Analysis of the grocery industry

Coles Supermarkets Australia
October 2012

Analysis of the grocery industry

Contents
Glossary ..................................................................................................................................... i Executive Summary.................................................................................................................. iii 1 Introduction .................................................................................................................... 1
1.1 1.2 Project approach and objectives........................................................................................ 1 Report structure ............................................................................................................... 2

2 3

Coles – an overview ........................................................................................................ 3 Economic contribution of Coles ....................................................................................... 5
3.1 3.2 3.3 3.4 3.5 3.6 3.7 Modelling approach .......................................................................................................... 5 Direct economic contribution ............................................................................................ 6 Indirect economic contribution ......................................................................................... 6 Total economic contribution ............................................................................................. 7 Regional economic contribution ........................................................................................ 8 Indirect contribution – Facilitated ..................................................................................... 8 Economic contribution comparison ................................................................................... 9 Context: Analysing ‘Down Down’..................................................................................... 10 ‘Down Down’: A whole of company perspective .............................................................. 11 ‘Down Down’: product prices under the microscope ....................................................... 14 The volume impact of ‘down down’ ................................................................................ 20 Explaining ‘Down Down’: the benefits of scale ................................................................. 21 Private labels .................................................................................................................. 22 Consumer welfare benefits of ‘down down’ .................................................................... 24 Consumer welfare benefits of retail grocery prices .......................................................... 25 Variety and choice at the supermarket ............................................................................ 27 Supermarket convenience: benefits for consumers ......................................................... 29 Supermarket quality: benefits for consumers .................................................................. 31 Key concepts and background ......................................................................................... 32 The grocery industry ....................................................................................................... 34 Competition in the downstream (retail) market............................................................... 37 Competition in the upstream market .............................................................................. 38 Review of arguments ...................................................................................................... 39 Competition policy in Australia........................................................................................ 41 Government policy directions ......................................................................................... 42

4

Price and productivity ................................................................................................... 10
4.1 4.2 4.3 4.4 4.5 4.6

5

Consumer benefits ........................................................................................................ 24
5.1 5.2 5.3 5.4 5.5

6

Competition in the grocery industry .............................................................................. 32
6.1 6.2 6.3 6.4 6.5

7

Impact of proposed policies .......................................................................................... 41
7.1 7.2

Liability limited by a scheme approved under Professional Standards Legislation. Deloitte refers to one or more of Deloitte Touche Tohmatsu Limited, a UK private company limited by guarantee, and its networ k of member firms, each of which is a legally separate and independent entity. Please see www.deloitte.com/au/about for a detailed description of the legal structure of Deloitte Touche Tohmatsu Limited and its member firms. © 2012 Deloitte Access Economics Pty Ltd

7.3 7.4

Competition law review .................................................................................................. 44 Market share cap and forced divestiture ......................................................................... 45

References .............................................................................................................................. 48
Limitation of our work ............................................................................................................... 50

Charts
Chart 3.1 : Value added: Coles and selected industries .............................................................. 9 Chart 4.1 : 2L Coles milk price composition ............................................................................ 16 Chart 4.2 : Milk production figures .......................................................................................... 17 Chart 4.3 : Milk sales figures ................................................................................................... 18 Chart 5.1 : Subcategory count ................................................................................................. 30 Chart 6.1 : Selected market shares of food processors in Australia .......................................... 36

Tables
Table 3.1 : Direct contribution, 2011-12 .................................................................................... 6 Table 3.2 : Indirect economic contribution – Intermediate Inputs 2011-12 ................................ 7 Table 3.3 : Total economic contribution 2011-12 ...................................................................... 7 Table 3.4 : Direct regional employment contribution 2011-12 ................................................... 8 Table 3.5 : Regional value added 2011-12 ................................................................................. 8 Table 3.6 : Economic contribution – Facilitated 2011-12............................................................ 8 Table 3.7 : Economic contribution: direct, indirect and facilitated 2011-12................................ 9 Table 4.1 : Coles Income Statement ........................................................................................ 11 Table 4.2 : Change in key aggregates for the 'Down Down' products (Jan 2011 to mid-2012) .. 14 Table 4.3 : Coles milk 2L .......................................................................................................... 15 Table 4.4 : Coles Smart Buy white bread 650g ......................................................................... 18 Table 4.5 : Coles chicken roast family ...................................................................................... 19 Table 4.6 : Coles 2 ply paper towel white 2 pack ..................................................................... 19 Table 4.7 : Colgate regular toothpaste 120g ............................................................................ 20 Table 4.8 : Coles volume of selected goods ............................................................................. 21 Table 4.9 : White bread 650g .................................................................................................. 23 Table 4.10 : Eggs 12 pack 700g ................................................................................................ 23 Table 4.11 : Soft drinks ............................................................................................................ 23 Table 5.1 : Price changes at Coles, by product category ........................................................... 24

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Table 5.2 : Sales revenue and savings (all figures in $m) .......................................................... 25 Table 5.3 : Food and beverage price inflation 1980-2012 ........................................................ 26 Table 5.4 : Regression results of change in volume given a change in SKU ............................... 28 Table 6.1 : Players in the grocery industry ............................................................................... 34 Table 6.2 : Market share of dominant player in other Australian industries ............................. 37

Figures
Figure 1.1 : Framework for the analysis ..................................................................................... 2 Figure 2.1 : Coles supply chain .................................................................................................. 4 Figure 3.1 : Coles indirect contribution flow .............................................................................. 7 Figure 4.1 : Direct to store logistics network ........................................................................... 13 Figure 4.2 : Distribution centre to store logistics network........................................................ 13 Figure 5.1 : Supermarket convenience – many shops in one .................................................... 29 Figure 6.1 : Vertically integrated supply chain ......................................................................... 35

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Glossary
ABARES Australian Bureau of Agricultural and Resource Economics and Sciences Australian Bureau of Statistics Australian Competition and Consumer Commission Australia Food and Grocery Council Australian Stock Exchange Average Competition and Consumer Act (2010) Council of Australian Governments Cost of doing business Cost of goods sold Consumer Price Index Deloitte Access Economics Australian Department of Agriculture, Fisheries and Forestry Earnings Before Interest and Tax Earnings Before Interest, Tax, Depreciation and Amortisation Fast Moving Consumer Goods Full-time equivalent Financial Year Gross Domestic Product Global Financial Crisis (2008) Gross Leasable Area Independent Grocers Alliance Information Technology i Commercial-in-Confidence

ABS ACCC AFCG ASX AVE CCA COAG CODB COGS CPI DAE DAFF EBIT EBITDA FMCG FTE FY GDP GFC GLA IGA IT
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KAP RBA SKU SSNIP TLS

Katter’s Australian Party Reserve Bank of Australia Stock Keeping Units Small but Significant Non-transitory Increase in Prices Tobacco, Liquor and Services

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Executive Summary
Purpose and framework
Deloitte Access Economics was commissioned to develop a report examining the economic significance and contribution of Coles to the Australian economy. Coles’s ‘Down Down’ marketing and pricing campaign is examined, including the impacts on consumers, suppliers and Coles itself. In addition, the report examines the broader value of supermarkets to consumers, takes a snapshot of market dynamics, and concludes with a discussion of policy directions for the sector. Figure i: Framework for analysis
MARKET & POLICY ENVIRONMENT Market share & power Policy : government, opposition & cross-bench

COLES SUPERMARKETS

ECONOMIC CONTRIBUTION
Expenditure Value added Employment Regional

SUPPLY CHAIN Farmgate, cost of goods sold Cost of doing business Margins, strategies & scale Private labels

CONSUMERS Price impacts Choice & variety Convenience Quality

Economic contribution
Coles Supermarkets’ economic contribution, as measured by direct value added, was $4.5 billion in 2011-12 – but its contribution including indirect value added and facilitated trade was five times as big at $20.8 billion. The total headcount of Coles Supermarkets employees is almost 100,000. In full time equivalent (FTE) terms, Coles Supermarkets employed 55,467 people in 2011-12. Indirectly, its activities supported another 9,468 FTE jobs. Facilitated trade supported another 118,995 FTE up the supply chain and across the economy. We estimate that around 28% of Coles’s economic contribution is in regional Australia. As shown in Chart ii, Coles’s direct and indirect economic contribution is as large as significant businesses like Lion or industries like Film and Television; including the value add through facilitated trade, it is as large as the contribution of Australia’s airports. These comparisons suggest that Coles is a very significant company as a contributor to the Australian economy.
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Chart ii: Value added, Coles and selected industries

Coles (direct, indirect plus 'facilitated')

4,488 1,541

14,754

Airports (direct and indirect)

17,266

Film and Television Industry (direct and indirect)

6,100

Lion (direct and indirect)

5,100

-

5,000

10,000

15,000

20,000

25,000

Source: ABS 8155.0 Australian Industry, Deloitte Access Economics. Note: Airport figures are for 2011, Lion figures are for FY2011 and Film is for 2009-10.

‘Down Down’
We analyse retail prices of Coles products and, if there are significant and sustained prices reductions, how these have been achieved: through reductions in cost of goods sold, COGS, (and/or reduced farm gate prices); through reductions in cost of doing business, CODB (i.e. by efficiencies achieved in the supply chain or reduced wastage); or through reduced margins. Looking from the top down, Coles’s income statement, the rise in Coles’s profits (EBIT) is achieved through a combination of rising revenue and lower per unit costs – with lower costs mainly resulting from lower CODB. Efficiency gains have been achieved through reduced wastage of goods, competitive tendering arrangements, self-scan checkouts and easier shelf replenishment, and distribution and logistics savings. Efficiencies have also been achieved through the operation of larger and more productive stores. Across the whole product range, prices for all goods at Coles have fallen by 4.2% on average over the last 18 months (and by 7.9% if cigarettes are excluded). For the 1200 ‘Down Down’ goods for which data is available, retail prices have been reduced by 8% on volume-weighted average basis since 2011. For these goods, COGS per unit has fallen by 17% overall, but only 2% on a volume-weighted basis. This suggests that lower retail prices primarily reflect lower retail margins for Coles or greater efficiencies.

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Individual goods
We apply our analysis of retail prices, margins, efficiencies (cost of doing business) and suppliers (farm gate prices and cost of goods sold) to individual products included in the ‘Down Down’ campaign – for a more forensic look at pricing dynamics. We find a number of different scenarios regarding the relationship between retail prices, supplier income, efficiencies, Coles’s margin and volume. Sometimes, Coles pays the same or more per unit to suppliers and reduces prices by reducing its margins or achieving efficiencies. On the other hand, sometimes Coles may pay suppliers less in headline income but provide more favourable contract terms (or assists in achieving efficiencies). Lower supplier income could also reflect an agreement between Coles and the supplier to reduce retail prices to drive volume. Of course, there will also be situations where Coles reduces prices paid to suppliers who then experience lower margins and profits.

Consumer benefits of ‘Down Down’
Over an 18 month period retail prices for most categories of goods have come down. On a weighted average basis, prices have fallen by 4.1%. The main exception is cigarette prices, which have increase because of changes in excise arrangements. To obtain an overall picture of the savings to consumers we aggregate the price movement during this period and calculate a savings figure – based on both old volumes and current volumes. We find that in 2011-12, the one-year savings of the price reductions during the ‘Down Down’ campaign (i.e. over the 18 months from January 2011) is between $1.05 billion and $1.19 billion. The midpoint is $1.12 billion.

