Now companies are improving their production by adopting different strategies in which backward integration is one of them. Backward Integration is a type of vertical integration in which a company gets control over its suppliers to improve the efficiency and save the cost which improves its profit margins and make the firm more competitive. Backward integration occurs through acquiring input suppliers, establishing long-term contracts with existing suppliers or investing in new input production capacity through internal corporate growth.
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The main advantages of backward integration regardless of the industry are decreased marketing expenses, the stability of operations, the certainty of supplies of materials, much control on the distribution of products, tighter quality control, the on time review of fabrication and allocation policies, more control over inventory, and additional profit margins or the ability to charge lower prices on final products. These advantages must be weighed against the disadvantages which normally are disparities among productive capacities at a range of stages of manufacturing, governmental pressure, lack in interest of specialty, the firmness of operations, the extension of the management team and lack of direct competitive influence on the costs of transitional products.
Background:
This report highlights the comparison of two companies from Pakistan Food Industry the ENGRO FOODS and NESTLE PAKISTAN, which are applying backward integration to enhance their production capability. In Pakistan these are the top most companies which are playing a vital role in the food industry through their dairy and beverage products.
Nestle is a subsidiary of Swiss origin company which headquarter is located in vevey, Switzerland. Nestle Pakistan started its operations in 1988 with the collaboration of Milk Pak Ltd in Pakistan which is further took over total control in 1992. In Pakistan, its head quarter is located in Lahore and the company currently operating four production facilities. Two of its factories are located in sheikhupura and Kabirwala while one in Islamabad and one in Karachi. It has also the biggest milk collection operation in Pakistan through which they collects milk from an estimated 190,000 farmers and from their dairy farms located in different areas of Pakistan. Nestle Pakistan is currently the leading food & beverage company of Pakistan.
While Engro food is another biggest and fastest growing company in Pakistan. In 2005 Engro Foods limited was established and it is 100% owned by Engro Corporation. Engro Foods limited began their operations in 2006 and within 5 years they make realization to their competitor by increasing their market share gradually. At the end of 2010 Engro Foods Limited took control in the market of Ultra High Temperature by launching new products including ice cream, juices, powder milk and flavoured milk which contain great potential to compete in future. The Company is also entering into global markets. Its first mission is that to administer a Halal food business in North America known as Al-Safa, which was recently acquired by Engro Corporation at a total cost of 6.3 mn dollars.
INDUSTRY OVERVIEW
Recently a seminar “Current Status of Foods Industry in Pakistan: Threats and Challenges” was held at Lahore on September 07, 2012 in which different analysts of PCSIR and Federal Minister of Science and Technology addresses that food industry in Pakistan has become the second largest industry by participating with 17% share in GDP and in Pakistan it is now become most consuming industry because people spent 42% of their earnings in foods products. And at the end of the session some analysts point out weak point of the food industry that the in appropriate management of food products and the large harvest losses in vegetables, fruits and grain create a food shortage in market.
There are several sectors of food industry while some are given below which are related to the project report, we will mainly focus on these. These sectors are as follows:
Dairy
Juices
Ice creams
2.1 Dairy
Dairy sector is one of the most important sectors of Pakistan which affects more than 10 mn families. There are a lot of companies in Pakistan who are purchasing milk from farmers for their satisfaction. The dairy industry is providing packed milk to its consumers in the shape of UHT, Pasteurized, Tea Whitener and Flavored milk. The industry is also producing Ice Cream, Yoghurt, Cheese, Butter and miscellaneous food items for children’s.
Milk is the most consumable food item having a life of 4 hours under at a certain temperature level of room. Pakistan is 3rd leading milk producing country in the world with more than 47 billion litters’ production and 11.30% contribution in GDP and a milk economy that in value terms is 27.7% of the total agriculture sector. According to analysts the milk production is expected to grow at 2% annually, however the processed industry is only 7% of operated milk. The milk, remaining wastages and farmer preservation is 20.7 bn liters of which 1.4 bn goes into processing and the rest is sold as a commodity in retail outlets and through door to door Gawala system. So, there is an immense prospect and +prospective to grow the processed milk business.
