Some Things to Consider as You Find Your Place in the Modern Pork Industry
By Dennis DiPietre, Ph.D. and Brian Buhr, Ph.D.
Global competitiveness is a difficult term to define. In 1989, a Canadian agriculture task force defined competitiveness as, the sustained ability to profitably gain and maintain market share in the domestic and/or export market (Westgren, R, The Micro Economics of Competitiveness: Using a Resource Based Model of Firm Strategy). While simple and straightforward, this definition fails to satisfy since it presumes that global competitiveness is a zero-sum game. The belief that the only way the U.S. or any nation can remain continuously competitive is by take existing share from other nations or by bidding share out of beef, poultry and other protein markets is small thinking.
To be competitive in the world market of 2005 and beyond, a nation’s industry will need to replace one-dimensional cost effectiveness with innovation and cost-effectiveness. Innovation begins with the proposition that existing suppliers of pork in the world market are not the competition. After a reasonable due diligence in examining their modes and methods, we leave them behind and focus on our real target, consumer preferences. Looking to those with current or declining market share for guidance or benchmarking will take the focus off the consumer and back onto traditional (and most likely) dated strategies. Hoping to displace competitors by simply doing what they already do but cheaper will not create and sustain competitive position.
Integral to competitiveness in the 21st century is innovation. Innovation does not promise incremental acquisition of existing share; it holds forth the prospect that the global “pie” is not fixed in size. Rather, the total effective demand for pork is determined by the responsiveness of market players to the real tastes and preferences of global consumers. Responsiveness to the preferences of a diverse group of domestic and global consumers of pork is the key to both creating additional share and sustaining the right to serve that share. Producing pork products in a financially and environmentally sustainable fashion will also be a deciding factor in long-run global competitiveness.
Differentiation on the Basis of Cost Will Not Be Sufficient
Several pork exporting countries, unable to match the low cost of the U.S. production and distribution system are differentiating their country’s pork offering along the lines of safety, wholesomeness and freshness, humane character of production, absence of genetic alteration either in pork or feed-stuffs used in its production, absence of repartitioning agents and rapid responsiveness to final customer preferences. Differentiation of our product in a global market primarily on the basis of cost will not be sufficient to counter these defensive strategies. Most countries would not accept free pork if they thought it posed real safety concerns to consumers.
New thinking in strategy formulation encourages firms to believe that the industry is not simply a given but it can be shaped. To not be constrained exclusively by what the industry is already doing but to ask, “What would we do if we were starting from scratch?” In the same way, the industry must think beyond its traditional boundaries of production methods, products, packaging, fresh vs. processed sales ratios, and conventional wisdom. Creating wealth in the industry will not be accomplished by doing the traditional things cheaper but by creating a total solution for the real and perceived needs of the customer.
The World Has Already Changed
It has become a cliché to say that we are in a period of great change. However, pondering the changes which are unfolding before us is pivotal to positioning a business for profitability in the next millennium. Before we consider the likely characteristics of successful production operations in the next century, it is crucial to understand the nature of the change within which these operations will compete.
First, it is revealing to recognize that the changes that we are observing today are not the result of recent decisions. Rather, the reshaping that is occurring in our industry has its roots in a fundamental shift that has already irreversibly occurred in our world. It is rooted in the mid-1700s in the rise of technology. When a producer asked me at a meeting in Moberly, Missouri, “Why can’t things go back to the way they used to be?” he was asking for something much more profoundly impossible than for large producers to stop expanding or for new buildings to stop being constructed. Several decades ago our modern world ceased to be fundamentally organized around labor and we gave birth to a knowledge-based society.
The emerging reality of the twenty-first century for all agricultural industry will be that those businesses which are organized around knowledge rather than tasks will have the opportunity to create wealth. Those operations primarily organized around tasks or formulas will enjoy a smaller and smaller return to their efforts. This reality is not confined to the producer but is already grinding its way through feed dealers, packers, veterinary practices, lenders, drug companies and extension programs. The return to raising pigs, transporting pigs, killing pigs, processing pigs and selling pig meat will shrink while the return to knowledge will grow.
Within the knowledge-based framework described, it is possible to think through the characteristics of firms that will be able to exploit the changing environment to create wealth. As we discuss each of the characteristics there will be both overlap and seeming contradiction. However, the successful firm of the future will have to create wealth within a very challenging environment requiring the ability to deal with confusion, unanticipated market movements and rapid change.