Benefits of lower retail grocery prices overall
It is important to recognise that ‘Down Down’ is not just an individual company strategy – it is also reflective of overall market conditions. ‘Down Down’ is one company’s strategy in a competitive market. Other companies also use pricing strategies to increase their market share. Some of these are a competitive response to Coles. Price reductions across the sector are of significant benefit to consumers. CPI for food and beverage from March 2011 to June 2012 was -1.85%. Based on a $78.4 billion industry this implies a saving of $1.45 billion across food and beverages. If we also take account of substitution bias, because CPI overstates inflation, price reductions could be worth $2 billion to consumers in 2011-12. It is not possible to precisely estimate Coles’s contribution to overall savings from food price reductions. However, the figures referred to in the report strongly suggest that Coles’s contribution to industry-wide savings is higher than its market share (of around 31%).

Variety, convenience and quality
It is important to recognise that beyond the price benefits to consumers, supermarkets, like any store, provide other benefits through variety of products and convenience of services.

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In the supermarket, we can measure variety by the total number of products offered – the number of stock keeping units (SKUs). A greater number of SKUs means consumers have more products, varieties, brands and sizes to choose from. Our analysis is that while SKU data shows declining variety at Coles Supermarkets in recent years, moderately lower SKUs are associated with higher sales volumes. This means there is either greater in store availability of goods because it is easier to keep fewer brands in stock, or that consumer demand for these goods is relatively ‘elastic’ - i.e. consumers switch between options relatively easily.

Private labels
The growing role of private labels has been controversial, with claims they are part of a long term strategy to increase market power and increase retail prices. Analysis of some examples suggests that it is unlikely that Coles systematically achieves higher margins on its own products and directly encourages consumers not to buy branded products. While it is difficult to speculate on the long term effects of private labels – so far the federal Department of Agriculture says they reflect consumer preferences and increase competitive pressures.

Snapshot of market dynamics
At one level, the grocery industry in Australia may appear highly concentrated, dominated by the major supermarket chains, Coles and Woolworths. However, a more sophisticated analysis reveals a complex picture which is heavily dependent on how the markets are defined and what methodologies are used to segment markets. Some key statistics for the participants in this industry is presented in the table. Table ii: Players in the grocery industry Retailer
Woolworths Coles / Bi-Lo Other supermarkets ALDI Speciality Foods Franklins Source: Coles Data, 2011

Market share
41.1% 31.0% 14.0% 7.3% 5.9% 1.2%

Policy directions
Policies impacting the supermarket sector are a regular feature of economic debates. Some relate specifically to the sector, others are general regulations that have impact on supermarkets. Three policy directions we discuss are:  government policy positions, focusing on industry codes and regulation; vi Commercial-in-Confidence Deloitte Access Economics

 

proposals for a review of competition policy settings; and proposals for market caps for individual supermarket chains, to deal with perceived market power.

Our overall conclusion is that policies focused specifically on major supermarkets such as market share caps would make consumers worse off, but that policies to reconsider industry codes, lower barriers to entry, and generally increase competitiveness in the sector could make consumers better off. It would also be worthwhile for the Productivity Commission to examine the long term impact of private labels on the Australian food manufacturing industry. Table iii: Policy directions Policy proposal
Existing competition framework; further assess industry codes Competition law review

Proposer
Australian Government Federal Opposition

Analysis
Benefits of mandatory codes must outweigh their red tape costs. Regular reviews are okay; Productivity Commission could review barriers to entry and supply chain with a focus on consumers and competitiveness and impact of private labels. Likely to result in higher prices for consumers and lower prices for suppliers and be difficult to implement

Market share caps on supermarkets

Katter’s Australian Party

Source: Deloitte Access Economics

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Analysis of the grocery industry

1 Introduction
The grocery industry is one of the most important industries in the Australian economy. The price of food and other staples has a day to day impact on the lives of consumers. The industry employs a significant proportion of the workforce and has links to many other industries in the Australian economy, including agriculture, manufacturing and transport. Accordingly, it is an area of interest to policy makers and government. In Australia, supermarkets are one of the key players in the grocery industry providing around 70% of the value of the retail market for food and groceries. Over the past five years, there have been some significant developments in the supermarket sector. New players like Costco have entered the market, while ALDI has expanded since its entry in 2001. The links between supermarket and fuel industries have been normalised. In response to concerns that cost of living pressures were affecting families, in 2008, the Australian Government commissioned the Australian Competition and Consumer Commission to review of the industry. In 2010, the Trade Practices Act was recast as the Competition and Consumer Act, with several competition policy amendments in recent years. Supermarkets themselves have developed new pricing and marketing strategies. ‘Down Down’ is Coles’s pricing and marketing campaign. This has been a high profile campaign from its commencement in early 2010. Other supermarkets have their own pricing strategies to compete, including IGA’s with “Locked Down Low Prices” from July 2012 and Woolworths’s “everyday low prices”. It is against this background that the Coles Supermarkets commissioned Deloitte Access Economics to report on the economic significance and contribution of Coles in the grocery industry. Coles’s ‘Down Down’ strategy is examined in detail – drawing out the impacts on consumers, suppliers and other stakeholders. In addition to this, we examine the value of supermarkets to consumers and the take a snapshot of market dynamics. We conclude with a discussion of policy directions for the sector.

1.1 Project approach and objectives
The purpose of this study is to develop a comprehensive report to examine the impact of Coles’s pricing strategy and analyse relevant issues that the policy makers currently face. As outlined in Figure 1.1, we look at Coles Supermarkets’ economic contribution, the supply chain, impacts on consumers, and how the market and policy environment affects Coles.

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Figure 1.1: Framework for the analysis
MARKET & POLICY ENVIRONMENT Market share & power Policy : government, opposition & cross-bench

COLES SUPERMARKETS

ECONOMIC CONTRIBUTION
Expenditure Value added Employment Regional

SUPPLY CHAIN Farmgate, cost of goods sold Cost of doing business Margins, strategies & scale Private labels

CONSUMERS Price impacts Choice & variety Convenience Quality

Source: Deloitte Access Economics

1.2 Report structure
The report is organised as follows:     Chapter 2 provides an overview of the activities of Coles Supermarkets. Chapter 3 calculates the direct, indirect and facilitated economic contributions of the industry. Chapter 4 analyses the Coles supply chain, focusing on the ‘Down Down’ pricing strategy. Chapter 5 quantifies the benefits to consumers of price changes in the supermarket industry; it also investigates other benefits of supermarkets for consumers including variety and choice and convenience. Chapter 6 reviews analyses of competition in the supermarket industry. Chapter 7 describes and analyses policy directions in the public domain including from the government’s National Food Plan, a review of competition policy, and the idea of market caps for major supermarket chains.

 

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2 Coles – an overview
In 19th century the Australian groceries market was very fragmented and typically operated by sole operators. Typically, they were called ‘corner stores’ and were very region specific and served a small community. Moreover, the range of products they stocked was somewhat limited as the purpose was to meet the needs of that small community. Given the limited range, this allowed other specialty stores to spawn such as bakers and delicatessens. The 20th century, saw the development of the ‘supermarket’ as we know today. Specifically, supermarkets provided a one stop shop for its consumers for their weekly grocery needs. Gradually over time, these supermarkets expanded their product range which furthers the convenience of the store. Coles was amongst the first supermarkets in Australia. Coles was founded by George Coles in 1914, he opened the first Coles Variety store in Collingwood as a variety store. In 1921, Coles became a propriety company and in 1927 the company was floated on the Melbourne Stock exchange. In 1985, Coles Myer Ltd. was established, after a merger with Myer Emporium Ltd. (Myer). Myer was acquired through total cash offer of $918 million. In July 2007, Wesfarmers purchased Coles Group Limited for $22 billion. Myer was demerged from the Coles Group in 2005 to private equity interests in 2005 and floated as a listed entity in 2009. It has therefore not been part of the Coles Group since 2005. Wesfarmers was founded in 1914 as a farmers' co-operative in Western Australia, in 1985 it was restructured to a public company and was listed on the ASX. Today, Coles Supermarkets is one of two major supermarkets operating in Australia. There are also several other supermarkets as well as numerous speciality retailers that comprise the grocery industry in Australia. Coles Supermarkets is part of the Coles Group owned by Wesfarmers. The Coles Group comprises:    national full service supermarket retailer operating 749 stores (Wesfarmers 2012); liquor retailer operating three brands through 792 liquor outlets and 92 hotels (Wesfarmers 2012); and national fuel and convenience operator managing 627 sites (Wesfarmers, 2012).

Between the different parts of the Coles Group, there were approximately 18 million customer transactions each week in 2011-12, and over 100,000 employees. In 2011-12, the Coles earned $23.6 billion in revenue from their supermarkets. Currently, Coles Supermarkets is represented in all states and territories in Australia. Coles can be characterized as a bundling service where all suppliers meet in Coles and consumers go to Coles to purchase the product. Thus, the product which Coles provides is convenience to its consumers. Accordingly, it is the supplier which provides the input for Coles to supply to the final consumers of the product. Thus, without the suppliers Coles cannot provide a service. A diagram of Coles Supply Chain is provided below:
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Figure 2.1: Coles supply chain
Wholesaler and Retailers are Integrated Supplier Retail Store

Supplier

Wholesaler

Retail Store

Supplier

Retail Store

Source: Deloitte Access Economics

Accordingly, Coles needs to ensure that they are able to meet the needs of its consumers. By doing so they are required to sense the needs of its consumers and adjust accordingly, thus Coles does depend on its suppliers to be flexible enough to meet their needs. Naturally, if they are not able to do so, then Coles would need to either forgo this market or find an additional supplier to meet this gap. It is commonly known that Woolworths and other supermarkets provide the same service to its consumers. Recent years have also seen supermarkets try to enhance convenience by providing online grocery shopping. Today, Coles possesses a market share of 31% in the grocery market. Woolworths holds a bigger market share. The remainder of the market goes to IGA and other independent grocers.

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3 Economic contribution of Coles
The economic contribution of Coles Supermarkets to the Australian economy is measured in terms of:   value added which is the contribution to GDP, and includes wages paid to employees and the gross operating surplus generated (including taxes); and employment which is measured by full-time equivalent (FTE) jobs.

The economic contribution is the sum of the direct and indirect value added by the economic activity undertaken by Coles Supermarkets. In addition, there is trade ‘facilitated’ by Coles.

Coles Supermarkets’ direct ‘value added’ was $4.5 billion in 2011-12 – but its contribution including indirect value added and facilitated trade was five times as big at $20.8 billion.

Coles Supermarkets contributed 55,467 FTE jobs in 2011-12, but including indirect and facilitated trade, it was 183,930 FTE jobs up the supply chain and across the economy

3.1 Modelling approach
The basis for estimating the economic contribution is the direct value added and employment contributed by capital and labour inputs employed directly by Coles Supermarkets in the provision of its Value added is a goods and services. These outputs are the retail services measure of how offered in the sale of various goods including grocery, frozen, meat, dairy deli, fresh produce, bakery, general merchandise much economic and apparel, tobacco, liquor and services. The value added is activity directly appropriate measure of the economic contribution happens inside an the most is the sum of the returns to the primary factors to GDP. It of organisation and production – labour and capital – and can be calculated by how much it adding the gross operating surplus1 and wages paid to employees. generates This is then combined with a selection of input-output elsewhere in the economic multipliers to determine the indirect or flow-on economy contribution to the economy. The indirect contribution is a
1

Gross operating surplus represents the value of income generated by the entity’s direct capital inputs, generally measured as the earnings before interest, tax, depreciation and amortisation (EBITDA).
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measure of the demand for goods and services produced in other sectors of the economy as a result of the direct economic activity of Coles Supermarkets. The size of the flow-on activity is determined by the extent of the linkages with other sectors of the economy. Given that Coles is in the retailing sector, beyond indirect we also look at the impacts arising from Coles as an intermediary for the suppliers – i.e. the trade ‘facilitated’ by Coles. According to the ABS: “Although retailers actually buy and sell goods, the goods purchased are not treated as part of their intermediate consumption when they are resold with only minimal processing such as grading, cleaning, packaging, etc. Wholesalers and retailers are treated as supplying services rather than goods to their customers by storing and displaying a selection of goods in convenient locations and making them easily available for customers to buy. Their output is measured by the total value of the trade margins realised on the goods they purchase for resale.” This effect is called, “Indirect Contribution – Intermediate Inputs”.

