Monday, March 9, 2015

An In-Depth Look at the American Chocolate Industry

Chocolates off the line

Chocolate as we know it is a relatively new invention. In 1828, a Dutch chemist invented the cocoa press, which allowed separating cocoa butter from the cocoa beans. It was not until 1847 that J. S. Fry & Sons, a British company made a chocolate bar combining cocoa powder, cocoa powder, and sugar. It was even later when mass production became possible with Lindt’s invention of the conching machine in 1879 (“Sweet History”). Processed chocolate caught on quickly. By a hundred years ago, it was one of the most popular confectionary items, in spite of a high price (“Chocolate”).
Chocolate has a much longer history. For the first three and a half millennia it was consumed as a food item, it was part of a drink mixed with water, vanilla, honey, and chili peppers. It was a rare treat for the upper classes of various southern American indigenous tribes such as the Olmec, Mayan, and Aztec tribes. This concoction was imported to Europe with colonization. Along with gold, the Spanish brought back chocolate, which remained an aristocratic treat (“Sweet History”).
Today, we can enjoy Chocolate in many forms, and throughout the year. In the United States, chocolate is an integral part of many holidays from Valentine’s Day to Easter to Halloween. It is also a year round treat that can be picked up almost anywhere in familiar forms for a low price. It is no longer just for the rich of pre-Columbian South America or the royals of colonial Spain. Chocolate is America’s treat. This paper will look at the current market for chocolate in the United States using the five forces analysis as described by Michael Porter and summarized in Besanko et al. in their 213 edition of “Economics of Strategy” p. 258-256.
The current market for chocolate is large. The average American is measured to consume twelve pounds of chocolate annually (“Sweet History”). Globally, the chocolate industry is expected to amount to $98.3 billion dollars in sales by 2016 (“How Large”. The United States is the number one consumer of chocolate, consuming 764 tons of chocolate (“Cocanomics”). This consumption translates to over 18 billion dollars in sales in 2010 (“Sweet History”). A quick look at the math shows that the American sweet tooth takes a large bite out of the global chocolate consumption.
The market for chocolate is divided by different segments. The divisions are by product, sales category, and geography. The product segment looks at the type of chocolate. There are different breakdowns for dark chocolate, milk chocolate, and white chocolate. The sales division looks at how the chocolate is sold and breaks down into category by premium chocolate, every day chocolate, and seasonal varieties (“Global Chocolate Market”). For many of the segments, different brands dominate. Whitman’s would be picked up more at Valentine’s Day while a Snickers is something that is directed towards a more every day chocolate.
The supply chain is long. The basis of chocolate is the cocoa bean. It is grown in equatorial regions across the world. The means most of the chocolate is grown in Southeast Asia or south America or Western Africa. The beans grow straight from the tree. A single tree can only yield enough beans for half a kilogram of finished chocolate per year. From growth, the bean is harvested, dried, taken to market, packed, roasted, ground, and processed. It is then made into chocolate and shaped into the form it will take for the consumer (“Cocanomics”). Other key inputs include sugar and dairy, which can be obtained from domestic markets for the American consumer.
The trade group representing the chocolate manufactures is the National Confectioners Association. They are bullish on the continued growth of the chocolate market at a rate above the expansion of the national economy. They forecast growth prospects at between three and four percent per annum for the next several years. Categories seen leading this growth include both dark chocolate and premium products (“Profile”). The growth prospects reflect the continued growth of the national economy, but the specific segments of growth show that as a nation we are tired of tightening our belts and are looking for specific ways to treat ourselves. Finer chocolate is an affordable luxury for most people.
Approximately 400 companies make up the chocolate industry in the United States. These companies manufacture ninety percent of the chocolate. These 400 companies support almost 70,000 jobs in the direct manufacture of the chocolate, and it is estimated twice as many more when the distribution and selling of the chocolate is taken into consideration (“Economic Profile”). The majority of these companies are rather small. Instead, the chocolate market is largely split between global giants. The biggest share of the chocolate market in the U. S. is enjoyed by Hershey, with 44.2% of sales. Mars is next with 29.5% of the market. Nestle, Lindt, and Russell Stover each have about five percent each. That leaves all other companies with just 11.6% of the market by sales (“Market Share”). Assuming the smaller three hundred and ninety five companies split the final 11.6% of the market equally, that gives the chocolate market a Herfindahl index of .29. An index of .29 shows that the market for chocolate in the United States is rather concentrated, to the point where it can be considered an oligopoly
            As the leading firms in an oligopoly, the Hershey and Mars have considerable power over the pricing and quantity of the chocolate they produce. There is some overlap in the types of chocolates produced, but a key aspect of the chocolate market is that there is strong brand loyalty. This brand loyalty has been built up through years of advertising and concentration amongst the industry. This differentiation means that the products of Hershey and Mars are not complete substitutes, and that they have certain aspects of monopoly power within their brands. There are plenty of substitute goods, so brand loyalty just means that the demand curve for specific brands is more inelastic than the market as a whole, giving the larger firms some pricing power. Even with this power, it is seldom used. The price of all chocolates has risen inexorably over time with inflation and it is often a spontaneous purchase, so it is in the best interest of all companies to sacrifice unit profit over volume profit and to keep the familiar brands an affordable commodity.
            In theory, entry into the chocolate market should be easy. All a potential entrant needs is the know-how to put the constituent parts together and then a place to sell the final products. This is true for very small producers. They can fill a specific niche as a specialty maker, but their own market will be geographically limited as well as limited by the expectations of the potential consumers in the geographic area served. How many consumers will pay more for a chocolate product when there is a much lower price substitute available almost anywhere? To go with the supposed ease, few high governmental hurdles exist to hinder entry.
            In fact, the barriers to entry are fairly high, since the market is dominated by so few firms. These larger firms have the knowledge and the scale to operate at lower costs than most new potential market entrants do. The price the consumers pay has not been artificially inflated, so if a new firm wants to enter the market, they have to achieve similar cost structures as the incumbent firms or forego the profits the larger companies make. Further, as spoken earlier, many consumers are brand loyal. Favorite chocolate brands are developed as a preference at a young age and that is hard to shake. The big companies foster this brand allegiance. Hershey, for one, tries to keep itself in consumer minds as an honest and trustworthy brand (“Brand Equity”). They have even gone so far to try to associate their brand with fun by building a theme park in its hometown of Hershey, Pennsylvania. The strong brand awareness creating high barriers to entry is seen even with the bigger companies. Often if they want to introduce a new product, it does not hang by itself but is tied to an existing brand. A new candy-coated malt ball product is does not have its own name, but instead it is reintroduction of Crispy M&Ms.       
