed new start-up brands and private labels to enter and gain a market presence.

The introduction of private labels

Why have private labels been able to enter this industry successfully? How do the cost structure of private label and branded cereals differ?

In the early 1990s, private labels finally found an opportunity to grow in the RTE cereal industry. Ralston Purina was the first major brand to enter the private label business; it held about 50% of the private label market in 1993. In addition to the private labels, Ralston also developed a line of licensed cereals that would be tied to a movie or television show. The popularity of licensed cereals would decrease and Ralston would discontinue the cereals in 1993.

The sales of private labels grew 50% over four years; by 1994, they were 9.2% of all cereal volume and expected to be 15% by 2000. While some of the major cereal firms did not see private labels as a threat, there were a few factors that led to the success and growth of the private label cereals.

? Increased quality: For years private labels suffered from poor quality and limited product variety, so after the short-lived success in 1980s, private label manufacturers discovered that even a price-sensitive customers demanded a level of quality similar to branded products. The increase in technological competence of private label manufacturers finally made the quality of such cereals similar to those of branded products.

? Lower retail price: After prices of the Big Three spiraled upward in lockstep, private labels were able to gain a toehold in the market by undercutting prices. Private labels averaged $1.90 per pound at retail as compared to $3.20 for the Big Three brands, approximately 40% less. With small advertising budgets and limited product differentiation, private labels spent limited funds on advertising. Any advertising was used to show the price differences between them and the branded products.

? Appeal to consumers: Private labels came at a time when consumers were upset by the continued price increases in the branded cereals. Private label advertising appealed to the consumer who felt like they were getting no value from paying a higher price/premium for a Big Three cereal brand.

? Lower wholesale price: Private labels offered grocers better margins compared to the branded cereal (15% compared to 12%). As a result, retailers were more willing to promote private labels in stores.

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