Production chains that can successfully identify and deliver on consumer tastes and preferences will define the swine industry.
Chain and Firm Organization
Competitive market conditions are defined by four circumstances: (1) there are many buyers and sellers in the market, (2) there is equal access to information (3) there are few barriers to entry or exit from the industry (e.g., low capital costs) and (4) the product being traded is uniform. With these conditions in place, it is expected that firms will be highly specialized in their activities when there are positive economies of size in production. In other words, hog production; packing, processing and distribution would likely be independent activities. This allows greater capital intensity in any phase of the operation so that participants can capture optimal economies of size and scale. In the competitive market, prices serve to transfer products through the vertically adjacent firms until the products reach the final consumer. Prices contain all the necessary information that is simply the quantity of pork produced and consumed in the market. Prices originate with the consumer’s willingness to pay for a particular product or its refined attributes.
Currently, the swine industry violates nearly all assumptions of a perfectly competitive market. Four packers account for 67 percent of total market hog slaughter. The essential meaning of this is there are fewer buyers and they are more geographically dispersed. Access to critical information such as net prices paid and the quality distribution of carcasses is limited or differentially available.
Barriers to entry and exit are high, as improved animal health has allowed greater concentrations of confined animals using capital-intensive all-in-all-out/multiple site production systems. These systems provide cost lowering economies of scale and lower the shutdown point (where variable costs of production per unit of output equals the sale price of output). Similar observations can be made in the packing industry where plants slaughtering less than 12,000 head per day are generally considered cost inefficient.
Finally, responding to increasingly diverse consumer demands (now export markets, but soon segmented domestic markets) requires the ability to alter and measure pork quality attributes and to differentiate pork products either through further processing or through manipulating attributes originating at the farm or genetics level. When perfect market conditions fail to exist, prices are increasingly ineffective at conveying all relevant market information. As this occurs, there are positive benefits to directly passing information beyond prices through the market chain. The benefits to chain alignment may, in some systems, exceed the costs of decreased economies of size while increasing economies of scope (taking on or aligning activities in the chain through information systems).
As the swine market moves further from competitive market conditions, there will be greater incentives to align segments of the chain to achieve the coordination necessary to meet consumer preferences.
Consolidation and Integration
The trends toward integration will continue due to several factors:
- There are complimentary and redundant inputs that can be coordinated or removed from the system.
This is best illustrated by the growth in case ready pork products. Although there are technical benefits (longer shelf life, better inventory control, etc.) packer/processors have moved towards case ready meats partly because the saws, knives and employees formerly employed by grocery stores were redundant inputs to necessary inputs in meat packing and processing. Hence, packing firms can integrate the grocery store retail fabrication functions reducing total chain investment while increasing uniformity, safety of products and reducing labor, inventory management and product wastage costs. - As mentioned earlier market imperfections and price distorting effects create incentives to integrate.
Recent growth in pricing market hogs using formula contracts or long term contracts have been caused by and likely resulted in compounding market price distortions. As these pricing inefficiencies become greater, firms have greater incentives to integrate in an attempt to avoid price discovery between segments of the chain. The only necessary point of price discovery is at the consumer level where products can be priced based on perceived value. All other prices are technically derived and can be internalized in an integrated system. - Increasing demands for specific and narrowly focused information creates incentives for integration.
This category may include measurement problems and moral hazard. Pork quality traits such as meat color, pH, water holding capacity, tenderness and others are only measurable AFTER the animal has moved from production into packing. At that point it is difficult for an independent producer firm to verify that the carcass was properly handled (for example pre-slaughter animal treatment, euthanasia techniques and cooler management as well as measurement methods can all have significant effects on actual and reported pH levels) in the plant. Since producer handling and feeding of pigs can also affect pH levels in meats and the handling and feeding is unobservable by the packer, there will remain the problem of two way miss-payment and by extension distorted incentives for pork production. Integration where both firms will have technical aspects fully revealed improves information and hence is an incentive for integration.On another level this may be as simple as a firm seeking to gain access to patented technologies or proprietary information of a vertically linked firm.
- Vertical diversification may be an alternative reason for integration.
By taking on additional stages, firms may gain diversification advantages which reduces risk exposure. This is only the case when one of the firms has additional activities not directly related to the primary vertical activity. Otherwise, they are both equally subject to the same set of risks (unsystematic risks) – namely shocks to primary supply and primary demand.
