The Cost Breakeven Point of Wine Point of Wine

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1 DRAFT FOR REVIEW ONLY The Cost Breakeven Point of Wine Tom Blok February 2007 July 2006 Assignment Assignment submitted submitted to the to Institute the Institute of Cape of Cape Wine Wine Masters Masters and the and Cape the Cape Wine Wine Academy Academy in partial in partial requirement requirement for the for the Cape Cape Wine Wine Master Master qualification qualification Page 1

2 TABLE OF CONTENTS ABSTRACT INTRODUCTION UNDERSTANDING THE GLOBAL WINE SURPLUS CRISIS Understanding the Concept of Wine Surplus Is the current Surplus related to Wine Production? Decreasing Wine Consumption The Impact of the Surplus Surplus within the South African Wine Industry UNDERSTANDING THE WINE REVENUE STREAM Understanding the Sales Value Chain Understanding Wine Retail Price Segments The Impact of the Supermarket Chains The Impact of Exports Bringing it all together UNDERSTANDING PRODUCT COSTING FOR WINE Accounting for Wine Costs The Cost of Grapes Costs incurred during Secondary Production The Impact of Overhead Costs Bringing it all together Can a Cheaper Wine be Produced? So what should wine cost? Trading Up to Higher Price Points Brand Management Vertical Integration of the Supply Chain Horizontal Consolidation across the Wine Industry Reducing Packaging Costs The Impact of Finance Charges Greater Government Involvement CONCLUSION REFERENCE LIST Specific References Background Reading...73

3 ABSTRACT With the reported surplus of wine available in both South Africa and other wineproducing countries increasing annually, there are widespread debates that retail prices of wine are set to decrease exponentially over the next few years. This can have serious repercussions to the South African wine industry if not managed properly, as reduced prices will have a direct impact on the profitability and long-term sustainability of wine producers. Specific aspects which have been addressed in this paper include: Understanding the reasons for the global surplus of wine, and the effect of this surplus on global markets and South African producers. Evaluating the profitability and sustainability of wine producers, taking into account that large percentages of South African wine are sold in lower, nonpremium price segments. Quantifying the numerous costs incurred in wine production, in order to provide illustrative examples of the breakeven cost point. At the same time, understanding how these costs compare to the revenue earned from selling packaged wine. Considering what practical, long-term solutions need to be evaluated to address the specific issues that this research has highlighted. This paper analyses and consolidates a number of research studies and articles that have been done over recent years investigating various factors which influence the profitability of a wine producer. It is aimed at providing an overall picture of the issues that impede the profitability and the sustainability of South African wine producers. A wine producer needs to be able to make informed decisions when making and marketing wine. One of the key pieces of information needed is to understand the cost breakeven point of wine. Changes to the methods by which costs are managed, closer co-operation, and a paradigm shift between all players in the wine value chain are necessary if the South African wine industry wants to continue to play a leading role in the increasingly competitive global wine market. Page 1

4 1. INTRODUCTION The global wine industry is in crisis. We are drinking less wine than ever, yet there is an overproduction of almost 60 million hectolitres mainly of supermarket-friendly branded wines that are forcing small quality-minded independent wineries out of business. (Joseph, 2005, p.28) This is a typical example of media coverage when addressing the subject of the state of the wine industry. During the past 3 years, a variety of references have been made in the general and wine industry media to the overall surplus of wine which exists and continues to grow around the world, as well as the impact that this is having on the overall competitiveness of the industry. Basic economic principles dictate that one of the primary impacts that a surplus of any product will have is to put downward pressure on prices. The wine surplus is already demonstrating this fact, with widespread evidence of exponential decreases in the retail prices of wine. The crisis for wine producers is that at some point, the prices that can be earned from sales of wine may decrease below what it costs to produce the wine. The price point at which this occurs is the cost breakeven point of wine. Once losses are incurred on sales of wine, questions need to be raised as to the long-term sustainability of the wine producer. If a large number of producers are influenced, there may also be repercussions for the industry as a whole. With South Africa being the 8 th largest producer of wine in the world (EuroWine, 2006), the domestic wine industry contributes an invaluable part to the economic welfare of the Western Cape Province, the economy of South Africa and to the global wine industry as a whole (Conningarth, 2004). The current global surplus can therefore have a significant impact on the South African wine industry if not effectively managed. This research paper evaluates the current global surplus, with the overall objective of considering what the typical cost breakeven point of wine is within a South African context. This has been done by breaking the subject into four distinct components: Understanding the nature of the global surplus, in order to evaluate whether the surplus conditions which exist are short-term or long-term in nature. This is important when considering what types of initiatives will be successful when Page 2