The processed milk has segmented into three categories namely:
Ambient UHT
Powder
2.1.1 Ambient UHT
As of 2010, Ambient UHT constitutes only 4% of the total Tradable Milk segment. Industry volumes have grown 10% from 2006-2010 and the market size was 790 million liters as of December 2010.
2.1.2 Powder
Currently, the size of the branded powder market is approximately 57,000 tons, which uses approximately 540 mn liters of milk and 3% of tradable milk. Powder market size has grown 17% from 2006 to 2010 and it is expected to grow 14% in the next five years due to economy that powder offers as well as its specialize use as growing up and infant nutrition source. Nestle Pakistan is the market leader in this segment.
2.2 Juices
The Juices, Nectars and Still drinks market are of 507 Million Liters which has total market value of PKR 31 Billion. This market is subdivided into Juice and Nectar and Value added Still Drinks. Juices contain 100% fruit substance, Nectar contain 25% to 99% fruit substance while still drinks contain 0 to 24 % fruit substance & value added still drinks have innovative packaging or addition of pulp etc. Nestle Pakistan is the market leader in this segment.
2.3 Ice Cream
The Ice Cream sector of Pakistan has growing constantly and registers a volume growth of 20% in 2010 as compare to 2009. The overall volume of ice cream sold in 2010 was 71 Million liters while the total market value was PKR 8.8 billion. The industry volumes have grown 11% over the last four years. However, it is expected that growth will be higher in next five years on the back of significant investment by the industry’s key players. Walls are the market leader in this industry which is followed by Omore.
COMPANIES PROFILE
3.1 Engro Foods
Engro Corporation Limited initially introduced with Engro Chemical Pakistan which rapidly built their growth in chemical industry and after few years Engro Chemical become Engro Corporation Limited by making diversified investment in different sector like Foods, Energy, Fertilizer and Business solutions. It started operations in 1957 as an Esso/Mobil joint venture which discovered the Mari Gas field near Daharki.
Engro food is now becoming the biggest and fastest growing company in Pakistan. From the beginning till date Engro Foods Limited 100% owned supplementary company of Engro Corporation. Engro Foods Limited operations began in the year of 2006 and within 5 years company started to climb the ladder of growth rapidly. It has manage to be the market leaders in Ultra High Temperature (UHT) Industry at the end of 2010 and has launched multiple new products including Ice Cream, Flavoured Milk, Fruit Juices and Milk Powders, that show great potential for future. In order to back these products and to achieve high quality standards Engro Foods Limited made backward integration strategy in which they heavily invested in milk processing and collection infrastructure. The Company has innovated by venturing out of the dairy sector and stepping in the Beverage Industry by launching Olfrute and ice cream industry by launching Omore.
The Company is also entering into the global markets. Its first mission is to manage a Halal food business in North America known as Al-Safa, which was recently acquired by Engro Corporation at a total outlay of 6.3 mn dollars.
PRODUCTION FACILITIES
Dairy Plants
Engro Foods has two UHT processing plants which are located in Sukkur and Sahiwal with total filling capacity of 1.1 million liter per day. Sukkur Plant capacity is 400,000 liter per day whereas Sahiwal plant facility is 700,000 liter per day. Engro Foods also has a powder plant at Sukkur with a capacity of 24 tons per day. Covered area of freehold land of Sukkur is 27 acres and Sahiwal production facility is 33 acres freehold land. These production sites are equipped with plant and machinery of European origin. Sukkur Production site started its operation in Feb 2006, whereas Sahiwal plant started its operation in December 2007.
Ice Cream Plant
The ice cream plant was set up in the same facility as the Dairy Plant. The total manufacturing capability of Sahiwal is 33 acres of free holding land. This provides deliberate advantage to the Company in terms of the supply of raw material, the utilities, and manpower and warehousing. The ice cream plant has total capacity of 22 million liters per annum.
