Cosmetics in the thick of advertising competition

François Meunier / President, Alsis Conseil, Associate Professor of Finance, ENSAE ParisTech / 2016-06-08

Why does a company like L’Oréal spend 10 times more on advertising than on research? The answer lies within a strategic competition, proving extremely tough in the personal beauty and care sector. This advertising arms race has a cost, paid by consumers. Economists are beginning to take a serious interest in these cases where the more intense the competition, the higher the prices.

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This photo herein is part of an advertising campaign that you may have noticed in an airport. It portrays Professor Andrea Gamarnik, a winner of the 2016 For Women in Science award. This award is presented by the L’Oréal Foundation, in association with Unesco.

A clever campaign aimed at linking L’Oréal as a friend of Science, through a strong R&D message from the company, and L’Oréal as a friend of the women, who make up the vast majority their customers.

Let us put aside the women’s cause for a second, to dig a little deeper into the R&D side. The 2015 financial records show that the Group’s research budget reaches a significant amount of 794 million euros. It employs nearly 4,000 people. But this represents only 3% of the 25.3 billion euros turnover. US companies in the Electronics and Biomedical industries generally invest 20% of their revenues in R&D.

Compared to this 3%, the advertising budget is then … 29% of revenues, that is 7.4 billion euros per year, increasing by more than 5% per year (this budget does not include indirect advertisement through the L’Oréal Foundation). When compared to the turnover without advertising costs, 29% is actually 41%. It is likely that should be added to this figure a certain fraction of R&D expenses, whose role is to differentiate products marketing-wise, marketing not being that unrelated to advertising.

The intriguing question is: why is it that a company like L’Oreal spends 10 times more on advertising than on research? The answer lies within strategic competition, proving extremely tough in the personal beauty care sector. If L’Oreal spends so much, it is because Unilever, Procter & Gamble, Estee Lauder, Shiseido, Beiersdorf, etc. do the same.

Arms race

The logic goes like this: a basic product, such as a shampoo or a day cream… hardly has the means to strongly differentiate itself from what competitors produce. This is not the case in the pharmaceutical market, where a product is recommended by a prescribing specialist, such as a physician. Therefore, in cosmetics, the product has to be strongly differentiated, that is to say, instill a lasting perception and image in consumers, in order to dominate the competing products. This reminds Stendhal, who rightly said: “The society pays only for what it sees.” The problem is that the advertising campaign of one weakens the relative image of the other … which urges the latter to outbid in advertising. The game is truly an arms race and, in saturated markets such as Europe or North America, it ultimately is tantamount to a zero-sum game.

Close but not quite: L’Oréal and its competitors are gaining market share in emerging countries, particularly in Africa, which experiences a very strong growth, where these large companies push traditional products out of the market. Perhaps sometimes for the benefit of consumers, and sometimes using the same recipes as traditional products, but resorting to advertising means that smaller companies will never have access to.

So here we are: advertising has a second function, that of erecting a barrier difficult to overcome, in a sector less protected than others by patents or approvals by health authorities.

This arms race, no doubt about it, is paid by the consumer. They buy their product actually 41% higher than if there was no advertising. Imagine that there would exist a collusion between the various market players, or international regulations prohibiting to exceed a percentage of 15% of turnover allotted to advertising: it would be as effective in the competition, and as effective in terms of consumers’ information. This example shows that in some configurations there can be fierce competition (such as between L’Oréal, Procter, Unilever and other actors) without lowering neither the costs nor the prices. Economists are beginning to take an interest in these cases where the fiercer the competition, the higher the selling prices. This is usually observed in industries where it is necessary to incur a great deal of marketing expenses to sell a product, whether through advertising (smartphones for instance), or via specialized sales teams (investment bankers salaries). Since the same costs are shared by all players in the industry, each of them is well informed about one of their competitors’ largest item in the operating expense budget. It is an industry of monopolistic competition, where competition is consistent with sustainably high returns.

To make a long story short…

Competition in the sector of personal beauty and care is fierce.

This competition means fights on marketing, which is paid by the consumer in the form of higher prices. The drain on purchasing power is very high: Business Wire, a market research firm, indicates that the global market of cosmetics and personal care amounts to 379 billion euros in 2013. If we assume that these actors spend on average 15% of their turnover in advertising, it then represents 57 billion euros (and 110 billion if the expenses amount to 29%).

These budgets are an obstacle to the entry or growth of smaller players or new-comers on the market. The competition is therefore expressed by higher operating costs, but also probably by the presence of super-profits. Market valuations of major players tend to confirm it: for example, the L’Oréal’s performance on equity is 14%, that of Procter, though more indebted, is 11.3%. L’Oréal’s market capitalization, nearly 90 billion euros, is 3.8 times the value of equity traded funds. A beautiful machine!

Oh! If only all these budgets could be devoted to R&D as well as to Science, whether feminine or not!

This article was originally published in French by our syndication partner Telos-eu.com.