5 addressing the problem and also to demonstrate the influence of the global surplus on South African producers. Analysis is also done of the surplus conditions which exist in South Africa. Considering the typical retail price points that South African wine will achieve in domestic and international markets. Factors that influence these price points are also highlighted in order to understand the sensitivity of these prices to the surplus conditions. Specific analysis is also done to determine what part of the retail price is actually returned to the wine producer. Creating a practical cost model against which to compare typical costs associated with wine production, in order to determine what the cost of a bottle of wine is. The question that must be answered is to what extent it is possible to produce wine within the revenue constraints that are created by the current reduced retail prices. Evaluating various mechanisms that can be adopted as long-term solutions to improve the profitability of wine sales. While there are a number of savings that can be considered for each of the stages of wine production, these are generally short-term savings that do not affect the long-term sustainability of the producers. The global wine surplus and its related impact on wine retail prices are economic realities. The contents of this paper should provide information to a South African wine producer that assists in understanding the nature of the current wine surplus. It also provides practical steps that a producer should consider when managing a wine cellar in times of surplus. It is important to note that the majority of the statistics and data contained in this paper are based on 2005 information. It is also only based on information that has been made publicly available, as per the research requirements of the Institute of Cape Wine Masters. The examples that are therefore contained in this paper are for illustrative purposes. It is essential that the wine producer using this paper must adapt the examples to specific numbers that are directly applicable to their own circumstances. Page 3

6 2. UNDERSTANDING THE GLOBAL WINE SURPLUS CRISIS The point of departure for this paper is to ensure that there is a common understanding of what the factors are that contribute to the global wine surplus. While it may be argued that this only provides background to the surplus problem, it is important that any actions that are considered stemming from this research take into account any possible long-term impacts that the current surplus may have. 2.1 Understanding the Concept of Wine Surplus The definition of surplus per the Collins Concise Dictionary is a quantity or amount in excess of what is required, or being in excess; extra. From a perspective of the wine industry, a wine surplus can simply be defined as a state where the overall production exceeds the overall consumption of wine. While this definition is easy to understand, the biological nature of grape and wine production and the extent of the global wine industry also need to be factored into this definition to demonstrate practically what contributes to the global wine surplus. The calculation of a possible surplus therefore needs to take four factors into account (EuroWine, 2005): Domestic Demand: total consumption of wine within the producing country. Total Demand: overall demand for wine from the producing country, which therefore also includes all exports. Production Potential: long-term average volume of wine that should be produced from the vineyards in the producing country, taking local terroir and growing conditions into account. The extent of overall vineyard plantings and the average age of plantings also need to be considered in determining this average. Actual Production: the actual production in a given year, as this is affected by the positive or negative climatic conditions that have an effect on a specific growing season. The actual volume of wine produced in a given season may show a substantial variation from the production potential in any given year due to the seasonal conditions. These four factors are shown on one graph below that has been adapted from EuroWine (EuroWine, 2005) using European data. The graph clearly illustrates the relative impact of each factor on a possible wine surplus. Page 4

7 185 Production vs Demand C Million hl A B /96 96/97 97/98 98/99 99/00 00/01 01/02 Harvest Production Domestic Demand Total Demand Production Potential Source : Eurowine, 2005 The graph demonstrates that there are three different components that contribute to a wine surplus. Eurowine 2005 advises that it is important that these three components are understood, as each could require a different course of action in the way that it needs to be addressed: A domestic surplus exists when there is an excess between production potential and domestic demand within a producing country. A given producing country s dependence on exports is determined by the extent of this surplus, which is indicated on the graph by arrow A. The more dependent the country is on the exports of wine, the more exposed the producers in the country are to the effects of the global surplus of wine. The structural surplus is determined by the excess between production potential and the total demand for the producing country s wines, depicted on the graph as arrow B. This is the area of most concern, as the only way in which to reduce this surplus over the long-term is to either increase global consumption of the country s wine, or to reduce the production of wine so as to balance the demand. As neither of these solutions can be achieved in the short-term, it is imperative that measures be introduced to reduce this surplus if forecasts indicate that this problem will persist in the longer term. The seasonal surplus, illustrated by arrow C on the graph, is determined by the variations between actual production in a given harvest and the long-term production potential. While this creates a surplus in a given harvest that will Page 5