Organizational Structure of Engro Foods:
President/CEO
Secretary
Secretary
Vice President Manufacturing
Vice President Marketing
Manager Public Affair
Manager Internal Audit
Special Projects
Vice President HR
Vice President HR
Compensation & Benefits
Sales
Production
Accounting
Recruitment
Planning & development
Maintenance
Treasury
Training & development
Technical Services
Process Engineering
Industrial Trade
Instrumental/Fleet
Purchasing
Administration
Legal
Brands of Engro Foods:
The product portfolio of Engro Foods comprises some of the country’s biggest and best selling brands which include:
Olper’s
Olper’s Lite
Olfrute
O’more
Omung
Omung Lassi
Tarang.
3.2 Nestle Pakistan
Nestle is basically a Swiss company and their head office is situated in Vevey, Switzerland. And Nestle Pakistan is one of it supplementary company. Since 1988 Nestle Pakistan is working with the alliance of Milk Pak Ltd and within short time period Nestle Pakistan took over Milk Pak Ltd. It is also listed in Karachi and Lahore Stock Exchange. Nestle Pakistan is one of the most prominent company which ensures it place among top 25 companies who are registered at Karachi stock exchange for last couple of years.
The Headquarter of Nestle is located in Lahore and the Company operates four fabrication facilities. In which the factories located in Sheikhupura and Kabirwala are producing different products under same umbrella. The other factory is present in Islamabad and one in Karachi produce packed water. Nestle Pakistan now operates the biggest milk collection process in Pakistan. At present, Nestle Pakistan gathers milk from a projected 190,000 farmers. At present Nestle is market leader in dairy and beverage industry of Pakistan because they are very keenly focusing on Nutrition and health by covering almost at all locations throughout Pakistan to serve the consumers. Nestle Pakistan distinct feature is that they are the leaders in Nutrition.
PRODUCTION FACILITIES
Sheikhupura Factory
The factory located at sheikhpura produces many most popular products s of Nestle Pakistan such as Milkpak UHT milk, Nevista products, Nestle pure water, Cerelac and yogurt. The factory starts operation as part of Milkpak Ltd in 1981. Formerly it produced only UHT milk but in 1988 it had expanded to produce butter, cream, ghee and fruit drinks as well. But with the passage of time Nido powder milk also started to produce in this factory.
Kabirwala Factory
Milk Pak took over this factory which is located in Khanewal district of the Punjab in 1990. In 1997 Nestle Pakistan got 100% share of that unit. After acquiring it Nestle upgraded its capacity and in 1992 they added Maggi Noodle plant to the factory. Over the years past the Kabirwala factory was constantly enhanced as Everyday tea whitening powder was introduced in 2002 .
Islamabad Factory
In Islamabad Nestle purchased the AVA water plant in year 2001. And in 2003 Nestle fully owned that unit. Gradually Nestle upgraded and introduced machineries to become more efficient in production through which they was able to provide differentiated products to their consumer with good packaging.
Organizational Structure of Nestle Pakistan:
Chief Executive
Water Group
Corporate Affairs
Human Resource
Supply Chain
Milk Collection Agriculture Services
Nestle Business Excellence
Technical Operations
Finance & Control Unit
Marketing and Sales Division
National Sales Management
Legal Affairs
Technical Purchasing
Financial Accounting
Corporate purchase
Treasury
National Brand
Management
Budget & Control
Information System
Taxation
Brands of Nestle Pakistan:
Nestle Pakistan has a lot of top most brands of Pakistan which added a lot of value to Nestle Pakistan over a last couple of years like:
Milkpak
Nevista
Nido
Everyday
Milkpak Cream
Nestle Desert cream
Nestle yogurt
Nestle fruit vitals
Nestle Zeera Raita
Actiplus Yogurt
Nestle Rawaiti Maza
Nestle Milo
Nestle Nescafe
4. FUNCTIONAL DESCRIPTION OF ORGANIZATIONS (BACKWARD INTEGRATION)
Nestle Pakistan and Engro Foods are currently doing backward integration to enhance their production efficiency by creating their own dairy farms and taking control of transportation. Currently they are focusing of creating their own farms to get control over their suppliers. Both the companies are also now directly approaching to the farmers and collecting milk form them as the old concept of middle man and gawala system has start perishing. The main advantage of creating own farms is that both the companies get on time delivery of their material, which help them to enhance their production and deliver their product on time to the end consumers. The details of Engro Foods and Nestle Pakistan farms are given below:
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4.1 Engro Foods Dairy Farm
Engro Food has selected the Nara Canal due to the presence of its outstanding water, farming land availability and suitable weather for its Dairy Farm. The company has launched a comprehensive vaccination programme with the provision of clean water and balanced nutrition to have infection free, strong and happy animals at all times. The Company’s Nara Dairy Farm continued to remain a rich and nutritious source of raw material for its dairy section. The Nara Farm formed over 5.8 mn liters of milk in 2011 with a total herd size of over 3,000 animals. But in 2012, Dairy Farm produced 26,979 liters of milk per day. At March 31, 2012 Dairy Farm herd increased to 3,204 animals. Through it the profit after tax stood at Rs. 5 million versus loss of Rs. 19 million in March 2011, primarily due to higher yield and production.