            Further barriers to entry are the scale at which the big companies operate. To have almost half of the chocolate industry entails a lot of knowledge in the manufacture and marketing of chocolates. It also means a lot of experience with the supply chain, which as we have seen goes all the way back to the growth of the original tree in Africa, South America, or Southeast Asia and into the tummies of satisfied Americans from Bangor to San Diego.  
When Americans want to treat themselves, they have other options than chocolate. There are various substitutes, from crunchy chips, to salty peanuts, to savory beef jerky. The availability of these substitutes is what keeps the lid on some of the pricing power. The chocolate industry is considered a subset of the confectionary industry, which includes many of the possible substitutes for chocolate. In spite of the many available substitutes, for the confectionary industry as a whole, chocolate accounted for over sixty percent of the entire industry. The industry itself has grown at a rate comparable to the growth rate of chocolate sales, meaning that the overall share of chocolate as a percentage of the industry has remained stable (“Confectionary Industry”). The continuing growth of the industry as a whole and for the chocolate segment in isolation bode well for industry, as being an affordable treat; it is also shown to be rather recession proof. People will continue to buy chocolate because chocolate is pleasing to the American palate in a way that those other substitutes are lacking.
Sugar and dairy are huge inputs into the chocolate industry as raw materials, but the one thing that makes chocolate chocolate is the cocoa bean. Once that is harvested, refined, and pressed, then the end user can enjoy a chocolate bar or a bonbon. That cocoa bean is also the source of much worry. Though the bean originated in South America, as of 2014 47% of U. S. cocoa imports came from the Cote d’Ivoire (“Economic Profile”). This is narrow neck for the supply chain. If any geopolitical issues arose in that country, there would be a price pressure on the raw materials that are needed to make chocolate. Ultimately, even if the prices doubled from that one supplier, there are other countries that fill the gap. There is also the fact that the raw materials cost for the cocoa is only a small fraction of the ultimate price the end consumer pays. It is estimated that only eight cents of every dollar stay with the immediate producers of the cocoa bean (“Cocanomics”).
            A larger worry would be if something happened on a global level that harmed the supplies from all cocoa growing nations. That would mean there would be fewer beans to meet the supply and no substitutes for them. Unfortunately, that has happened. Weather issues from drought and a fungal disease known as frosty pod have put significant price pressure on the chocolate industry globally. This supply shock has seen the larger companies approach different changes. Some companies have raised prices at the retail level, while others are reformulating their products in the hope that the public will accept less chocolate and more nuts and nougat in the mix (“Cocoa Crunch”)
            A final consideration for supply issues is in the use of sugar. The American government has long protected domestic sugar growers, limiting import of sugar from abroad where foreign growers can refine sugar at lower cost. This means that any chocolate made in America will have a higher cost because of higher cost American sugar (“Confectionary Industry”). This increased cost of sugar is an issue that is faced by many of the substitutes for chocolate, so it is not a pressing concern for the chocolate industry as they try to maintain their advantage over the other segments. The pressure on the cocoa bean is real and is a potential game changer. If the supply of cocoa beans dries up, the cost of chocolate will take it from an affordable luxury to a product to be enjoyed in limited amounts at special occasions or just a thing rich people consume.
            Buyers have a lot of power in the chocolate market. The end consumer is the one that will eventually take all of the output from the firms, but there is a key mediator between the consumer and the companies manufacturing the chocolate. That mediator is the retail stores that the majority of the chocolate sold has at appear. Mass-market stores such as Target and Walmart are the largest sellers of chocolate, followed by drug stores and supermarkets, with convenience stores in fourth place (“Sales by Distribution Channel”). This means that there is a finite amount of space that all chocolate or confectionaries can take up on the shelves. Given a finite space, the power of the branding is crucial. Stores want to stock the familiar brand that will move product, not to try out something new that may or may not sell. It also gives the firms selling the goods power. If they want to pay a particular price for the wholesale box of cholates, they can ask it. If they are a large enough customer of the chocolate companies, they will get that price and thus be able to sell their good for less or capture more of the profit. An example is Walmart. If your product is not on the shelf at Walmart, then in many areas it is just not for sale at all. Walmart prices many of their candy bars at just a dollar. Who is taking the haircut there, Walmart or Hershey?
            Further pressure from buyers might be seen in two different areas. First of all, even though it might be easy to be flippant about the prospects of industry growth, saying, “As long as people are gaining money, they will continue to buy chocolate. You can’t cure a sweet tooth,” there are some potential pressures that the end consumer might take. The first potential pressure on the makers of chocolate by the buyers of chocolate is that there is question over how their chocolate is grown. The West African nations that grow the cocoa are poor and poorly governed, so it should be no surprise that there have been allegations of human rights abuses including reports of child trafficking and slavery on the cocoa plantations (“Chocolate”). Fair Trade chocolates have filled a niche at a higher price point than the large companies trying to alleviate the fact that the grower of the cocoa received a small amount of the ultimate dollar spent – and even that amount is shrinking (“Cocanomics”). Ultimately, for the good of the industry, the players will want to ensure that the raw materials are sourced from reliable vendors, but in the short term, it has proven that few of the ultimate customers are looking too hard at where their chocolate comes from.
            The second demand pressure from the end users may come from a growing health consciousness about the food consumed. Most chocolate is high in diary, fat, and carbohydrates from the added sugar. Of the twenty-four pounds of confectionaries Americans eat, a lot of that weight sticks to the bones. Accepting the fact that some Americans are becoming more health conscious, chocolate companies are filling the gap to create a healthier chocolate. Varieties of chocolate have been released with less gluten or less sugar or less fat (“Healthier Chocolates”). Ultimately, chocolate is not a staple of the diet, instead it is a limited treat portion. Americans as a whole seem to not want much of the healthier chocolate offerings for now, relegating the healthier choices to a small niche of the chocolate industry as a whole.
            The economy as a whole looks to be in full recovery mode. Jobs have been added at a fairly brisk pace, the unemployment rate is going down, and the stock markets have been reaching new highs lately. The recovery has also trickled down to the consumer level. The chart in figure one shows the real percent change in consumer expenditures. The drawback during the crisis is evident, but looking at the last few years, not only has spending by consumers been growing, the general trend for growth is positive, meaning consumers are finally starting to feel comfortable spending money again, almost a decade after the peak of the housing bubble. This bodes well for industries that are highly reliant on consumer spending such as the chocolate industry. Barring any unforeseen shocks, the industry anticipated rate of growth of between three to four percent seems within reach as long as no consumer preferences change.
Figure 1