8 require specific management interventions, it is important that no knee jerk reactions are taken, as actual production in following seasons may result in a seasonal deficit (Die Burger, 19 May 2004). 2.2 Is the current Surplus related to Wine Production? The first component of the surplus equation to be considered is to determine to what extent the current global surplus is related to existing seasonal or structural production. When considering comments like more than 20 million hectolitres (2.6 trillion bottles) more wine is produced in 2004 than in 1980 or in 2002, Australia produced twice as much wine as they did just 6 years earlier published by Wine International (Joseph, 2005), the immediate conclusion is that production potential is growing. This view is shared by Becket (2005) who reports that while the reported areas under vine are decreasing in Old World territories, the overall plantings that have taken place in the New World territories over the past three years are keeping the overall area of vines relatively constant. The predictions going forward are that plantings will continue and that the area under vine worldwide will reach 8 million hectares in the foreseeable future, an overall increase of hectares on the reported statistics from This forecast seems to be contradicted by the information in the table below taken from the Becket article (2005, p.30), which indicates that the global surplus actually decreased from 2000 to Adverse climatic conditions, especially in the Old World, resulted in significantly reduced harvests, with the averages for all three years being below the five- and ten-year averages. These decreases, however, were largely cancelled by similar growth in volumes in New World countries such as Argentina, Chile and South Africa. This however points to the fact that actual seasonal production and not structural production is the cause of this decrease. Wine Production Wine Consumption Surplus % of Production Table 1 : Global Wine Surplus (000,000 hl) (Provisional) (Projected) Source : OIV 2004 Page 6

9 The reported harvests for 2004 and the initial reports on harvests for 2005, clearly show that this production trend has reversed significantly. Growing conditions around the world were favourable in both years and all publications show significant increases in actual production, thereby increasing the global surplus. Wine International (Joseph, 2005) reports that the surplus will probably increase in the foreseeable future due to the large areas under vine that are only now beginning to come into production. The size of the current and likely future global wine surplus is therefore difficult to determine, especially given the number of recently planted vines in the New World that have yet to produce any wine. Convincing estimates, however, place it at around 57 million hectolitres the worst figure in history and more than the annual production of all of France s vineyards. (Joseph, 2005) 2.3 Decreasing Wine Consumption Production is only one side of the surplus equation. There would not be a surplus if growth in consumption matched the growth in production. The following quotes, together with similar opening paragraphs of various published articles, illustrate that this is not currently the case: Today s wine market is characterized by oversupply (Heijbroek, 2004, p.5) Australia s 20 million inhabitants don t even manage to drink half of the wine they produce. (Joseph, 2005, p.28) The economic reality is that wine consumption is generally decreasing around the world. Becket (2005, p. 30) reports that consumption is down almost 3% on 2002 levels in the European Union. The traditional wine drinking nations of France, Italy and Spain show the most significant decreases, which are quantified as being more than double the overall increases in consumption that are being shown in all other countries around the world combined. 2.4 The Impact of the Surplus The international over-supply of wine is a reality. It is seen to be a combination of the structural surplus caused by the significant growth in the area under vine around the world, accentuated by the significant seasonal surplus resulting from the 2004 and 2005 harvests. Wine producers need to take cognizance of this fact and manage their business accordingly. The practical impact of this excess is made apparent in the following quotes: Page 7

10 As reported by Wine International (Joseph, 2005), 2005 saw Australia s biggest-ever harvest, which resulted in a surplus estimated to be nearly 2 million hectolitres. Growers in many regions simply left grapes unpicked because there were no wineries to take them. In 2006, at least tons of grapes were not harvested in Australia, compared to approximately tons in (Die Burger, 9 May 2006) It is estimated that wine producers (in Australia) will have about 190 million litres of excess wine by June (2006), 80 percent of it red. This will probably have the effect of lowering prices across the board for red wine priced below $10 (Hunter Gordon, 2005) The current global oversupply of wine is largely a relative concept. There are many wines that are produced in volumes that will not come anywhere close to satisfying market demand. According to Foulkes (2004), the problem is rather that there is too much lower quality wine that blocks the systems. Judged on the basis of basic economic laws, the wine industry is in one hell of a mess. And the situation seems set to get a lot worse (Joseph, 2005) Australian producers are considering converting surplus wine into ethanol, an industrial type fuel. This is already being done in France, where 100 million litres of wine was converted to ethanol during 2005 (Die Burger, 9 May 2006) California dealt with its excess in 2002 and 2003 by introducing wines at ludicrously low prices, such as Charles Shaw s Two Buck Chuck and the recent wave of cheaper US reds and whites that have recently begun to arrive in Britain (Joseph 2005) The immediate impact is that as competition for a share of the consumer market increases, there will be significant downward pressure on wine prices. This in turn will force wine producers to reduce prices on grapes. At some level, the wine and grape prices will result in many producers in both the Old and New Worlds not being able to survive financially. The impact will not only be felt by the wine and grape producers. Beveragedaily.com (2003) clearly shows how general suppliers to the industry e.g. cooperages, dry goods suppliers, etc. will also be directly impacted, as the overall willingness to invest in wine production is set to decrease. Page 8