4.2 Nestle Dairy Farms
Nestle Pakistan manages the project under its Agricultural Division. Over 75 professionals are currently associated with these services; intend to help in increasing the sustainability of the dairy segment in Pakistan. They give the farmers with free technical assistance and veterinary services to build the skills of the farmers in best farming practices and improved livestock management and link them to small businesses and to the dairy market.
For this purpose,Nestle has built two demonstrations and teaching farms, one of which is still under process. The main training facility is the Sarsabz Demonstration and Training Farm which is located on Multan Road, near Okara. The second training Sukeki Farm, is under in building process near Lahore. At the farm, there are more than 250 cows, animal huts, milking machinery, a teaching centre, and hostel for the farmers, management office and necessary farm equipment and highly qualified instructors who train farmers on high quality dairy farming and livestock management. Nestle Pakistan has established this training facility over 103 acres of leased land as an investment for the development of the dairy sector and to work towards sustainable farming and an improved rural economy.
5. LITERATURE REVIEW
The concept of vertical integration is very old and we saw a lot of academic and legal debates over the costs and benefits of vertical integration. McGee, Bassett and Williamson (1975, 1985, 1989) said that vertical integration is a mean of reducing transactions costs, assuring supply, reducing risk and alleviating the efficiency losses.
But on the other side, economists see vertical integration as a means for firms to reduce competition or extract market rents (Scherer, Perry 1978, 1989).Perry, Hart and Tirole (1978), said that most discussions have focused on the effects of forward integration into a competitive product market and little work exists on the effects of backward integration into a competitive input market. However, Knoeber and Thurman (1996) further said that backward integration is of growing importance in many agricultural and natural resource industries.
According to Azzam (1996), backward integration occurs through acquiring input suppliers, establishing long-term contracts with existing suppliers or investing in new input production capacity through internal company growth. In some businesses, there is growing concern about the effects of such integration on remaining un- integrated input suppliers. First he said that backward-integrated dominant firm benefits from production efficiency gains. Second he further adds that backward-integrated dominant firm may benefit from a lower acquisition price for externally supplied raw inputs.
As per Blois (1972), the biggest advantages of backward integration are to lower down transportation and marketing expense, production or operation stability, timely supplier services, high quality control, necessary revisions in production and execution policies, maintained inventory control, and high profit margin able produces to charge lower prices on finished products.
While Williamson (1971) do not consider supply dependability as a necessary advantage and point out the interests harmonization and efficient utilization in process of decision making as the core advantages of backward integration. As per Williamson (1971), backward integration allows management to easily harmonized interest as possible differences can be resigned.
As per Lambertini and Rossini (2008), backward vertical integration is indirectly proportional to producers and suppliers. As compare to forward vertical integration, backward vertical integration provides large incentives in investment to the manufacturer. The biggest disadvantage of backward integration for trader is that it discourages them for innovation, on the other hand forward integration discourages producers to innovate. This theory is not parallel to transaction cost theory which does not consider forward and backward integration as a separate concept.