The main firms within the industry are in a good position for further success. They have the use of the learning curve and have long ago achieved economies of scale so that they have lower costs than potential rivals have and have built strong brands that will be hard to compete with. These large firms should maintain a steady-as-she-goes outlook, not diluting their brands but also on the lookout for new opportunities. The lesser firms should continue finding the places where the larger firms are not, filling in the spaces for specialty chocolatiers and fair trade and health conscious fare. They may not be able to challenge the giants, but they could find a profitable living in these areas.
Overall, the prospects for the continued success and growth of the chocolate look good. The consumer base is built in and enjoys the products. There are few negative externalities built into the consumption of chocolate, in that it may be unhealthy for the consumer and unhealthy in a different way for the producers of the raw material. The supply of cocoa is the only real unknown in the health of the industry. Chocolate is competitively priced with regards to its potential substitutes, but a supply shock to the cocoa plant may see some switching. The demand for chocolate is inelastic, but only to a point. It is now widely enjoyed and pricing pressure might limit it to a special occasion consumer item. The market continues to grow as a whole even though there are barriers to new entrants.
            Doing the research for this paper has been instructive on the varieties of chocolate and the various substitutes that exist. A surprise was how much of the general snack and treat market was occupied by chocolate. A further learning experience was in finding out about the concentration of the chocolate market between just two big players, while the rest of the firms struggled for the crumbs and other market niches abandoned by the big players.

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