11 A positive impact could be that wine producers will need to become more market aware and ensure that they effectively market and sell their wine almost before the wine is produced. More advertising and marketing spend by producers will create a greater awareness of wine and should stimulate positive growth in consumption and the associated trading in wine. In an environment where a global surplus exists, it is essential that both the export market and domestic markets are carefully managed. The current situation in Old World countries such as France, Italy, Spain, Germany and Portugal is that both domestic consumption and the overall share of the export market is decreasing, making them even more exposed to the international surplus (Die Burger, 8 May 2006). 2.5 Surplus within the South African Wine Industry South Africa, compared to several other New World countries, has generally been less buoyant in expanding supply, partly due to the high cost of capital, and possibly its traditional, more risk mitigating industry culture (Heijbroek, 2004). As a result, South Africa does not appear to be too exposed to a structural surplus. This statement is supported by the Production and Market Estimates for prepared by SAWIS (2005). Although based on a number of assumptions which are not repeated in this paper, the forecast which is displayed in the table below shows that there is actually a structural deficit that exists for both red and white wine. Page 9

12 Table 2 : Supply and Demand of South African Wine (million litres) Red Wine Production Domestic Sales Exports Total Sales Shortage / Surplus Stock 31 December White Wine Production Domestic Sales Exports Other Products ** Total Sales Shortage / Surplus Stock 31 December ** The total demand for distilling, rebate and non-alcoholic wine products. There are three major challenges that the forecast highlights, which the South African wine industry as a whole will need to manage: The large stock of red wine (164.5 million litres) in 2005 which has resulted from the above-average 2004 and 2005 harvests is going to take time to reduce to acceptable levels (Martin, 2006). Alternatives to traditional wine sales will need to be considered as a standard increase in sales will not alleviate the current situation in the short-term. These measures may include considering using red wine as an alternate to white for distillation purposes, thereby reducing shortage for white wine, or also to consider the economic viability of wine-to-ethanol conversion. The forecast is based on significant growth in both domestic and export demand for natural wine. Given the international statistics on wine consumption and related commentary that is provided in this paper, a great deal of emphasis will need to be placed on consumer education within South Africa to increase the domestic demand for wine. At the same time, concerted and co-ordinated marketing efforts will need to be done internationally to ensure that South Africa increases its share of the international wine market. Page 10

13 The deficit on white wine is only achieved taking the demand for other wine products into account. The largest component of this Other Product category is distilling and rebate wine. Caution must be expressed that this segment of the alcoholic beverages market is also under global pressure (Euromonitor International, 2006) and may not be able to meet these volume requirements in the longer term. These statistics demonstrate the fact that from a volume perspective, the South African industry should be able to survive. The key issue that remains is that with global wine prices being reduced and South Africa being very dependent on the global market for export sales, the overall profitability of the South African industry will be negatively influenced. This highlights the fact that South African producers need to have a clear understanding of the factors influencing the retail prices which can be achieved for South African wine, as well as the retail price point at which production of South African wines is no longer profitable. Page 11

14 3. UNDERSTANDING THE WINE REVENUE STREAM The previous section has highlighted the fact that there is significant pressure being placed on wine retail prices due to the global oversupply of wine. The pressure of the surplus in the wine market is a source of twofold concern for most wine producers - there is general pressure on prices that can be maintained within the market, while also demanding an answer to the question of whether the wine produced can or will actually be sold. In the introduction to this paper, the explanation was given that the cost breakeven point of wine is that point where the revenue that can be earned from the sale of a bottle of wine to a consumer is equal to the total costs that are incurred by a winemaker to produce the same bottle. This chapter will provide insight into the portion of the final retail price that is returned to the producer. This amount needs to be compared to the production costs in order to determine the profitability of making wine. As the revenue stream is an important part of determining the cost breakeven point, various factors that impact significantly on the retail prices are also addressed in this chapter. Packaged Wine Available for Sale Cellar Door Sales Wholesaler Retailer Wine Purchase by Consumer Page 12

15 3.1 Understanding the Sales Value Chain In order to understand the cost breakeven point of wine, it is essential that the wine producer has a clear image of which factors contribute to the price of wine. One mechanism with which to do this is to understand the typical supply chain that wine will follow from the time that the wine is packaged and available for sale, up to the point that the wine is purchased by the consumer. The diagram on the previous page, adapted from Perrin & Lockshin (2001), has been constructed to provide a visual image of this supply chain. Every intermediate step that the product takes from leaving the cellar to being purchased by the consumer, will impact the portion of the retail price that is actually earned by a wine producer. Wine Distribution in South Africa From a South African domestic sales perspective, the two most common routes to the consumer is either for wine to be sold directly to the consumer by the producer through cellar door sales or direct marketing, or for the producer to sell directly to the wine retail stores, of which supermarkets form an integral part. Marketing agents sometimes also play an intermediary role in this part of the sales chain. While there are some wholesalers who operate within the domestic market, these tend to be producing wholesalers who produce their own wine. For these producers, wine is often purchased in bulk form and bottled under an own brand, or used as a blending component. Wine Distribution in International Markets For export purposes, most market channels are increasingly complex, or are particularly legislated e.g. the US market that requires a three tier distribution structure. In these cases it is generally common to appoint an agent or wholesaler within each market that the wine producer targets. Wine is then shipped in volume to the wholesaler, who will then take responsibility for the distribution of the wine within the given market. The positive attribute of this distribution channel is that it enables larger volumes to be pushed into the market. The drawback is that each additional player in the value chain takes a margin on the cost price, diluting the amount that can be returned to the producer. Page 13