3.2 Direct economic contribution
The direct economic contribution comprises the value added and the FTE jobs generated by Coles Supermarkets. Table 3.1 below outlines the direct economic contribution of the Coles Supermarkets in 2011-12. Table 3.1: Direct contribution, 2011-12

Wages paid to employees ($ million) Gross operating surplus ($ million) Direct value added ($ million) Direct employment (FTE jobs) Source: Coles 2012, Deloitte Access Economics.

2,947 1,541 4,488 55,467

3.3 Indirect economic contribution
The expenditure of Coles has a flow-on impact on other sectors, creating an indirect contribution to the Australian economy. In 2011-12, the expenditure of Coles on the goods and services of other organisations amounted to $19,148 million, of that $17,412 million was COGS and $1,735 million was expenses. The basis of the calculation of indirect contribution-intermediate inputs will be based upon the expenses figure. COGS will be used for facilitation measures later. The flow of Coles’s expenditure into other sectors of the economy is represented below. It demonstrates the breadth of the sectors to which Coles contributes. The multiplier for each sector is applied to calculate the extent of the indirect contribution.

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Figure 3.1: Coles indirect contribution flow

Indirect gross value

Coles expenditure
$19,148m

Cleaning, electricity, marketing and other business services

added $1,541m
Indirect employment 9,468 FTE jobs

Source: Coles 2012, Deloitte Access Economics.

The indirect contribution relates to the additional contribution that Coles make as an intermediary who on sells products. Table 3.2: Indirect economic contribution – Intermediate Inputs 2011-12

Wages paid to employees ($ million) Gross operating surplus ($ million) Indirect value added - intermediate inputs ($ million) Indirect employment (FTE jobs) Source: Coles 2012, Deloitte Access Economics.

747 793 1,541 9,468

3.4 Total economic contribution
Table 3.3 outlines the total economic contribution of Coles – the sum of the direct and indirect (intermediate input only) contributions. Table 3.3: Total economic contribution 2011-12

Wages paid to employees ($ million) Gross operating surplus ($ million) Total value added ($ million) Total employment (FTE jobs) Source: Deloitte Access Economics.

3,695 2,334 6,029 64,935

The economic contribution of Coles highlights that it is an important organisation, as an intermediary Coles contributes over $6 billion to Australian GDP, and supports almost 65,000 FTE jobs.

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3.5 Regional economic contribution
Table 3.4 outlines the direct regional employment economic contribution of Coles. Of the 77,827 (total) employees employed in Coles supermarkets in CBD, metro and country areas, (not including Bi-Lo) 22,503 are employed in country supermarkets. That is, almost 30%: Table 3.4: Direct regional employment contribution 2011-12

Total employees, Coles country supermarkets Total employees, Coles supermarkets Country proportion of Coles direct regional employment Source: Deloitte Access Economics.

22,503 77,827 29%

Note: does not include BiLo or Store Support Centres

Note that these figures are for supermarkets only and do not include distribution centres. We assume that distribution centre activity is also divided between regional and nonregional areas in the same proportion. Assuming that regional/non-regional breakdown of direct activity is same as store sales figure that have been provided by Coles we have a regional contribution of direct activity of 30%. Further, our analysis of the industries and regions of Coles’s indirect activities, suggests a regional proportion of 23%. The proportion of total activity in regional areas is 28%. Table 3.5: Regional value added 2011-12 Value Added
Direct value added Indirect economic contribution – intermediate input Total Value added Source: Deloitte Access Economics. 1,330 351 1,681

Proportion of Total
30% 23% 28%

Note: does not include BiLo or Store Support Centres

3.6 Indirect contribution – Facilitated
Coles purchases products which in turn generate business for the suppliers and thus contributes to the economy. The figures presented reflect the contribution of Coles when it is facilitating trade for the suppliers. Table 3.6: Economic contribution – Facilitated 2011-12 Total
Wages paid to employees ($ million) Gross operating surplus ($ million) Indirect value added - Facilitated ($ million) Indirect employment (FTE jobs) Source: Coles 2012, Deloitte Access Economics. 6,997 7,757 14,754 118,995

Regional
1,952 3,216 5,167 n/a

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If the figures are included as part of Coles’s economic contribution we find its contribution to be: Table 3.7: Economic contribution: direct, indirect and facilitated 2011-12

Total value added ($ million) Total employment (FTE jobs) Source: Deloitte Access Economics.

20,783 183,930

If we consider Coles as a facilitator as well, this would imply Coles’s economic contribution to more than $20 billion which supports more than 180,000 jobs.

3.7 Economic contribution comparison
The economic contribution of Coles can be compared with key industries in Australia. Chart 3.1: Value added: Coles and selected industries

Coles (direct, indirect plus 'facilitated')

4,488 1,541

14,754

Airports (direct and indirect)

17,266

Film and Television Industry (direct and indirect)

6,100

Lion (direct and indirect)

5,100

-

5,000

10,000

15,000

20,000

25,000

Source: ABS 8155.0 Australian Industry, Deloitte Access Economics. figures are for FY2011 and Film is for 2009-10.

Note: Airport figures are for 2011, Lion

Chart 3.1 shows that the direct and indirect economic contribution of Coles is about the same size as contribution of the film and television industry or Lion. If we include the facilitated component it is about three times the size of the film and television industry and larger than that of Airports in Australia. These comparisons suggest that Coles is a very significant company as a contributor to the Australian economy.

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4 Price and productivity
4.1 Context: Analysing ‘Down Down’
The ‘Down Down’ pricing strategy of Coles Supermarkets has occurred within a dynamic supermarket industry. Just the last few years have seen significant developments, including the shift of Coles Supermarkets from Coles Group to Wesfarmers, the takeover of Franklins by Metcash, and the entry and expansion of new competitors ALDI and Costco. All these developments have occurred since the ACCC’s 2008 grocery inquiry, which took place in response to perceived rising prices of groceries. It found that important factors included drought and supply disruptions, quarantine restrictions, and world commodity prices. By contrast, it found that ‘the potential contribution of any weakening of price competition in grocery retailing/wholesaling to food price inflation is limited.’ It found that a very small proportion of increases in food prices over the previous five years could be directly attributable to the increase in the gross margins achieved by major grocery players. Over the last four years, Coles sales have increased by $4.8 billion to around $24 billion. Coles have out-performed the supermarket sector overall over the last four years, market share has gone up slightly. Growth in revenue reflects changes in prices and volumes. On the face of it, a campaign like ‘Down Down’ should have the effect of lowering prices and increasing volumes. As might be expected with any increase in market share, Coles have been criticised for being too big and abusing its market power by squeezing the suppliers. Furthermore, there has been public debate about the current competition policy framework. What is ‘Down Down’? ‘Down Down’ is a pricing and marketing strategy adopted by Coles from 2010 designed to increase its company performance. Part of the strategy is that prices for selected goods stay down rather than experience a short term price reduction as during a normal sale. The purpose of this Chapter is to analyse consumer retail prices of Coles products and, if there are significant and sustained prices reductions, how these have been achieved: through reductions in cost of goods sold (and/or reduced farm gate prices); through reductions in cost of doing business (i.e. by efficiencies achieved in the supply chain or reduced wastage); or through reduced margins. Specifically, we analyse food prices and the role of Coles’s ‘Down Down’ pricing strategy:    What has happened to Coles prices and profits over time? Where have ‘Down Down’ savings come from? What has been the role of private labels?

In presenting this analysis we recognise that there can be changes in impacts over time.
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4.2 ‘Down Down’: A whole of company perspective
Here, we analyse changes in Coles’s income statement over time to uncover trends in revenue, retail prices, volumes sold, cost of goods sold, gross profits, cost of doing business, and net margins (as measured by earnings before interest and tax, EBIT). The relationship between these items is shown in the following formula: ( ) ( )

The impact on suppliers can be measured by looking at the ratio of COGS to revenue and the impact of changing volumes over time. On the other hand, if retail price reductions were being achieved through internal efficiencies, one would expect the CODB/Revenue ratio to be falling over time. Box 1: Understanding the Coles Supply Chain Farm gate price: Price of the product sold by the farm. Cost of Goods Sold (COGS): Inventory costs of goods a business has sold during a particular period. Cost of Doing Business (CODB): Expenses incurred to run the business. Gross Profit: Gross profit refers to the difference between revenue and COGS. Earnings before interest and tax (EBIT): Revenue and non-operating income less operating expenses. Table 4.1 shows these values for in recent years. In recent years Coles have registered significant growth – reflecting a range of factors including rising volume. Table 4.1: Coles Income Statement FY08 FY09 FY10 FY11 FY12 Compound Annual Growth Rate
5.87% 5.59% 6.71% 3.56% 29.44% 74.43% (AVE) 21.76% (AVE)

Growth (%) Revenue Growth (%) COGS Growth (%) Gross Profit Growth (%) CODB Growth EBIT (pre-NTIs) Growth (%) COGS/Revenue ratio (%) CODB/Revenue ratio (%) Deloitte Access Economics 74.7% 23.0% 5.42 % 5.56 % 5.00 % -0.84 % 65.21 % 74.84% 21.7% 4.87 % 4.06 % 7.28 % 5.69 % 17.10 % 74.26% 21.8% 7.33 % 7.50 % 6.84 % 4.10 % 22.13 % 74.38% 21.2% 5.90 % 5.26 % 7.74 % 5.41 % 18.82 % 73.93% 21.1%

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From the above, the following observations can be made:    EBIT has seen significant growth, recording a compound annual growth rate of 24.44% (or 19.4% over the last three years); compound average annual growth of revenue was 5.87% and 5.59 for COGS – but for CODB was only 3.56%; COGS/Revenue has been relatively constant in recent years; and

 CODB/Revenue has fallen marginally in recent years. Overall, we observe that the rise in profits is achieved through a combination of rising revenue and lower per unit costs – with lower costs mainly resulting from lower CODB.

4.2.1

Suppliers and efficiency

The figures above suggest that lower CODB has played a role in rising profits. Partly, this has been achieved through savings through reduced waste (worth more than $400 million a year in FY12):    Changing fresh produce sourcing strategy from 100% spot purchases to 90% planned purchases. Increasing the proportion of fresh produce purchased directly from farmers from 54% to 67%, which has enabled a shorter field to shelf lead time (and greater shelf life). Coles claims distribution and transportation improvements have increased the speed of stocks through the supply chain and increased the shelf life of goods in-store. By moving to a system where the goods are collated in a distribution centre, Coles has been able to increase their capacity utilisation by 2.9%, cartons packed by 8.9% and their on-time deliveries by 2.4%. This reduces the cost by about 10%. Grocery and dairy products are now ordered into store via an automated sales-based system known as Easy Ordering. This systems forecasts demand for a particular store and makes orders based on a just-in-time approach.



Secondly, Coles claims savings through competitive tendering, centralising procurement and improvement specification of requirements of goods (worth more than $200 million a year in FY12). Thirdly, savings of almost $100 million have been achieved through self-scan checkouts and changes to shelf replenishment. Finally, there have been efficiencies by increasing sales per square metre of selling floor area by almost 20%. These changes are discussed in more detail in 4.5. The savings generated for the above initiatives contributes to the savings pool which can then be utilised to fund price reductions in the store. One of the key changes in Coles’s supply change is in logistics. In the past, many of Coles products were delivered direct to store i.e. the supplier/Coles pays for a truck to deliver their goods to the store.
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Figure 4.1: Direct to store logistics network

Supplier

Retail Store

Supplier

Retail Store

Supplier
Source: Deloitte Access Economics.