Many researchers like Armour, Teece, Langlois, Robertson, Gopala Krishnan, Bierly (1980, 1989, 1992, 1996, and 2001) have stated that vertical integration facilitates the development and implementation of systemic innovations. Further, Armour and Teece (1980) argue that if the innovation at one stage involves adaptation in a preceding or a consequent stage, then the usual ownership of the various stages i.e. vertical integration enables the necessary adaptations and adjustments to be made in a timely and efficient fashion.
Similarly Langlois, Robertson (1989) and Langlois (1992) propose that vertical integration is the most appropriate organizational structure for integrative systemic process innovations because the necessary learning and experience proceed faster between functions in a vertically integrated environment. Furthermore, Teece (1996) explains that vertical integration enables the successful development and implementation of systemic innovations by facilitating information flows and coordination and removing institutional barriers such as cost and benefit allocation. Similarly, Gopal krishnan and Bierly (2001) point out that open exchange of information is easier and safer in house than between different organizations because each firm wants to gain more from the innovation and therefore unwilling to share information freely.
Teece (1996) however adds that while systemic innovations favour vertically integrated structures from the coordination point of view and some relevant technological or other capabilities needed in the development and implementation of the innovation may exist outside of the vertically integrated firm. Therefore, larger firms may still have an advantage by using their scale to create sufficient momentum and attract smaller firms to get involved with the innovation or simply by being able to secure minority investment positions in smaller firms that have the necessary capabilities needed in the innovation.
6. ANAYSIS
6.1Swot Analysis
Strengths Of Engro Foods
Strengths of Nestle Pakistan
Brand Association:
Engro being a renowned and well established brand in fertilizers, infrastructure and IT solutions, it creates a great brand association and consumers can relate to Olper’s as a high quality and premium product. This is evidence that Engro Food in its first year crossed 1.4 billion sales figure.
Financial Backing:
Engro being renowned brand and can attract foreign investors, which enable them to compete with global brands like Nestle. They can afford high costs for research and developments for their current products and in introducing new products.
Strategic Relationship:
Engro has been creating business relationship with farmers who supply milk to them which enables them to secure the supply and to solve shortage issues. Engro also has created long-term business relationship with distributors this help them to ensure smooth distribution through better channels to make sure that there are no shortages for their product.
Research and Development:
Engro for Olper’s precisely has done strong consumer and product research before launching the product and are continuing this practice post launch. This has helped them to emerge as a strong brand in food industry. To further development and new products, they have engaged various global research partners Mindshare, AC Nielsen, JWT Asiatic and MARS marketing and advertising agency.
State of the Art plants:
Only Engro Foods has the 3rd generation UHT milk plant in the country. It is the only plant that uses Bactofuge technology to virtually eliminate bacteria and ensure premium quality and hygiene.
Parent Company:
Nestle has a global presence and is recognized as a huge name worldwide. Nestle Pakistan has a strong support from its parent company, which is the world’s leading processed food and beverage company.
Company Image:
Nestle has been doing business since many years. It has created an excellent image and reputation in consumers mind all around the world. This helps them to retain market even in unfavorable conditions.
High Quality Products:
Nestle always ensure to produce good quality products. Nestle being worldwide renowned company creates high quality product to retain that image and to attain consumer loyalty. It cannot compromise on quality as consumers nowadays are more quality conscious.
Market Share:
Nestle has the highest market share almost in every SBU’s line, like as in Milk pack & Nestle pure life.
Brand strength:
Nestle Pakistan has created some very strong brands like Nescafe, Milpak , Everyday, Nestle water and most of these brands have become generic to their product category. When a brand becomes generic it creates a strong presence in minds of consumer.
Research & Development Team:
Research and development is a continuous process at Nestle. It gives updated info on consumer behaviors, changing trends and consumer demands; this helps Nestle to adapt to changing trends.
Weakness of Engro Foods
Weakness of Nestle Pakistan
Packaging:
Engro Food is dependent on Tetra Pak for packaging of its entire dairy products. It is the only option for them as Tetra pack has monopoly in packaging sector. This cause higher production costs.
Distribution cost:
About 85% milk collection centers of Engro Foods are located in Punjab, and its processing facility is in Sind. This huge distance increase distribution cost and increasing overall cost of production. Also it increases the chances of milk getting spoiled due to long travelling time.