16 3.2 Understanding Wine Retail Price Segments Another important factor for the wine producer to understand is that the retail price of wine is not very flexible, as wine is generally marketed and sold within specific retail price segments, commonly referred to as price points (Jarvis & Goodman, 2004). It is essential that the South African wine producer has a good understanding of the various quality and price segments in both the domestic and international markets in order to understand the prices which are actually achieved when selling wine. Careful analysis of the price segments and countries in which the wine will be marketed can be an important guide to the producer as to the styles of wines to make, to evaluate what revenue can be earned, and to have a better idea as to the maximum costs that should be incurred during production. There are various studies that have been performed around the world aimed at categorizing the wine market into various segments, each returning a wide range of possible answers. One of the studies conducted by Ernst & Young Consulting (Perrin & Lockshin, 2001) in 1999 and further used by the Comitee Interprofessionnel des Vins du Languedoc (CIVL), a producers union in the south of France, was a division of global wine competition broken down into four categories, named basic premium, popular premium, super premium and ultra premium. Icon Wine Quality Segm ents Ultra Premium Super Premium Premium Popular Premium Basic l ow c ost pr i c e : US D/ bot t l e Source: Rabobank, 2003 Page 14

17 Countries like France and Australia have also invested heavily in studies aimed to categorise the various market segments, in order to understand the nature of these segments in more detail, as well as to analyse the competition that exists within in each of the segments. The general consensus of these studies is that the wine industry is characterized by a range of quality segments, each with its own trends, price ranges, market requirements, distribution outlets and so forth (Heijbroek, 2003). The graph on the previous page is published by Rabobank (Heijbroek, 2003) and depicts a common analysis of wine quality segments. These categories are often used within the European and United Kingdom markets when performing market analysis. While the graph clearly illustrates that there are differences within the various segments, based largely on the volume of wine available (the relative size of the bubble) and the overall value per bottle, it is important that the producer understands the related definitions that are associated to each of the segments. The data below which is also taken from the same Rabobank study (Heijbroek, 2003) includes a short description of what the characteristics of the wine should be in order to be included in the specific market segment. These definitions are, however, very generic and in most instances would allow for many of the wines retailed today to be placed into a number of different segments. Category Europe Ex-winery EUR / bottle Europe Consumer EUR / bottle Requirement Icon >30 >150 Long-term image (this takes time!), complexity, cellaring potential, high scores among critics Ultra premium Typical, varietal or good blend, more complexity, typical character, origin, image, quality brand Super premium In the higher price ranges: Image, cellaring potential, complexity, well received by critics Premium Brand, recognition, origin, full body, more character, rich, typical for single or two-varietal blend Popular premium Combination of character and accessible, recognizable characteristics of variety, origin, brand Basic <1.10 <3 Varietal, fruit, accessible, brand Price Segmentation in Europe Source : Rabobank 2003 Each of the quality segments depicted in the table above also has indicative price points. The consumer prices that are highlighted are illustrative of continental European off-trade prices (prices paid for wine that is not consumed on the Page 15

18 premises), as on-trade prices (prices within a restaurant or hotel) can be at least twice as high. It is however important to take into account that these are indicative prices only and the category pricing and quality perception vary significantly from country to country. In France and Spain, for instance, the popular premium segment is considered to begin at around EUR 1.5 per bottle, whereas in the USA the premium and popular premium segment generally begins above EUR 3. The number 5, albeit EUR 5 or 5 or $5 appears to be an important barrier in many markets for both retailers and consumers and is generally used as category distinction. It is generally only above the 5 level where it is apparent that quality becomes more important than volume. It is also the level at which volumes of wine sold drop considerably. (Heijbroek, 2003) Price Segmentation in Australia A study performed in Australia in 2001 by the Wine Industry Journal (Perrin & Lockshin, 2001) used the common terminology of basic premium, popular premium, super premium and ultra premium as a starting point, and then did market research amongst wineries, winemakers, exporters, retailers and journalists to determine the existence of these categories within the Australian industry. The general consensus achieved was that there are typically four categories of wines within the Australian market. Commercial Wines, which are generally packaged in large scale packaging such as casks or bag-in-a-box, and which are very rarely intended for export. Retail prices are generally less than A$8 10. Semi-Premium Wines, often seen as the Australian wine industry s strength, with sensible prices and good value for money, with associated improvements in quality. The majority of wines in this category are exported and retail prices range from A$10 A$ Premium Wines generally retail from A$20 A$ The price limit between this category and super premium wines is often blurred and some winemakers only talk about a hedonistic distinction that exists between the two categories. They maintain, however, that it is important that the two categories exist. Among the larger producers who have an extensive range of products, the need to be able to categorise more expensive ranges in a higher price segment is important. Page 16