Retail Store

Recently, Coles have changed their logistic strategy to one which relies more on a distribution centre. The purpose of the distribution centre is to collate their goods before delivering to the store. The purpose is to ensure better utilisation of the truck and greater efficiency of delivery. Figure 4.2: Distribution centre to store logistics network

Supplier

Retail Store

Supplier

Coles Distribution Centre

Retail Store

Distribution Centre collates the goods to each store to Retail Store ensure a full truck Primary Transport: Paid by Secondary Transport: Paid either Coles or Supplier by Coles Source: Deloitte Access Economics. Supplier

4.2.2

Profits

Coles, over the last few years, has been very profitable for Wesfarmers. In 2012, Coles recorded an EBIT of $1,175m on $23,552m of revenues. This implies a margin of 5%. Return to equity for Wesfarmers was 8.4%. We provide some other results for context.     Telstra recorded profits of $3,424m on $25,368m revenue which implies a margin of 13.5%. Return on equity was 29.3%. David Jones recorded profits of $143.8m on $1,867m which implies a margin of 7.7%. Return on equity was 12.8% (2011). BHP Billiton recorded profits of $23,725m on $72,226m revenue which implies a margin of 33.3%. Return on equity was 36.0%. In FY2012, for 343 public companies, we found the average margin (profit/revenue) to be 8.3%.
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This suggests that while Coles returns have increased in recent years, there are other profitable listed companies as well.

4.2.3

Overall prices all goods

Before we look specifically at the prices of goods in the ‘Down Down’ strategy it is important to mention overall trends in a basket of goods. If non-‘Down Down’ goods experienced an increase in prices to offset ‘Down Down’ reductions consumers would be worse off overall by buying at Coles (assuming that they do not substitute between goods). Overall, we find that all goods prices have fallen by 4.2% on average over the last 18 months (and by 7.9% if cigarettes are excluded). This is discussed in more detail in chapter 5. While many goods prices increase over time, this suggests that on average prices have come down.

4.2.4

Overall prices ‘Down Down’ goods

For the 1200 ‘Down Down’ goods for which data is available, retail prices have fall by 8% on average, on a volume-weighted basis since 2011. For these goods, COGS per unit has fallen by 17% overall, but only 2% on a volume-weighted basis. It is difficult to come to one broad conclusion about the impacts of these changes on suppliers because there will be many individual experiences. But overall, while supplier volume has increased faster (50%) than income (30%), reducing per unit margins, it is likely that this will be significantly offset by rising volumes itself, contributing to profit. From another perspective, with retail prices falling faster (8%) than COGS per unit (2%), it suggests that most of the savings to drive volumes has come from Coles (either as reduced per unit margins or internal efficiencies). Table 4.2: Change in key aggregates for the 'Down Down' products (Jan 2011 to mid-2012) Volume of goods
+49.63% Source: Coles Data

Supplier Income ($)
+30.45%

COGS per unit (unweighted)
-17.02%

COGS per unit (volume weighted)
-2.00%

Retail prices ($)
-8.00%

4.3 ‘Down Down’: product prices under the microscope
We now apply our analysis of retail prices, margins, efficiencies (cost of doing business) and suppliers (farm gate prices and cost of goods sold) to individual products included in the ‘Down Down’ campaign – for a more forensic look at pricing dynamics. Though the overall result for suppliers is higher income and margins, there are different dynamics for different goods.
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We find a number of different scenarios regarding the relationship between retail prices, supplier income, efficiencies, Coles’s margin and volume. Lower retail prices can reflect:   Coles pays the same or more per unit to suppliers and reduces prices by reducing its margins or achieving efficiencies; Coles pays suppliers less in headline income but provides more favourable contract terms (or assists in achieving efficiencies) and covers own costs by achieving efficiencies elsewhere; and



Coles and a supplier may together agree to reduce supplier and retail prices to drive volume to mutual benefit. Of course, there will also be situations where Coles reduces prices paid to suppliers who then experience lower margins and profits.

4.3.1

Milk

We analyse trends in a commodity of particular interest – a 2 litre bottle of milk. We use Coles branded milk because that is part of the ‘Down Down’ schedule. Where appropriate, we convert to per litre. We find that retail prices for Coles branded milk have come down from $2.41 to $2 – i.e. by 17.1% per 2L over the 18 months from January 2011 to mid-2012. Over the same period, public data on farm gate prices have been steady – 43 cents in 201011 and around 42 cents in 2011-12. Because retail prices are lower and the farm gate price is steady, farm price as a proportion of milk price is actually rising. Over the same period, for Coles, the cost of goods sold (which includes farm gate, processing and distribution costs) has gone up by 17.6% per unit. For Coles, retail margins on its own branded milk have gone down by 72.5% per unit. Table 4.3: Coles milk 2L COGS (per unit)
Change (2010-11 to 2011-12) Source: Coles Data +17.6%

Retail margins (per unit)
-72.5%

Retail Price
-17.1%

Chart 4.1 shows the composition of the retail price of milk.

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Chart 4.1: 2L Coles milk price composition
$2.60 $2.40 $2.20 $2.00 $1.80 $1.60 $1.40 $1.20 $1.00
$1.54 (64%) $1.16 (55%)

Retail Price = $2.41

Retail Price = $2.00

$0.80
$0.60 $0.40 $0.20 $0.00 2010-2011 Farmgate price 2011-2012 Processing, Distribution retail activity and margins
$0.86 (36%) $0.84 (45%)

Source: ABARES 2012, Coles data

Coles purchases their milk from the milk processors and not the farmers. As a result, farm gate prices are not directly influenced by Coles’s purchase decisions. In fact, about 47% of milk products are actually exported and drinking Milk makes up about 25% of all dairy products. ABARES predicts that for 2012-13, that farm gate prices will come down from 84 cents to 78 cents. However, we note that the farm gate price is not primarily driven by Coles, but rather through international factors and the Australian Dollar. We also note that during this period that Coles have made a number of changes in their logistics network to improve their efficiency. For milk ,Coles changed from a direct-to-store delivery system to a system where the suppliers deliver to a distribution centre then delivers to the store. Therefore, we conclude that over this period, the reduction in retail prices is not accounted for by a reduction in farm gate prices but rather through some combination of lower retail margins (and most probably internal efficiencies). Volume has increased and supplier payments have increased. We note that while these are current trends in the market, they can change over time. It is possible that changes to any part of the milk supply chain – farmers, processors, transport operators, retailers – could see the effects of competition play out differently over time.

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We conclude with a few observations about milk volumes. In the 1980s and 1990s, the production of milk trended up. Since 2002, production has come down due to the drought and deregulation of the milk industry. In the last two years production and sales has picked up. Chart 4.2 shows milk production figures for the last 25 years. Chart 4.2: Milk production figures

Millions of Litres 12,000

10,000

8,000

6,000

4,000

2,000

1985 1990 1995 2000 2005 2010 2012

Source: Dairy Australia

Consumption in milk has also seen significant increases over the last 20 years. Increases in consumption have been apparent in the last five years. Chart 4.3 shows the sales in Milk for the last 20 years.

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Chart 4.3: Milk sales figures

3,000

2,500

2,000

1,500

1,000

500

1990 1995 2000 2005 2010 2012

Source: Dairy Australia

Rising production and consumption suggest that conditions in the retail market are favourable for the milk industry.

4.3.2

Bread

Retail prices of a loaf of white bread have come down from $1.15 to $1.00 per loaf over the 12 months from July 2011 to mid-2012 which implies a reduction of 13.04%. Over the same period, the cost of goods sold has decreased by 16.1%. Table 4.4: Coles Smart Buy white bread 650g COGS (per unit)
Change -16.10%

Retail Prices
-13.04%

In the same period wheat has reduced from $274.11 to $253.46 per metric ton. This implies a reduction of 7.53%. According to the suppliers of bread, they have been undergoing fundamental restructuring to improve efficiencies. Publicly available information suggests some suppliers are planning to reduce costs significantly in coming years. Accordingly, the supplier is able to reduce the price of the goods they sell, which Coles is then able to pass onto consumers. Another factor changes in bread is a change in the contractual change in the management of wastage. Whereas normal bread supply contracts see the supplier paying for unsold bread, for Coles Smart Buy bread sold through the ‘Down Down’ programme, Coles pays for
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unsold bread. Therefore, while suppliers receive a lower headline price, this will be offset by this. Therefore, we conclude that over this period, the reduction in retail prices reflects lower COGS, but there could also be internal efficiencies. Lower COGS represents a combination of lower prices to suppliers, offset by some efficiencies and changes in contract terms.

4.3.3

Roast Chicken

Retail prices for a family sized roast chicken have come down from $9.44 for one family sized roast chicken to $8.69 each over the eight months from October 2011 to mid-2012 – an 8.26% fall. Over the same period, the cost of goods sold has marginally decreased by 1%. This implies that the reduction in retail price significantly exceeds the reduction in COGS. Table 4.5: Coles chicken roast family COGS (per unit)
Change Source: Coles Data -1.00%

Retail Prices
-8.26%

In the same period the cost of fresh chicken has been around $5 per kilogram. (ABARES, 2012). According to the supplier of Coles Roast Chicken, they have recently made a number of major acquisitions which has influenced costs of production. It is expected that this will contribute towards lower COGS. Therefore, we conclude that over this period, the reduction in retail prices is not accounted for by a reduction in farm gate prices and only to small extent supplier income (as part of COGS). Instead, we find that a reduction in margins or improved internal efficiencies, such as in logistics and wastage, mostly explains the reduction in retail prices.

4.3.4

Paper Towels

Retail prices for a two-pack of paper towels have come down from $2.47 to $2.45 over the seven months from November 2011 to mid-2012. Over the same period, the cost of goods sold has remained constant. Table 4.6: Coles 2 ply paper towel white 2 pack COGS (per unit)
Change Source: Coles Data -0.00%

Retail Prices
-0.8%

This implies that the reduction in retail price is financed by either improved internal efficiencies such as in logistics or reduction in retail margins.

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4.3.5

Toothpaste

Retail prices have come down from $2.34 for one tube of toothpaste (120g) to $2.02 each over the 24 months from July 2010 to mid-2012 which implies a reduction of 13.68%. Over the same period, the cost of goods sold has decreased by 11.60%. The reduction in retail price exceeds the reduction in COGS. Table 4.7: Colgate regular toothpaste 120g COGS (per unit)
Change Source: Coles Data -11.60%

Retail Prices
-13.68%

For this product, according to Coles, suppliers and Coles reached agreement to reduce retail and supplier prices to drive volume and profits overall.

4.3.6

General Conclusion

From the above we have seen the price of commonly used goods come down in price. We have analysed changes in supplier income, efficiencies, margins and volumes. In the next chapter we look at the impacts on consumers. The impact of ‘Down Down’ Coles’s competitors may be unfavourable, since lower prices drive competition elsewhere, putting pressure on margins. This reflects the operation of competitive forces. If this is ‘predatory pricing’ it is anti-competitive. That is where price reductions were temporary. Further to this, it would need to show that strategy implemented was aimed at increasing market share and those losses would be subsequently recouped through higher prices.

4.4 The volume impact of ‘down down’
From our sample we can see that retail prices are down. Accordingly, lower prices would encourage consumers to purchase more (and improve revenue, if the goods have ‘elastic’ demand). This makes lower prices part of a broader strategy is to increase market share or customer foot traffic. The increase in volume is reflected below, where selected goods volumes have increased by between 50 and 200%. Coles Milk has increased even more.