Methods of Integration
Strictly speaking, vertical integration is ownership of at least two vertically related stages of production. Vertical coordination does not imply ownership but may be contractual. Which method improves competitiveness the most is an empirical question. It will depend greatly on managerial execution and strategic vision.
Relative merits of coordination and integration assuming common quality of execution:
- Integration requires greater capital costs and may compromise economies of size with economies of scope. Integrated firms must own cost-center assets that drag down return on capital. Concentrated focus on improving value added to the final consumer is frequently lost as management attention is diverted to fixing problems associated with cost-center assets in the integrated chain. Outsourcing this function is a solution but essentially results in a coordinated system rather and an integrated one.
- Integration improves the odds of achieving desired information flows. Contracts must be carefully crafted to assure proper performance and moral hazard and imperfect information are more likely still present. The virtually integrated firm, which involves coordinating existing and new assets via an information system, may approximate the
advantage of full integration. - High quality information systems are likely to be more difficult to manage for coordinated chains than integrated chains because of command and control issues.
- Integration usually increases barriers to entry for other firms that must also incur all integrated capital costs to enter the market. This is good from the integrated firm’s perspective but can lead to further reduced market competition at which point government intervention may occur. Coordinated chains may also achieve this.
Industrial Management Issues
Managerial efficiencies will also affect the structure of firms in the industry. In general, integrated firms with a hierarchical decision structure will be more efficient at implementing decisions, but run the risk of making more bad decisions, as there is only one “filter” for a decision to pass through. Vertically coordinated enterprises are likely to be less efficient in making decisions as two or more decision filters must be passed through. Hence, one of the entities can likely still choose not to implement a particular strategy even though the other sees it as necessary. However, vertically coordinated firms will tend to reduce the number of both good and bad decisions.
Management knowledge and business information structure will be critical in executing vertically coordinated or integrated chains. Currently, integrated chains have the advantage because in the rapidly changing environment of swine production they are most able to respond quickly and decisively.
Food Marketing, Innovation and Efficiency
Food marketing to consumers in the United States is evolving rapidly along two fronts: innovation and efficiency. Factors driving innovation include serving the changing ethnic mix of the U.S. population and the growing demand for foods with high flavor, premium quality, high nutrition and safety/environmental assurances. This had led to a proliferation of niches and branded food items targeting various groups of consumers. Niches are targeted not only with different food offerings but with varying store formats too. Formats include limited assortment stores, supercenters (merchandising food, drugs and mass merchandise), superstores (food only), wholesale clubs and warehouse formats. Many food companies have stores representing all of these formats in different target locations.
While the richness of the offerings and formats have increased, the demands to deliver the products in a cost effective manner has driven scale into every part of the food chain. As a demonstration of the remarkable ability of the food chain in the U.S. to deliver on both cost and innovation, the U.S. consumer now spends only slightly more than ten percent of disposable income on food. The mix of consumption is still weighted toward food consumed at home, 6.2%, while food consumed away from home accounts for about 4.2% of disposable income.
Staying ahead on innovation is both costly and difficult. Firms test thousands of new offerings each year and spend millions of dollars in consulting expenses for such things as focus groups, scanner-data analysis and third-party surveys such as Neilsens. A recent survey by the Food Marketing Institute (FMI) revealed that taste and flavor are still king in determining selection at the supermarket. The major drivers of supermarket purchases are (in order of importance): taste/flavor, nutrition, health and safety issues, price/value and storability/shelf-life. Driven by rising incomes and a history-making growth in economic output, the U.S. consumer is more demanding on quality and willing to pay for combinations of products and services.
Wal-Mart and the End of Loss Leaders
On the efficiency front, the emergence of mass merchandisers such as Wal-Mart and KMart into the food retailing area is changing marketing strategy and increasing the drive toward efficiency. These firms are bringing a focus on coordinated sales forecasting and replenishment, developed in mass merchandising to the food chain. These firms focus on “everyday low prices” and tend to shun more traditional approaches such as loss leaders and periodic low-price sales as a means to build market share. Providing suppliers with sales data and forcing the cost of inventory holding down the chain has created a scramble to better organize the flow of production and distribution all the way back to production. These trends are assuring that the real winner in race for innovation and efficiency will be the consumer.
Where Will Value-Added Take Place and Whose Name Will be on it?