19 Super-Premium Wines, are often only used by the larger producing companies with extensive ranges as marketing tools to allow for perceived higher values. With price ranges that vary from >A$30 or >A$50, it is largely dependent on the size of the winery as to where this category begins. While these four categories are commonly used, there are parties that would argue that a fifth category of Exceptional Wine should be added to the top of the list to be used for rare and expensive wines (very similar to Icon Wines used earlier on page 15). There are also parties that would prefer to only have three categories, with premium and super premium wines being collated as the distinction between these two categories is too blurred. Price Segmentation in South Africa Price segmentation within the South African market is differentiated between the official descriptions that are used by the industry regulators and the terminology that is used within the retail sector. The official descriptors that are used to describe market segmentation use categories that are referred to as High Priced (HP), Medium Priced (MP) and Low Priced (LP) wines. While there could be significant price differences between these categories, the differentiation is currently explained by the nature of the packaging used, rather than a specific analysis of price: High Priced (HP) wine refers to wine in glass or bottle packaging. Medium Priced (MP) wine includes Bag-in-a-Box and Tetrapak packaging. Low Priced (LP) packaging includes foil bags and plastic bottling. It must be noted that the use of foil bags ( papsakke ) has recently been prohibited in terms of liquor industry regulations, with resulting increases in bag-in-a-box volumes. Even with the category of HP wine, the pricing of wine in South Africa is very diverse, with the type of still or sparkling wine which is sold being the major contributors to the price segment. Examples to support this are taken from Euromonitor (2006): In looking at the wine market as a whole, almost 50% of all white wine sold in South Africa retails for under R10 for a 750 ml bottle. This is generally due to Page 17

20 an extremely high volume of very poor quality wine that is typically consumed by low-income groups in rural areas (Euromonitor International South Africa, 2006). With medium- to higher-priced still wines, white wine is generally priced significantly lower than the same quality red wine. This can be clearly seen by the fact that an estimated 9% of red wine sold in 2005 costs more than R50 per 750 ml bottle, compared to only 5% of white wine (Euromonitor International South Africa, 2006). Data extracted from the Euromonitor International data service shows the volume of wine that retails in various price segments in South Africa: Table 3 : South Africa - Volume Sales of Wine by Price Segment (million litres) White Wine Red Wine Under R Under R8 1.4 R5.01 to R R8.01 to R R10.01 to R R15.01 to R R15.01 to R R30.01 to R R25.01 to R R40.01 to R R50.01 and above 8.9 R50.1 and above 2.5 Total Total 27.6 When considering this information, there is a clear distinction that wine sales in South Africa can be categorized into three primary segments. The very cheap white wine retailing for less than R10, as well as the cheap red wine priced below R15 can generally be categorized as commercial and bulk wine. These wines will normally not be destined for exports. For purposes of this paper, these wines will be excluded from any evaluations. The semi-premium category, making up in excess of 75% of the remainder of the volume of wine sold, is the R10 R 25 price level for white wine and the R15 R40 segments for red wine. Discussions with retailers have indicated that these are typical price ranges for consumers buying value-for-money wines. This is also supported by Maxwell (2006, p.30) who refers to similar ranges for the domestic South African market. In using the volumes and associated values within these categories depicted in the above table, an Page 18

21 average price per bottle of R17.00 and R24.50 can be determined for white and red wine respectively. Volumes drop significantly in the price bands above these levels and this category will be referred to collectively as the premium category. Prices in this category are more closely aligned between white and red wine and return an average price of approximately R45.00 per bottle. Price Segmentation in the United Kingdom A similar distinction can be made with regard to price bands for wine in the United Kingdom market. The same Euromonitor data analysis has been performed for this market: Table 4 : United Kingdom - Volume Sales of Wine by Price Segment (million litres) White Wine Red Wine Under Under to to to to to to to to and above and above 16.3 Total Total For purposes of this market, the assumption is made that as wine is not produced in the United Kingdom, sales of commercial and bulk wine will not skew the analysis. The lower price classes are therefore reflective of wine of an acceptable quality that is sold within normal retail distribution channels. This would therefore lead to two general price categories. The fact that the same price bands are used when comparing red and white wine also result in the average prices achieved within the bands to be more comparable than what is apparent when using the South African analysis: The semi-premium category makes up 60% of the volume of wine sold and represents the price bands under The average price within this band based on the volumes provided in the table is approximately 4.00 per bottle, regardless of red or white wine. Page 19