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Table 4.8: Coles volume of selected goods Product
Coles Milk Full Cream HDPE 2L Uncle Tobys Plus Cereal: Fibre 430g Coles Eggs Free Range 12 Pack: 700g Farmpride Eggs Free Range 12 Pack: 700g Coles Baiada Chicken Roast Family Colgate Toothpaste 110‐ 120g: Regular Coles 2 Ply Paper Towel White 2 Pack Smart Buy Coles White Bread 650g Source: Coles data, 2012

% Change
333.38 172.97 157.50 97.22 80.51 72.98 62.95 50.08

Thus, if margin reductions are lower than volume increases, this would increase revenue, and thus increased the dollar profit. This would explain why profits and market share is up when many margins are down. On the cost side due to the increase in volume we expect that there are more economies of scale opportunities. As a consequence this would partially explain the reduction in CODB.

4.5 Explaining ‘Down Down’: the benefits of scale
The benefits of scale are generated due to the large average store size and the ability centralise their procurement so that they obtain better terms. Overall, Coles finds that the larger its stores, the more efficient they are, as measured by costs per store size (measured in GLA, m2). On average, a store that is 1000m2 larger has costs that are 3% lower – reflecting the spread of a number of fixed or standard costs for a store that are incurred regardless of store size. Over the past four years, Coles have also increased the productivity of assets, part of these improvements come for the fact that Coles operates larger stores whilst keeping the number of stores relatively constant. In this period Coles have divested or closed almost 90 smaller and underperforming stores and has acquired or built almost 90 larger, more productive stores. Sales generated from every square metre of selling floor area have increased almost 20%. While sales revenue has increased by 25%, total selling floor area has increased by 4.5%. Larger stores enable cost savings as not all costs increase proportionately in line with the size of a store. Examples include requiring only one store manager regardless of store size, and having only one set of IT equipment for each store. Thus, the greater the volume the lower the average cost of sales since these costs do not vary significantly with sales volume (noting that larger stores tend to sell more goods due to a broader range).
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It is apparent that a lot of the savings mentioned in this section are generated through the significant size of Coles and the fact that they are integrated. If Coles was non-integrated this would make the savings (mentioned above) difficult to realise.

4.6 Private labels
Private labels are unbranded products purchased by supermarkets and then sold as their own products. Typically, these products are cheaper than branded products because of limited marketing activities. Historically, private brands had an image of being ‘no-frills’, targeting the most price-sensitive consumer; these days they are increasing thought of as an equal-quality, lower-price alternative. Private labels in Australia are not produced by the Supermarkets. They are sourced from a major supplier of the product which is then labelled as a Coles product. In Australia, private labels make up about 23% (Oct 2011) of fast moving consumer goods (FMCG). This is relatively small when compared to the UK where private labels represent a market share of 49.2% (2011). Compared with the US where private labels represent 18.5%, private labels in Australia are marginally more prevalent. Private labels have been a matter of policy discussion: critics have asserted that they are part of a strategy to dominate the supply chain, thus reducing the viability of branded products. The claim is that the volume sold gives supermarkets more bargaining power which enables them to achieve lower COGS and thus higher margins. In the short run the supermarkets gain is at the expense of the suppliers. In the long run it is claimed that it could be part of a predatory pricing strategy. That is, eventually prices will rise and this will enhance margins. Consequently, there will be less choice for consumers. Another contention is shelving preference: where the supermarket deliberately places preferred products (in this case private labels products) so that it is readily visible to the consumer. Thus, consumers are more likely to choose that product over another given the convenience of the location. According to Coles’s data on ranging and space allocation decisions, Coles brand products are treated in the same manner as proprietary brand products. In many cases Coles brand products are located together with similar brands and less shelf space than proprietary brands. Coles periodically reviews if their brand is over/under represented by examining the quantity they sell relative to the space on the shelves. If a good is underrepresented i.e. Coles Brand items have less proportion of the space than their sales, an independent review will be undertaken that may lead to more shelf space. If the opposite occurs, the Items will likely be reworked / deleted at next review. According to Coles’s data, shelving decisions are driven by the demands of consumers. If a product is popular, then potentially more shelf space will allocated. Accordingly, if a product is underperforming then it may be removed from their product range.

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Finally, we look at margins for branded and private label products. Table 4.9: White bread 650g Retail Prices
Coles Smart Buy White bread 650g Wonder White Bread Wholemeal Plus Iron 700g Source: Coles Data $1.00 $3.31

Margin above COGS
1% 5.4%

Table 4.10: Eggs 12 pack 700g Retail Prices
Coles Eggs Free Range 12 Pack 700g Farmpride Eggs Free Range 12 Pack 700g Source: Coles Data $4.04 $5.44

Margin above COGS
24.5% 20%

Table 4.11: Soft drinks Retail Prices
Coles Lemonade 1.25 Litre Coca Cola Soft Drink Cola 600 ML Source: Coles Data $0.80 $2.55

Margin above COGS
12.5% 23.1%

For white bread and soft drinks the branded product yields greater margins for Coles – for Eggs, the opposite. This suggests it is unlikely that Coles systematically achieves higher margins on its own products and directly encourages consumers not to buy branded products. DAFF (2012) acknowledges the critics claim that the impacts of private label products are worth considering. However, DAFF argues that popularity of private labels ultimately reflects consumer demand. Furthermore, they believe that private labels can actually increase competitive pressure on branded products thus reducing the price of those products, thus improving consumer welfare. DAFF (2012) also recognizes that the long-term impact of such price reductions on the manufacturing sector, product diversity, consumer choice and long term prices is not clear. The government notes that strong brand power on many products gives the manufacturers countervailing power during their negotiations.

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5 Consumer benefits
In this chapter we analyse the consumer impacts price changes at Coles and other supermarkets. We also look at some of the broader benefits offered by supermarkets in terms of choice and convenience.

5.1 Consumer welfare benefits of ‘down down’
Consumers face a choice about how they allocate their income to spending and saving decisions. How much they decide to spend and on what will be determined by incomes and prices. If prices rise, this reduces the purchasing power of income. Conversely, lower prices are the equivalent of an increase in the purchasing power of income. Consumers can decide what to do with such additional income: whether to save it, or spend it on goods whose prices have come down, or spend it on other goods. (If it is a ‘normal good’, spending on the cheaper good should increase). However, they use it, lower prices and increased purchasing power is an unambiguous improvement in consumer welfare (provided consumers are rational, in the economic sense). For further background, see Mas-Colell, Whinston and Green’s “Microeconomic Theory”.

5.1.1

Measurement

As a starting point, Coles claimed in its 2011 Community Report, “Quality food costs less at Coles and since January 2011 we have saved Australian prices of over 6,000 products by an average of 10%.” We analyse this statement with a full breakdown and weighting of figures for the full 18 month period of price change under the ‘Down Down’ strategy. A breakdown of these saving is provided in the table. Note this is for all goods not just ‘Down Down’ goods. Table 5.1: Price changes at Coles, by product category 2H FY11
Grocery Dairy Deli Meat Bakehouse Fresh Produce Gen Merchandise Apparel Liquor (Coles) Over Head Cigarettes Total Source: Coles data, 2012 Deloitte Access Economics 24 Commercial-in-Confidence -5.00% -4.10% -0.20% 1.40% -1.70% 10.50% 1.60% -4.20% -2.00% -7.20% 18.10% -0.6%

FY12
-3.4% -2.9% 0.3% -0.3% -1.8% -15.0% -3.2% -4.9% -1.5% 1.5% 5.7% -3.5%

Full period
-8.3% -6.9% 0.1% 1.1% -3.4% -6.1% -1.7% -8.9% -3.5% 5.8% 24.9% -4.1%

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The table above describes the movement of Coles’s inflation figures over an 18 month period. FY2012 refers to financial Year 2012 and is an annual figure; 2H 2011 reflects the inflation for the second half of 2011. Over an 18 month period prices for most categories have come down. On a weighted average basis, prices have fallen by 4.1%. The main exception is cigarette prices, which have increase dramatically because of changes in excise arrangements. To obtain an overall picture of the savings to consumers we aggregate the price movement during this period and calculate a savings figure. This is presented in Table 5.2. Estimating the consumer welfare benefits of the savings is not a straightforward task: consumers have bought more products from Coles over the past 18 months – probably because of price reductions but perhaps other factors as well.   First, consider that the goods purchased before ‘Down Down’ (such as in financial year 2010) are now cheaper. That is a lower bound estimate of the welfare gain.

Second, consider that all the goods purchased now have been done so at lower average prices. That is an upper bound estimate of the welfare gain. The true value of the welfare gain from savings will lie between these values – depending on what value consumers placed on what they have chosen not to do with their money: i.e. whether it has come from spending in other supermarkets, other food stores, other spending in general, or saving. Table 5.2: Sales revenue and savings (all figures in $m) Sales FY10
Total

Sales FY12

Savings (FY10 Sales)
1,047

Savings (FY12 sales)
1,185

20,722 23,471 Source: Coles data, 2012, Deloitte Access Economics analysis

From the above we find that in 2011-12, the one-year savings of the price reductions during the ‘Down Down’ campaign (i.e. over the 18 months from January 2011) is between $1.05 billion and $1.19 billion. $1.12 billion is the midpoint. If we remove the effect of Tobacco, Liquor and Services (TLS) and Overhead the corresponding figures are $1.2 billion and $1.4 billion. We note that Coles tobacco sales have fallen during this period. For food alone it is between $1.2 billion and $1.3 billion (midpoint of $1.26 billion).

5.2 Consumer welfare benefits of retail grocery prices
It is important to recognise that ‘Down Down’ is not just an individual company strategy – it is also reflective of overall market conditions. ‘Down Down’ is one company’s strategy in a competitive market. Other companies also use pricing strategies to increase their market share. Some of these are a competitive response to Coles. Price reductions across the sector are of significant benefit to consumers.
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For background, we note some longer term trends in food prices. Australia has experienced significant increases in food prices over the past 30 years. Table 5.3 charts the movement of the price for a food basket. Table 5.3: Food and beverage price inflation 1980-2012

Price of Food Basket
300

250

200

150

100

50

0 Mar-1980

Mar-1985

Mar-1990

Mar-1995

Mar-2000

Mar-2005

Mar-2010

Source: ABS 6401.02

From Table 5.3, prices have been trending up until early 2011. In 2011, there was a dip in the price of the ABS food basket, implying that grocery prices had dipped. This period roughly corresponds to when the effects of ‘Down Down’ have been fully realised. Thus we note that ‘Down Down’ occurred at a time of a resetting of trends in grocery prices. CPI for food and beverage from March 2011 to June 2012 was -1.85%. Based on a $78.4 billion industry this implies a saving of $1.45 billion across food and beverages. The ABS acknowledges that there is substitution bias, so that the CPI overstates inflation. Based on one measure of substitution bias calculated by the RBA (2011) of 0.5% a year, overall savings in food could in fact be worth $1.8 billion or more over the 18 month period. It is not possible to precisely estimate Coles’s contribution to overall savings from food price reductions. However, the figures referred to in Chapters 4 and 5 strongly suggest that Coles’s contribution to industry-wide savings is higher than its market share (of around 31%). Even so, Coles’s ‘Down Down’ strategy has occurred alongside an industry where prices have come down. It is difficult to determine the cause of lower prices, some factors to consider but not limited to include:

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     

entry of new supermarkets including ALDI and Costco; Coles’s ‘Down Down’ strategy itself: to focus more on volume and lower prices (i.e. improve market share and profits); competitive responses to ‘Down Down’ from other major supermarket chains and speciality retailers; other market dynamics such as changes in consumer spending pattern consumers are more cautionary in their spending post GFC; changes in competition policy and other regulatory measures; and strong Australian dollar (for imported or import-competing food items).