One of the key issues facing the pork production segment is where the commodity/value added transformation takes place. Traditionally, raw agricultural products were produced as commodities with most of the value-added and differentiation of products taking place at the processing level. As the cluster of demand attributes consumers are willing to pay for becomes more varied and complex, it seems likely that more differentiation of products will be required at the production level through such things as certified systems, specialized genetics and feeding systems. Demand attributes such as color, naturalness, organic, humanness in production etc. cannot be “added” to a commodity at the processing level and are therefore providing the opportunity for segregated production schemes to develop adding value and thereby enhancing potential profits.
As the pork and beef industries reach maturity as commodities, the race to brand products is on. It is fascinating to see that efforts to brand fresh pork have begun at every stage of the production and processing chain – from feed inputs to the case-ready package.
This move is easier to understand when you see that, without question, branding is the most powerful concept in consumer sales. Whoever owns the brand and branding process will capture extra profits often unrelated to production costs. In commodity chains, which have largely exhausted the cost reduction options, branding offers the possibility of increasing sale value without loss of market share and thus increasing profitability.
Branding is a way for manufacturers or sellers of goods to distinguish their products from like commodities. For many centuries, the concept of branding was limited to the “maker’s mark”. This mark, applied to everything from knives to brandy, assured the buyer of a consistent quality.
Brands based on technical attributes were always subject to being displaced by competitive products with better performance. Brands based on low or moderate price are always subject to erosion from the cheaper, better and faster competitor.
In the last 50 years, with the advent of mass media and rising per capita incomes, branding has become much more revolutionary. It has shifted from assurances of technical quality or performance to defining the very relationship between product and buyer. This form of branding, referred to as emotional or lifestyle branding, offered something performance-based claims could never do-an emotional connection to the product. And the instrument of modern branding – mass media advertising – has greatly reduced the time it takes to establish brand identity, though much more than advertising is needed to successfully develop a brand.
Fresh meat branding can take place around attributes that are both observable and unobservable. Examples of observable attributes include color, size, absence of visible fat, etc. Unobservable attributes include “family farm raised,” safety, U.S. produced, “corn-fed” and so on. Unobservable attributes require the trust of the consumer and therefore require information systems and/or strict production and processing protocols since, if the trust is violated even once and discovered, the equity in the brand is eroded forever.
In economic theory, we say that successful branding allows price differentiation. It makes the demand for the branded product more inelastic. This means if you increase the price of successfully branded pork chops by a certain percent, say 5%, it will result in less than a 5% loss in sales to unbranded, commodity chops or other substitute meats. Commodity pork chops are relatively price elastic as beef and poultry prices fall. This means even small percentage increases in price will result in larger declines in quantities purchased as consumers seek cheaper alternatives.
Branding in meat has been almost exclusively reserved for processed products. Your local supermarket has a proliferation of branding applied to hams, bologna, luncheon meats, bacon, etc. But in the fresh meat case, with the exception of poultry, branding is just beginning. Most fresh meat brands have failed because actual and perceived differences are difficult to demonstrate and maintain.
Perdue brand was one of the first successful fresh meat brands in poultry. A perception of extra quality was established partly because of successful branding of Perdue eggs and partly because of a truly superior quality, uniformity and color of Perdue brand chickens.
In the case of U.S. pork, several attempts at branding are underway, although most only promise a consistently leaner and, by implication, “more healthy” product. Others try to capture successful brand names from the processed case and simply transfer them to fresh products.
In Europe, fresh pork branding has been very successful around attributes such as “outdoor-raised” and product “traceability.” In Great Britain and France some fresh pork cuts have a tracking number on the package that identifies the farm and the animal from which the cuts came. These attributes command a higher price than unbranded commodity cuts since they provide a certain kind of reassurance.
Branding transforms perfectly competitive markets to monopolistically competitive ones. Prices can be charged which exceed the long-term average cost of production. These extra profits are called brand “rents” and if maintained over time, create brand equity.
With the advent of costly fixed asset investment and the savings associated with economies of scale, finding a profitable long-term market for the increased amount of pork produced is critical. Successful pork branding will allow prices at the retail level to increase while reducing the normal substitution of beef and poultry when they become relatively cheaper. For this reason, branding is the next frontier as commodity pork and beef markets move into the 21st century. The big question: How to establish an emotional relationship between the buyer and the pork—unlike technical attribute branding, this brand will resist competitive challenge and could last a lifetime.