Narrow Product Line:
Since the launch of its first dairy product, Engro Foods has only extended to very few products, where as its competitors like Nestle has diversified and extensive product lines.
Owning Red Color:
Engro Food like its competitors has not owned colors that identify its products. Colors represent products, like green represents Milkpak. There is no color connection attached to Olper’s which creates problems for consumers in remembering the product.
Less Proactive:
Nestle being a huge company is very less proactive to the demands. Unless competitors initiate a campaign or come up with new strategy, Nestle does not bring changes.
Limited Distribution Channel:
A major weakness of Nestle is their limited distribution channel as compared to their competitors. Nestle distribute their products to whole sellers in their own factory vehicles.
Stock outs:
Due to their in-efficient distribution channels, Nestle has experienced stock outs on regular basis. This had adverse effect on company’s image and consumer base. It also gives opportunity for competitor to penetrate into market and capture large market share.
Premium Brand:
Common men generally perceive Nestle as a premium brand, and have perception that all Nestle products would be highly expensive.
Opportunities for Engro Food
Opportunities for Nestle Pakistan
Government Funding:
Government has provided increased funds to farmers. This has allowed farmers to invest in better storage facilities to save milk for longer period of time and to cope bad weather conditions.
Awareness:
Extensive awareness programs for health and hygiene has created awareness among consumers for the benefits of processed milk. More and more consumers are shifting from loose milk to processed milk. This will create higher demands and consumption of processed milk. This is a great opportunity for growth and to gain more market.
Fifth Largest producer of milk:
Pakistan is the 5th largest milk production country in the world, the country is blessed four seasons and high quality crop, good species of buffaloes and cows and largest canal system. However it is only obtaining 2500ltr of milk per annum from an animal in comparison with 18000ltr per animal in developed countries. This is a good opportunity to increase production significantly by adopting best practices and modern techniques.
Support from Foreign Investors;
Government is supporting overseas outlay in Pakistan which is a great opportunity for Nestle to expand its business in Pakistan and to cater large markets.
Enhance Distribution Channel:
Nestle should work on its distribution channel to make it efficient in order to maintain supply of their products. This will not allow consumer to shift to competitors brand in case of stock outs.
Changing Social Trend:
Consumers, especially younger generation are hugely influenced by western societies. This has changed the trends for packed ready to use products. This changing social trend has created large demand and opportunity to increase market share.
Best Practices and Assistance;
Nestle should invest in educating the farmers for best practices and providing them resources and assistance to create greater value and to ensure high capitalization and quality.
Threats for Engro Food
Threats for Nestle Pakistan
Competition:
Engro foods biggest competitors like Nestle has been in market since very long. For its brands it might be difficult to penetrate in the market where these brands have created loyalties and presence in mind of consumers.
Perceptions and Price Differentials:
Consumer preferences and perceptions plays very important role in success of a brand. It is very important for Engro to understand and come up with ways to meet consumer expectations and provide quality that a brand promises. Price factor is also a very important factor, as still consumers prefer loose milk as it is cheaper than processed milk.
Economy:
Higher inflation rates is eroding buying power of consumers, making products more expensive to use.
No Entry Barrier:
Industry is growing at rapid rate, very low entry barriers making it attractive for new competitors.
Dependency:
Nestle is dependent on whole sellers and super market shelves which can be influenced by the competitors.
Loss of Market Share:
When the market drenches the loss of the market share of Nestle products is the major threat to them.
Differentiated products:
Consumers are indifferent to buying Engro products or Nestle. It is a threat to Nestle that consumers can easily shift to Engro products in case of any unfavorable condition.
6.2 Pest Analysis
PEST analysis is used to determine and understand external factors such as Political, Economical, Social and technological, and their effect on business. For understanding Nestle and Engro foods position in market, we will carry out PEST analysis to understand the external forces.
6.2.1 Political, Legal & Economic Factors
Pakistan current fiscal year inflation rate has been grown to 7.7% which decreases the purchasing power of consumers as a whole and which also create higher impact on those products which transform from another products like packed milk & powder milk because these is
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