5.3 Variety and choice at the supermarket
Recently, choice in the supermarkets has come under scrutiny. The argument is that by restricting choice, the supermarkets are able to increase their bargaining power with the suppliers whilst reducing their overheads. Further to this the reduction in choice is also damaging to welfare since consumers have less choice and are unable to purchase goods they desire. The economic value of choice for a large supermarket is difficult to measure. In the supermarket, choice is measured by the number of stock keeping units (SKUs) – the most granular measure of items offered for sale. For example, each different brand, variety and size of a product has its own SKU. However, effective choice at the supermarket is also affected by its in-store availability. If a customer goes to the shelf and there is no good in stock, this does not feature for the benefits of variety. Thus the reduction in choice may not be damaging to consumers if an unpopular good is taken off the shelves and replaced with alternative that is constantly out of stock. How much consumers benefit from choice relates to how distinctive (or preferred) certain varieties of goods are to one another and the preferences of individual consumers:  for generic products for which differentiation is not as important, an extensive product range will not add greatly to consumer welfare; on the other hand, where varieties are very distinctive, product ranges increase welfare (economists refer to this concept as the cross price elasticity); and for consumers with typical or mainstream tastes, such as those who prefer common varieties of soft drink, an extensive product range does not add as much to consumer choice; for those with atypical tastes, variety is more important.



Overall, economists approximate the value to consumers of product variety as the revenue from sales divided by the cross price elasticity. While this sounds relativity straightforward, there is a complicating factor: maximising effective choice for customers also requires in-store availability. Consumer choice is an optimisation problem for supermarkets: there is a trade-off between varieties offered and likelihood of having goods on the shelf. If there are too few varieties it limits consumer
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choice. If there are too many varieties, it limits the shelf space allocated to the most popular varieties – when these run out this reduces consumer choice. Analysing choice at Coles Supermarkets in recent years produces some interesting conclusions about consumer choice and welfare. First, if one looks at simple SKU data, it suggests that overall choice for consumers has fallen. Between mid-2010 and mid-2012, for example, Coles SKU fell from around 62,000 to around 55,000. That is an 11% reduction. Even if revenue from those 11% of SKUs was relatively low, such as being equivalent to around half as much of Coles revenue (5% of over $20 billion in revenue is $1 billion), and the goods were elastic (with a cross price elasticity of 10) – that would still amount to a $100 million loss in consumer welfare from the reduction in choice. However, the picture becomes more complicated when we also consider availability. All goods will experience changes in the number of SKUs over time as growing areas see new products emerge and declining areas see significant reductions in SKUs (e.g. as DVDs are replaced by Blu-Ray). Some subcategories will experience massive proportional increases or decreases in SKUs that will significantly affect volume. If we look at a snapshot of subcategories where SKUs have been moderately reduced (to improve availability), we find that, on average per unit sales quantities have held up. Quantities have not just gone up on average (as one would expect when store volumes and generally rising), SKU falls are enhancing volumes. Although not statistically significant, for these 458 types of goods (around 1/3 in the supermarket) volumes have increased in response to SKU reductions (as seen by the -0.10343 in column 1 of the table). Table 5.4: Regression results of change in volume given a change in SKU Coefficients
Intercept Variable Source: Deloitte Access Economics 0.035171 -0.10343

P-value
0.439496 0.762167

This means that it is possible that while headline choice and variety has fallen, effective choice in the store is still high and consumers may be better off overall. For the above analysis we had percentage change in volume as the dependent variable and percentage change in SKU as the independent variable. The sample we considered had seen up to 25% reductions in SKU. The sample left us with 458 subcategories and the total reduction in SKU is approximately 6000 for the sample. The above results suggest that where the product range has fallen, some combination of the following two factors is at play:   consumers have been able to buy the more popular brands more easily because they have not been out of stock (if shelf space has been reallocated); and consumers have switched easily between different varieties of a product.

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The first explanation would suggest an increase in consumer welfare since the products are more readily available and thus consumers can consume the product readily. The second explanation would suggest these goods are relatively elastic – in which case, the loss in consumer welfare is minimal.

5.4 Supermarket convenience: benefits for consumers
The convenience factor of supermarkets also provides benefits for consumers, in that many types of goods are available in one place. The alternative to shopping at a supermarket would be to visit a number of ‘traditional’ retailers which sell a specific type of good or service. This is represented in Figure 5.1, which shows the relative convenience of being able to access a number of goods and services in a single location, compared to many separate stores. Figure 5.1: Supermarket convenience – many shops in one

Source: Deloitte Access Economics

In 2012, Coles Supermarkets has increased the number of subcategories of goods it sold from around 1,260 sub-categories of goods to about 1,300. This implies that Coles is supplying more types of goods. The new subcategories which Coles have introduced include Active wear, Footwear & accessory, General Storage, bedroom storage, kitchen storage, intimate apparel and knit wear.
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By introducing these new subcategories Coles have potentially saved a trip to the department store and home furnishing store. The benefits are easy to conceive but difficult to quantify. The benefits depend on the distance of the alternative store (and the opportunity cost associated with it) but also the additional time associated with shopping at the alternative store. Another benefit of making additional good available is the increase in competition in the market for that good. For example, when intimate apparel is introduced in Coles this not only provides convenience since consumers no longer has to go to another store, but also it may induce other sellers of the good to reduce their prices to compete with Coles. Brennan (2006) acknowledges the increase in competition in sector as a consideration in analysing welfare when goods are bundled together. Chart 5.1 shows the upward trend in the number of goods offered for sale by Coles. Chart 5.1: Subcategory count

1,380 1,360 1,340 1,320 1,300 1,280 1,260 1,240

y = 2.0354x + 1304.7

1,220
1,200 Aug 2010
Subcat Count Source: Coles Data

Jan 2011
Linear (Subcat Count)

Jun 2011

Jan 2012

Jun 2012

Aug 2012

The main benefit that supermarkets provide is convenience. In general the more subcategories a supermarket covers the more convenient it is since consumers can do most of their purchases in the one store. Convenience can be separated into two components:   time savings and the opportunity costs associated with it; and lower transport costs i.e. consumers travel less to make the same purchase.

Furthermore, supermarkets are generally open for more hours a day when compared to alternative stores. Coles have also made their products available online this implies that consumers are able to purchase their groceries online without having to visit a store. These benefits allow consumers to access these goods outside traditional shopping hours.

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In the academic literature, there is little work that has been done to quantify these benefits. There are theoretical models which explore convenience as motivators for online shopping (e.g. Forman et. al. (2006), Cairncross (1997)) with convenience being a key factor. The literature in this respect remains theoretical and does not attempt to quantify these benefits.

5.5 Supermarket quality: benefits for consumers
Food quality is crucial to any consumer. Coles at the most basic level ensures that the quality of the food complies with the law. In this respect Coles is like a regulator by ensuring the food they distribute is safe for consumption. The fact that consumers can be confident in the safety of the food is of great value to consumers. Beyond fulfilling the requirements of the law, Coles also has additional requirements on the quality of products they distribute, e.g. the tenderness of beef which are set out in their contracts. These additional requirements ensure that the product that Coles supply is products that are consistently reliable. The benefits of having quality in the product Coles distribute are easy to conceive and apparent. However, these benefits are difficult to quantify as consumers value safety and quality very differently.

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6 Competition in the grocery industry
This chapter provides an overview of the level of competition in the Australian grocery market. It reviews recent analysis and commentary of the level of market share of major supermarkets and the implications for the functioning of markets and for final consumers. The conclusions of this chapter inform the policy discussion in the following chapter.

6.1 Key concepts and background
At one level, the grocery industry in Australia appears to be highly concentrated and dominated by the major supermarket chains, Coles and Woolworths. However, a more sophisticated analysis reveals a complex picture which is heavily dependent on how the markets are defined and what methodologies are used to segment these markets. A market can be defined across a number of spaces these include:     product space; geographic space; functional space; and time space.

Given these spaces, it is possible to define the market by applying the “Small but Significant Non-transitory Increase in Prices” (SSNIP) test. The test examines the impact of a price increase on profits. If profits increases this implies that a firm does not face significant competition. This would imply that there are few substitutes for the product and thus it is a separate market. SSNIP encompasses the level of substitutability and geography when segmenting the market. Other metrics used to segment the market include cross-price elasticity (measure substitutability) and geography (distance away from consumers). More broadly we are concerned with competition and market power. High market concentration does not imply that the industry is not sufficiently competitive. In many cases the market is only large enough for a limited number of firms (this may be due to high fixed entry costs). In such cases too many firms will be detrimental to welfare. Furthermore, markets are dynamic thus market conditions can change dramatically which will affect a firm’s market position. These must be accounted for in any analysis of the level of competitiveness and/or the level of market power a firm possesses. These dynamics can be affected by the strategic behaviour of other retail businesses, a change in the dynamics of upstream business and finally a change in consumer’s preferences.

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When industries are concentrated often there are concerns about market power, and the abuse of this market power. Market power is the ability of a firm to raise prices without losing ‘too many’ customers or losing too much market share to competitors. When evaluating the level of competition in the grocery industry, it is necessary to consider the (potential) market power that Coles possesses in the retailing sector and up the supply chain. In the context of groceries one prime concern is the use of predatory pricing. Predatory pricing refers to the practice of under-pricing a product the short-run with the aim of increasing prices/profits in the long run. The purpose is anti-competitive where in the short run the firm cripples its competitors so that in the long run they can no longer compete. By its very nature predatory pricing involves low prices, which makes it very difficult to discern whether an action is a reaction to a competitor or predatory in nature. Is the reduction in prices a competitive response to new entrant or is it predatory pricing? This presents many problems for the regulators. If the regulator is too sensitive to price reduction this may result in prices remaining high for a sustained period which ultimately hurts consumers. It may keep inefficient producers in business. A source of market power for incumbent firms is high barriers to entry. High barriers to entry enhance an incumbent’s market power since new entrants cannot enter the market to compete (or constrain the incumbent’s market power). Accordingly, the demand curve the incumbent faces is more inelastic. This implies that if a firm increases prices they will increase profits. Another benefit of low barriers to entry is that it will make tacit collusive agreements more difficult to facilitate. When a firm enters the natural best response is to reduce prices. Accordingly, the price reduction which results from other members of the cartel cannot be easily dissected as either a deviation or a competitive response. This makes punishment difficult to justify and thus makes the cartel difficult to sustain. Thus if anti-competitive concerns are paramount, lowering barriers to entry could help. Coles and Woolworths regularly engage in acquiring and selling stores. Creeping acquisitions are where individual decisions might not be anti-competitive, but, over time, significant players increase their geographic footprint and reduce competition. This is a matter of significant interest to the ACCC. Recently, the ACCC has recommended that competition issues be considered at all appropriate levels of government when approving development sites and considering leases. Another important consideration is the role of international trade. Trade reduces the monopsony power of domestic grocery retailers. Equally, domestic retailers buy imported products in global markets where their market power is limited which also dilutes the market power that the suppliers have on the supermarkets.

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6.2 The grocery industry
According to the National Food Plan in 2010-2011 the grocery industry was worth $130.6b. This implies that the groceries industry makes up about 10% of the Australian economy. Supermarkets are a key player in the grocery market, beyond supermarkets; groceries also include specialty stores which sell more specialised products and other stores which sell the same products e.g. service stations which would be part of the grocery industry. To summarise the players in the grocery industry at the retail level include:      Coles and Woolworths – both are large, vertically integrated retailers which operate throughout Australia; ALDI – vertically integrated retailer operating in Victoria, NSW, ACT and Queensland; Franklins and IGA (independent Grocers) – Franklins is owned by Metcash and Metcash is typically the sole supplier of packaged products to IGA; Costco – vertically integrated retailer which operates in NSW, VIC and ACT other independent supermarket operators – retailers supplied with packaged groceries by Metcash and fresh produce generally sourced directly from suppliers or through wholesale markets; and specialty retailers (Non-supermarkets) – selling standard and specialised groceries in a particular range e.g. bakeries, greengrocers, fishmongers, butchers.