22 While there are still significant volumes in the price band from , volumes decrease significantly above this price level. If all the price bands above 5.50 are considered to be the premium category, the average price per bottle is approximately Price Segmentation in the United States The analysis of the United States market using the same Euromonitor data analysis highlights similar trends to the South African data, with significant volumes of wine being sold at prices below $2.99. These wines are typically the Two Buck Chuck, Jug Wines and bulk wine, which for purposes of this analysis will be considered commercial wines and excluded. Table 5 : United States - Volume Sales of Wine by Price Segment (million litres) White Wine Red Wine Under US$ Under US$ US$3 to US$ US$3 to US$ US$7 to US$ US$7 to US$ US$10 to US$ US$10 to US$ US$14 and above 36.5 US$14 and above 50.5 Total Total The two remaining price categories within the US market can therefore be described as follows: The semi-premium category makes up more than 80% of the volume of wine sold and falls within the price band from $ $9.99. The average price within this band is approximately $6.20 per bottle, regardless of it being red or white wine. The premium band starts at $10.00 a bottle and returns an average of approximately $13.00 per bottle. General Comment on Price Segments Examples have been provided on price segmentation for four different markets, each with different terminology and different pricing. While there is some commonality in terms of the typical trends within each of these markets, it is important that producers do a detailed analysis of the target price segments and markets in which they aim to Page 20

23 sell their wine. This is made even more appropriate by the following explanation of market segments from Rabobank (Heijbroek, 2003, p. 3): It is therefore very apparent that the ultimate and clearest criterion for quality is the value of the wine as perceived by the market and consumer. From a market perspective, the producer has the ability to manage and market the brand and image of the wine, which contributes significantly to the perceived value of the wine, and is also where the concept of brand value comes into its own. The overall value of the wine is determined by what the consumer is prepared to pay for the wine, and is expressed in the average price per bottle. This prompts the price distinctions in the market, and so creates different quality and related price segments. This definition, as well as the actual price data depicted in this section, also makes it apparent that price differences between segments are NOT only a factor of the volume of wine available for sale. The quality of the wine produced as perceived by the consumer is an important factor affecting the overall price for which the wine will retail. While price sensitivity and competition will be at its fiercest in the commercial, semi-premium and lower priced premium wines, wines in the premium and higher segments are generally less price sensitive, as the consumer will focus more on the quality and reputation of the wine than on the price. 3.3 The Impact of the Supermarket Chains While this chapter has focused on the impact of the global surplus on retail prices, there is actually a second key factor that is putting pressure on wine prices (Lockshin, 2003). The increased buying power that the large retail chains are exerting on the overall supply chain (Heijbroek, 2004) is also resulting in price reductions, as this route to market becomes increasingly important to the cellar as a primary distribution outlet. The South African wine producer must understand the impact that using the supermarket chains as a retail outlet may have on the wine sales prices that are achieved. The table below has been compiled from the country specific analyses of the Alcoholic Drinks Business published by Euromonitor in 2006 for South Africa, the United Kingdom and the United States (Euromonitor International, 2006). It shows the relative volumes of off-trade wine sales by distribution channel. It clearly Page 21

24 illustrates the dominant position that the supermarkets and discounters have on the global wine industry. Table 6 : Off-Trade Sales of Wine by Distribution Format 2005 South Africa % United Kingdom % United States % Supermarkets Other Food Stores Discounters Specialists Direct Sales Other Total Many people would argue that this is a good position to be in as it enables significant consolidation of the wine distribution channel. It should therefore allow for efficient and profitable management of wine sales. There are three important factors that need to be understood when considering what the impact of this dominant position is on the profitability of wine sales. Retail Price Points within the Supermarket Channel Firstly, consideration must be given to the fact that more than 50% of the wine sales in the United Kingdom for the year to March 2005 made across multiple supermarket stores were priced below 3.00 (Schmitt, 2005). Given the overall volume of wine that is moved through this channel, the significance of this average price becomes enormous. This simple statistic becomes even more terrifying when considering the distribution of this amount within the value chain: 1.71 represents Value Added Tax (VAT) and Customs and Excise taxes, approximately 0.95 will go to retailer and wholesaler margins, which leaves only 34 pence that will go to the producer to harvest, make, bottle, close and ship the wine to the United Kingdom. The impact of fixed retail price points in the supermarket distribution channel is clearly illustrated in the graph below, where due to the drive on volumes, almost 80% of wine is sold for an average price of less than 4, and more than 90% is sold for less than 5. Producers and retailers have been reported to make the comment: you cannot sell any significant volumes at prices over 5 pounds, and you cannot make any significant margins at prices below this level... (Schmitt, 2005, p. 26). Page 22