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6.2.1

Groceries and supermarkets

Supermarkets are a key player in the grocery industry. A reason why they are valued is due to the convenience they provide. Supermarkets provide a wide range of all in the single store. Some key statistics for the participants in this industry is presented in Table 6.1. Table 6.1: Players in the grocery industry Retailer
Woolworths Coles / Bi-Lo Other supermarkets ALDI Speciality Foods Franklins Source: Coles Data, 2011

Market share
41.1% 31.0% 14.0% 7.3% 5.9% 1.2%

Currently, Coles possesses a market share of 31%, we also note that their market share has not moved materially in recent years. The entry of ALDI has primarily come at the expense of independent retailers. The entry of ALDI and others implies that the grocery industry does not have prohibitively high barriers to entry.

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From the above it is easy to segment the firms as either (vertically) integrated or nonintegrated. An integrated firm is one where the firm owns the wholesaler as well as the retail. Examples include Coles, Woolworths, ALDI and Costco. Their supply chain is represented in Figure 6.1. Figure 6.1: Vertically integrated supply chain
Wholesaler and Retailers are Integrated Supplier Retail Store

Supplier

Wholesaler

Retail Store

Supplier

Retail Store

Source: Deloitte Access Economics

In the case of non-integrated supply chains, the retailer would source the products from the wholesaler. In the economic literature, non-integration can give rise to higher costs to retailers due to wholesaler marking up from their cost of production. Spencer (2004) found that there is a high level of industry concentration in the food retail sector but did not find any evidence of abuse of market power.

6.2.2

Wholesalers

Coles is a vertically integrated firm, thus is its own wholesaler. The margin that Coles places is for the entire firm. This is in contrast to other situations where a firm is only the wholesaler, and needs to charge its own margin for a profit. In that situation, the retailers will place another margin to ensure they are profitable also. Accordingly, the ACCC (in the grocery inquiry) acknowledge that wholesalers may be exercising their monopoly power over the independent retailers by charging higher prices.

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6.2.3

Food processors

A significant proportion of Coles’s suppliers for processed food are very large multinationals which provides strong countervailing market power. Chart 6.1 shows a number of suppliers where their market shares exceed that of Coles. Chart 6.1: Selected market shares of food processors in Australia
100 90 80 70 60 50 40 30 20 10 0
Gum - Mars RTD Tea - Unilever Other Hot Drinks - Nestle Biscuits - Campbells (Arnotts) Carbonates - CCA Coffee - Nestle Tomato Pastes and Purées - Simplot Deodorants - Unilever RTD Coffee - Nat Foods Concentrates - Schweppes Hot Drinks - Nestle Butter - Fonterra Breakfast Cereals - Kellogg Bleach - Sara Lee Oral Care - Colgate Chocolate Confectionery - Cadbury Pet Care - Mars Dishwashing - Reckitt Retail Tissue and Hygiene - KCA Vegetable and Seed Oil - Goodman Baby Food - Heinz Bleach - Unilever Drinking Milk Products - Nat Foods Salad Dressings - Kraft Tea - Unilever Laundry Care - Colgate Fruit/Vegetable Juice - Nat Foods Toilet Paper - SCA Sports and Energy Drinks - CCA Confectionery - Cadbury Spreads - Kraft Soup - Campbells Salad Dressings - Goodman Fielder RTD Coffee - Parmalat Yoghurt - Nestle Toilet Care - Sara Lee Soup - Heinz Toilet Paper - KCA Noodles - Nestle

Source: Euromonitor; AFGC; Senate Economics References Committee transcript (10/3/11)

Given that many of the food processors that Coles deals with are large it is not clear that it always has the upper hand when bargaining for these products. Supplier products may be ‘must haves’ for Coles.

6.2.4

Farmers

Farm gate prices are determined by international factors beyond the control of Coles. Coles typically pays processors for the final product and thus is not directly involved in negotiation with the farmers.

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6.3 Competition in the downstream (retail) market
The most significant issue in this sector is barriers to entry, thus planning laws play a critical role. Planning laws determine the areas which can be located by supermarkets. Thus changes in local planning laws could act as a starting point for any competition law review. Inevitably, the debate about market power will lead to debates about market concentration. The headline market concentrations figure stems from the retail market sales. However, this figure is very sensitive to the how the market is defined. We also note that there are other markets in Australia where the dominant player possesses much greater market share than Coles, see Table 6.2 below. Table 6.2: Market share of dominant player in other Australian industries Industry
Rice Growing Diamond and Gemstone Mining Milk Powder Manufacturing Manganese and Other Mineral Mining Horse and Sports Betting Domestic Airline Biscuit Manufacturing. Soft Drinks Manufacturing. Tobacco Product Manufacturing Pesticide Wired Telecommunication Carriers Recorded Music Retailing Casinos Nickel manufacturing*

Dominant Player
Rice Growers Limited Rio Tinto Murray Goulbourn Co-operative BHP Billiton Tabcorp Qantas Arnotts Biscuits Holding Coca-Cola Amatil British American Tobacco (Aust) Orica Telstra JB Hifi Crown BHP Billiton

Market Share
100% 80% 70.2% 68% 68% 68% 63.1% 63% 63% 62% 56.4% 52% 51.1% 51%

Source: IBISWorld, NB*: and Other Basic Non-Ferrous Metal Manufacturing

There are many industries which possesses very high concentrations that do remain competitive. One reason is due to the large economies of scale that all the participants possess and for these firms if they are uncompetitive the rival firm will dominate. Thus, the firms have to remain competitive to survive in the market. In the academic literature it is not clear that high market concentration leads to high market power. Fixed costs are a key consideration too many firms will result in replication of fixed costs and loss of economies of scale. In this case there is a loss in productive efficiency.

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Furthermore, Mankiw and Whiston (1986) and Suzumura and Kiyono (1987) showed that in the presence of fixed costs, free entry may result in a socially excessive number of firms. This is also detrimental to welfare for the reasons indicated above i.e. replication of fixed costs. In fact, in the ACCC v Metcash, the trial judge noted that ‘[t]here is clearly vigorous competition at the retail level’ [341]. Prices are often perceived as a critical indicator of competition (since participants need to reduce their profit margins). However, this can be flawed if not analysed correctly especially in the context of predatory pricing. Price reductions could also result other aspects which are less measurable e.g. in a reduction in service quality or the lack of refurbishments to the store. Another cost saving measure is to reduce the number of variety they stock. There are many important issues here – the relationship between market power and market concentration is very complex and thus the welfare implications are unclear.

6.4 Competition in the upstream market
A distinction needs to be made when considering the potential monopsony power between an abuse of market power and mere exercise of bargaining power. The latter is not anticompetitive and neither is any resulting impact on profit margins of wholesalers upstream. Competition in the upstream market is of a lesser concern to regulatory authorities. However, if the upstream firm exercises market power on the downstream firm then this is a basis of concern. In the context of Coles as a wholesaler they are vertically integrated and typically to not sell to other retailers. Thus, it is a lesser concern in this context. However, we note that Coles’s suppliers are very big and the Australian market is relatively small. Thus, we suspect that Coles may not always have the upper hand in negotiations. Note that if a supplier cannot meet these demands (assuming a competitive market and prices are transparent) is not necessarily an undesirable outcome since this is the result of the market checking the efficiency of suppliers.

6.4.1

Impact on farmers

In the Grocery Inquiry, the ACCC found that the extent to which the market power of retailers contributes to driving down prices for farmers is limited. The ACCC did not find any evidence that major supermarkets were acting in an anti-competitive way in dealing with supplier of fresh produce. Furthermore, the bargaining power of Coles and Woolworths when purchasing from farmers and the impact they can have on farm gate prices is limited. Farmers have the option to sell to the export market which dilutes Coles’s threats and market power. Coles and Woolworths account for about 50% of fresh produce sold in Australia. This implies that farmers also have other domestic channels to sell their products.

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6.4.2

Impact on food processors

While noting that combined, the buyer power of Coles, Woolworths and Metcash may adversely affect individual competitors; the ACCC did not find any significant evidence that innovation or competition at the processor level was being affected. Rather, consumers have benefitted from lower prices negotiated by the major supermarkets. In recent years, competition in the upstream market has intensified due to the rise of the private labels. The current trend has been to introduce private labels due to the perception that they are a more affordable. In fact many of the food processors encourage private labels alongside their own branded products to boost sales. It is also widely known that supermarkets do negotiate with the processors to slice margins of Coles and the food processors (for both branded and private labels) to drive sales. A common perception of private labels is that this is detrimental to welfare because it allows Coles to consolidate its market power by monopolising the entire supply chain. It is important to note that Coles does not produce the product. They rely on the food processors to supply the product. A more subtle but sophisticated concern is that private labels can be used in a predatory manner. The argument is that it is a means to lure consumers into the store after which they face higher prices for all other products. Groceries by its very nature are repeat purchases, thus to be a profitable strategy the customers they capture must continue purchasing with Coles. For Coles to retain customers, it would need to maintain low prices. Note that low prices are also costly for Coles, since they are forgoing current profit for potential future profits. From the above it can be argued that private label is not necessarily detrimental to consumers. In fact it could benefit consumers due to the additional competition introduced by the private label.

6.5 Review of arguments
Competition is always a subject of debate, for an analysis to be valid requires an accurate definition of the market of interest. Further to this we also note that high market share does not imply an uncompetitive industry as other considerations are equally important. The ACCC Grocery Inquiry in 2008 found that: Viewed overall, supermarket retailing is workably competitive, but there are a number of factors that currently limit the effectiveness of price competition. These include high barriers to entry for large-format supermarkets, a lack of incentives for Coles and Woolworths to compete strongly on price and the limited price competition from the independent sector. The ACCC identified high barriers to entry as the most significant hurdle in explaining the nature of competition in the grocery industry. As such, recommendations were made to lower the barriers to entry.
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One barrier to entry that was used was restrictive leases; in part they were used to secure a supermarkets geographic market position with the purpose of recouping their investments made in developing the site. This was a key theme that was spelled out in the ACCC inquiry, and will be discussed in the forthcoming chapter. The ACCC noted that Coles and Woolworths would price more keenly in localities where an ALDI store is present. Thus the presence of ALDI had a significant influence on the pricing behaviour of Coles and Woolworths. This implies that other retailers can also influence the behaviour of the major supermarkets. With regards to competition we also note that it is very important to distinguish the sector of interest. Competition in the upstream sector is of a lesser concern since the impact is indirect. Unless the upstream firm exercises its market power to improve margins the fact that Coles is able to drive down prices is not necessarily detrimental to welfare. Many upstream suppliers have the option of exporting and selling through other channels. These additional channels further dissipate Coles’s market power and makes for a more competitive market.

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7 Impact of proposed policies
7.1 Competition policy in Australia
Competition policy settings in Australia are outlined in the Competition and Consumer Act 2010 (the Act). The Australian Competition and Consumer Commission is responsible for enforcing the CCA 2010. It has the powers in relation to:      enforcement; authorisation; notification; access regimes; and dissemination of information.

The Australian Competition Tribunal has the function of hearing applications for review of determinations of the ACCC granting or revoking authorisations permitting conduct and arrangements that would otherwise be prohibited under the CCA 2010 because of their anti-competitive effect. The Tribunal also hears applications for review of determinations of the ACCC granting or refusing clearances for company mergers and acquisitions. The National Competition Council is a research and advisory body established by COAG. Its main function is to recommend on the regulation of third party access to services provided by monopoly infrastructure.

7.1.1

Developments over time

The evolution of competition law in Australia has taken place through a combination of developments in case law, amendments to legislation, often arising from recommendations of various reviews of competition policy and the legal framework. The most recent change has been renaming the relevant competition legislation to the Competition and Consumer Act 2010 from the Trade Practices Act 1974. The existing prohibitions on anti-competitive conduct have been largely unchanged, with the focus on amending national consumer law provisions. The most comprehensive review of competition law in Australia was the Hilmer Review conducted back in 1993. The scope of the review was to develop a national competition policy. Most of the recommendations were adopted by the Australian Government to deliver significant changes to the content and administration of the Trade Practices Act 1974 (as it was then).

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7.1.2

Current proposals

Policies impacting the supermarket sector are a regular feature of economic debates. Some relate specifically to the sector, others are general regulations that have impact on supermarkets. Three policy directions we discuss in this chapter are:    government policy positions, focusing on industry codes and regulation; proposals for a review of competition policy settings; and proposals for market caps for individual supermarket chains, to deal with perceived market power.

In the analysis of each of these policy directions, consideration is given to a range of implementation issues and the possible impact of such policies on the economy overall, and a range of sector specific outcomes and stakeholders such as: consumers, retail prices, shareholders, investment, innovation, and the level of industry regulation.

7.2 Government policy directions
Successive governments have recently considered and implemented many policies affecting the supermarket sector. In the area of the competition policy, these measures include:   Renaming the relevant competition legislation from the Trade Practices Act (1974) to Competition and Consumer Act (2010), Additional Competition policy amendments, which include the Birdsville amendment (2007), Competition and Consumer Amendment Act (No 1) (Act 185 of 2011) which included price signalling as part of the Act.

In general the government has been very active in making amendments to competition policy to address current issues. In 2008, the ACCC has had an inquiry on groceries, namely, ‘ACCC inquiry into the competitiveness of retail prices for standard groceries’. Furthermore, the Horticulture Code of Conduct was also strengthened to protect horticulture producers. One of the key issues that resonated from the 2008 inquiry was barriers to entry. High entry barriers restrict competition, since potential entrants find it difficult to enter. The ACCC suggested that zoning issues and restrictive leases was a contributing factor to the barriers of entry. The ACCC has recommended strict limits placed on the availability of new sites for retail developments to address the zoning issues. Accordingly, the ACCC suggests that all appropriate levels of government accounts for competition issues when approving planning proposals. Especially when restrictive leases are utilised, particular attention should be noted since this would directly increase concentration in the geographic region. The government has also tried to improve consumer awareness in terms of prices. These initiatives include:  Establishing the grocery choice website, whose purpose was to indicate price of goods from the major supermarkets. The website was transferred to Choice and then abandoned.
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

Unit pricing so that consumers can fairly compare across different quantities.

The government’s most recent policy posture (as outlined in the National Food Plan, DAFF, 2012) includes the following points:  To enhance “the welfare of Australians by maintaining a robust and effective competition law, backed by appropriate and proportionate sanctions that can be effectively enforced by the ACCC as the independent regulator when necessary.” The government’s intention is to “hold a forum to examine options for better managing supplier/supermarket relationships, such as better voluntary arrangements or an oversight mechanism such as an ombudsman, taking into account available outcomes of any ACCC investigations.” • In September 2012, the Government convened a Forum on Food Sector Relationships. The parties agreed to develop high level principles and a work plan by the end of 2012 for a framework for improving commercial relationships, with a focus on transparency, business practices and opportunities for businesses.





To improve the effectiveness of the Horticulture Code of Conduct it conducted an ACCC review and consulted on the recommendations, including through the Horticulture Code of Conduct committee. It says there is little consensus on the issues and that wholesaler and grower representative groups were working together to attempt to form an industry view for the government. The government says a mandatory code of conduct for the supermarket sector is not justified at this time, noting the compliance costs, regulatory burden on business and higher retail food prices, could outweigh the potential benefits. The government says it will further consider this option and monitor developments in other countries, including the United Kingdom.



From the same report, the government’s view is:  Current legislation is adequate to deal with the current issues: “there is no clear demonstration of a fundamental problem with the current competition law and policy framework as it applies to the food industry”. The regulator is active and believes that the industry is “workably competitive” and that the ACCC will continue to monitor and encourages individual and businesses to report any anti-competitive practices. The government considered the current competition and consumer law framework was appropriate and was committed to ensuring the framework remained robust and effective, backed by appropriate and proportionate sanctions. Generally speaking there is evidence that competition can benefit consumers in various ways, including placing downward pressure on prices and encouraging innovation and greater choice. (DAFF 2012, pp188)

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

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7.2.1

Analysis

Ultimately, the test of whether a framework is effective or not is whether there is adequate competition between firms, containing price pressures. The entry of ALDI and Costco suggest an increase in intensity in competitive pressures. Prices have been falling recently.
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Industry codes are also important if they are effective. The implementation of a code imposes additional red tape on participants which becomes an additional burden. In addition to costs on participants, it is also an enforcement burden on the regulator. However, if codes are effective they are a mechanism which ensures that the industry remains fair for all participants. Therefore, additional mandatory codes should be done in consultation with the industry to ensure they are not costly and to ensure that there are realisable benefits. To date, it is not clear that existing codes are generating sufficient benefits. This might be part of an argument for the Forum on Food Sector Relationships. Finally, we note that the ultimate issue is competitiveness, not competition policy. The policy settings should ensure markets are fair, but if the industry is not competitive then the effectiveness of competition policy is limited.

7.3 Competition law review
The Opposition has committed to having a ‘root and branch review’ of the competition framework, the available policy and legal tools and the way they are administered. The review would particularly focus on the impact of current and emerging pressures on economic growth and vitality and durable consumer interests, and how well-equipped existing competition framework is at dealing with these pressures (Bruce Billson 2012). The review would look at:       growing market concentration in key areas; the impact of dominant players on supply chains; the responsiveness of the current law to abuses of market power; the effectiveness of mandatory Codes; the accessibility and effectiveness of sanctions and remedies; and the suitability of infrastructure access regimes, particularly for export-orientated industries.

7.3.1

Analysis

Policy should be informed by analysis and periodic reviews to ensure that the current posture of the government remains current and relevant. Past reviews include:     1993 Hilmer Review – National Competition Policy; 1997 Cultivating Competition; 2003 Dawson Review – Review of Competition Provisions of the Trade Practices Act; and 2008 ACCC Grocery Inquiry.

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During this period the laws been changed several times including the Birdsville amendment (2007), Competition and Consumer Amendment Act (No 1) (Act 185 of 2011) which included price signalling and 2010 the shift from the Trade Practices Act to Consumer Competition Act (2010). Many of the reviews that have been undertaken have focused on competition policy in an attempt to address anti-competitive practices that a firm may undertake. To date many of the changes suggested by previous review have been implemented. The goal of these reviews is to ensure that the sector remains competitive so that consumers can continue to benefit from lower prices. To date the industry as a whole is “workably competitive” (ACCC 2008). In 2008, the ACCC also found that the gross margins have not risen significantly and the effect of Coles and Woolworth buying power contributes little to the low farm gate prices. One area that might warrant further attention is barriers to entry. High barriers to entry restrict competition and blunt incentives to increase efficiency and reduce prices. Changes to zoning and planning laws may need to be modified to account for regional concentration issues. Furthermore shopping hour restrictions should also be examined as it is a barrier to entry. Another issue to consider is the situation between the wholesaler and independent grocers. The key issue here is competitiveness: are the suppliers and supermarkets efficient? Competitiveness extends beyond the realms of competition policy. Competitiveness addresses the issue of efficiency and which is critical to ensure that retail prices can stay low for extended periods. In the past, the Productivity Commission has done industry reviews e.g. retail industry review, NSW Dairy Industry review, shipbuilding industry review to identify areas to improve productivity. A supermarket industry competitiveness review would encompass the full supply chain and business and consumer relationships and need not be confined to competition policy. For example, in a recent speech Gary Banks named pharmaceutical goods being sold in supermarket as possible policy consideration. It would also be worthwhile for the Productivity Commission to examine the long term impact of private labels on the Australian food manufacturing industry.

7.4 Market share cap and forced divestiture
Katter’s Australian Party (KAP, 2012) has proposed breaking up the ‘two chain oligopoly’ by implementing a cap on any individual supermarket chain’s market share at 22%. A direct consequence of this policy is the forced divestiture of Woolworths and Coles. The rationale behind a market share cap is that it will increase competition. By reducing the market power of any of the large supermarket will provide a more hospitable environment for independent retailers to compete. Accordingly, with more firms in the market the rationale is that the market is more competitive – and that this would help suppliers upstream, and consumers in the retail market.

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7.4.1

Analysis

Market share caps could result in large welfare losses for Australia. Existing market shares reflect consumer decisions on where to shop and what to buy, based on the prices and other features of different stores. To achieve a reduction in sales to comply with a market share cap, a major supermarket chain such as Coles would have to increase its prices or reduce the quality of its service. With higher prices at one supermarket, competitors will raise prices as well because the demand for their goods (residual demand) will be relatively inelastic. Higher prices will see consumers worse off. Even so, it is unlikely that supplier firms to supermarkets will be better off. If major supermarket chains are selling less, they will demand volume less from suppliers. There will be less competition for supplier products and prices will fall. Beyond the anti-competitive effects of the policy, in the medium term it could also reduce the opportunities for economies of scale, which could see efficiency fall and prices rise. There are also practical implementation issues with the proposal. There are very few firms that have the capital readily to purchase the divested stores. There are also several practical issues for consideration in terms of how such a market share cap would be regulated and how the forced divestiture would be implemented. A question is whether the market share should be determined with reference to sales or numbers of stores. If it was based on sales, then it would punish successful and even competitive retailers. A retailer could be increasing sales by offering lower prices and a better service. Furthermore, even if such a retailer is forced to close stores to remain under the market share cap, consumers could still choose to access other stores, maintaining the previous level of sales. Alternatively, if the market share cap is based on number of stores operated by a single retailer, it would be distorted in regional areas where the local economy requires only one or two retailers. Market size considerations are paramount in this respect. Imposing a market share would reduce incentives for a firm to grow – if additional sales resulted in increased market share and forced divestiture. There are examples of government policies that have the impact of restricting market share in various industries, such as in media and broadcasting. But these restrictions generally do not have the objective of limiting market power, but rather to achieve some other social policy objective.

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Box 2: Forced divestiture: the case of AT&T in the US One of the most significant instances of forced divestiture with the purpose of enhancing competition was the breakup of AT&T in the US in 1984. The outcome of that divesture was that AT&T struggled to survive and there was no decline in industry concentration in telecommunications (Noam 2008). While initially concentration fell because of the policy; subsequently prices increased to current levels as the struggling firms consolidated. Accordingly, the industry went back to similar levels of concentration, with a duopoly structure of vertically integrated firms. The analysis by Noam (2008) found that the divestiture was unnecessary to reach the existing levels of competition based on evidence. Rather than enhancing competition, the divestiture reduced the market value of AT&T, returns for shareholders and employment. Furthermore it also eliminated the research and development being undertaken by AT&T. The result was that consumers did not benefit from possibility of lower prices. This suggests that the existing market structure reflects industry features and arbitrary intervention will not necessarily lead to a permanent change. Where there are large gains from economies of scale, it will drive concentration in the industry.

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References
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Limitation of our work
General use restriction
This report is prepared solely for the use of Coles Supermarkets Australia Pty Ltd. This report is not intended to and should not be used or relied upon by anyone else and we accept no duty of care to any other person or entity. The report has been prepared for the purpose of analysing the grocery industry in Australia. You should not refer to or use our name or the advice for any other purpose.

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