25 Wines Sales by Supermarket by Price Band Under % % 25.0% % 2.0% 6.4% 5.7% 19.3% % 0.5% or more 0.5% 0.1% 0.1% 0.1% Source; TN5 (52 w/e ) Volume Drivers within the Supermarket Chain The second factor is that the primary aim of supermarkets and discounters is to be a volume business, where success is measured by the increases in product volumes that are passed through the store (Bolin, 2005). There is also a greater emphasis on wine as one component of a basket of products, with less emphasis being placed on the overall contribution that wine as a product in its own right would have in a specialist environment. This leads to increased use of sales techniques for wine that will either encourage increased volume buying, or entice more people to visit the store. The mechanics for a wine promotion vary from supermarket to supermarket. These are some of the more common techniques that are used in the United Kingdom (Gold, 2006): Buy 2 get 1 free 2 for for % off 1.00 off per bottle The effect of these promotions is significant, with the 1.00 off or 3-for-the-price-of- 2 deals tending to generate 10 to 20 times the normal weekly sales level, and the half-price deal resulting in more than 100 times the normal weekly sales level, and enticing more customers to the store (Schmitt, 2005). Regardless of the nature of the discounting used, the important factor to take into account is that these discounts Page 23

26 are ultimately factored into the average price which the consumer pays per bottle, and most often comes predominantly at the suppliers expense. It is also essential for a producer who wishes to use the supermarket channel as a route to market to be able to produce the volumes of wine that will be able to support this distribution channel continuously. These wines are generally known to be easy drinking and value-for-money, but quality cannot be lacking. There is also a requirement of ongoing consistency of the product, as this volume of wine is closely linked to a brand image that is created by the producer. In contrast to this, experience will show that it becomes increasingly more difficult to produce a quality wine when winemaking is done on a large scale, and the consistency of the wine needs to be maintained through varietal and vintage blending. Because of this, the end product is most often not at the same level of quality that a small scale producer would be able to achieve with the same grapes. Cost Drivers within the Supermarket Chain With the expanding number of producers, the related brands on the market, and the general state of oversupply, it is not only the decreasing prices paid for the wine that impact on the profitability of the wine. Gold s analysis of the English Wine Market (Gold, 2006) shows that there are also a number of direct costs that need to be incurred in order to obtain and maintain a listing and shelf space with a retailer. The materiality of these costs is an important factor to consider when distributing wine through the supermarket channel and should be considered as a specific category of marketing and distribution costs (discussed further on page 47). These costs include: Listing Fees: normally a once-off payment, or an annually negotiated amount, to get the wine on the shelf within the supermarket. Distribution Fees: transport costs are paid to the supermarket to distribute the wine from the supermarket s central warehouses to the various stores. Advertising Fees: these can be a page or section of the store magazine, or in-store advertising where advertising material is placed within the store. Space or Gondola Fees: this fee is paid to have the wine prominently displayed within the store e.g. the end of an aisle, or on a separate display stand. Page 24

27 Club Card and Research Fees: any costs incurred by the retailers to attract customers to provide research information are passed on to the producers. 3.4 The Impact of Exports Questions can be raised at this point as to why there is so much emphasis placed on the wine quality segments and related price points across different markets outside South Africa, as well as using examples of supermarket prices in the United Kingdom. The concept of a domestic surplus was introduced in section 2.1, which explained that the larger the domestic surplus is, the more dependent the country is on exports to utilise this surplus. When evaluating the annual SAWIS statistics on the extent of the South African Wine Industry (2006), the dependency that the South African wine industry has on exports is apparent. Table 7 : South African Wine Production vs. Domestic Consumption vs. Exports 2004/05 Natural Wine 2004 Million Litres 2005 Million Litres 2004 / 2005 Trend Production % Domestic Consumption % Exports % The Production and Market estimates for also published by SAWIS (2005) further illustrate this dependency on export markets (refer to page 10). Domestic consumption of wine is forecast to be largely constant year on year, whereas the export requirements are increasing at rates of 12% and 6% for red and white wine respectively. While it is known that the South African wine industry has been very successful in major export markets over the last ten years (Heijbroek, 2004) (the UK and the Netherlands in particular), the pressure on the industry is to maintain these market positions against the increasing competition that is being experienced due to the global surplus. Countries like Australia, Spain, Italy, Argentina and Chile have always been considered as major threats to South Africa due to the volume of wine that is already produced in these countries. New threats to South Africa s market share may also come from China, as Chinese producers are beginning to produce significant volumes of wine at improving levels of quality (Murray Brown, 2005). The surplus experienced by the French producers as a result of increased global competition and reduced domestic consumption is leading to a major change in Page 25