CIGARETTE INDUSTRY IN

INDIA – ROLE OF ITC

IMT

September, 2009
Institute of Management Technology
Ghaziabad

Project undertaken by: GROUP VIII

1. Abhik Sarkar 09FN-001

2. Basab Chakrabarty 09FN-023

3. Deepankar Goyal 09FN-029

4. Kaushik Dutta 09FN-049

5. Abhijit Mukherjee 09FN-120

6. N Balasubrahmanyam 09FN-126

ACKNOWLEDGMENTS

1
We are sincerely thankful to our faculty, Dr. Sadananda Prusty, for guiding us regarding the
project and also helping us to analyze the results obtained so as to come to the correct
conclusion. We also thank him for providing us the opportunity to undertake this project, which
enhanced our learning on Managerial Economics.

We are also thankful to Mr. Surya Bhushan Kumar of CMIE for making available to us any data
that we required in order to carry out this project.

Table of Contents

2
Contents
Contents.....................................................................................................................3

INTRODUCTION
Tobacco is a principal cash crop of national importance. It has been playing a prominent role in the
development of Nation's Economy. Although the cultivation of Tobacco is restricted to 0.3% of the
total cultivated area, it provides employment to large number of people on the one hand. On the other
hand, it makes significant contribution to National Exchequer by way of excise revenue and foreign
exchange earnings. Tobacco being a labor intensive crop provides employment to more than 60 lakhs
people who are engaged in the farming, curing, redrying, packaging, grading, manufacturing
distribution, export and retailing activities.

Although there is nation-wide anti-Tobacco campaign, the commercial importance of Tobacco can
never be underestimated due to the revenue earning potentiality and employment generation capacity of
the crop. Presently there is a call for substitution of Tobacco with other crops, but the research findings
show that there is no economically viable alternative crop which is as remunerative as Tobacco to the
farmer.

India ranks 4th in total tobacco consumption among all the countries in the world. However, India's
cigarette consumption ranks 11th in the world. Out of the total production, only 19% of the total
consumption of Tobacco is in the form of cigarette whereas 81% is in other forms like, chewing, bidi,
snuff, Gutkhas paste, Jarda, hookah paste etc. Tobacco is traditional item of India's foreign trade. India
is one of the leading Tobacco exporting countries in the world. India accounts for 5.8% of the
3
international trade and ranks 5th after Brazil, U.S.A. Turkey and Zimbabwe. The principal markets for
Indian tobacco are U.S.S.R, U.K, Japan and Middle East countries.

Cigarette industry in India is essentially capital intensive in nature. The growth of cigarette industry
both in domestic and international market represents a big revenue opportunity for the economy. But
the burden of Tobacco tax has increasingly shifted to cigarette with the removal of duty on raw
Tobacco since 1979, resulting in discriminatory rates of duty compared to other Tobacco products.

India is a major grower and exporter of tobacco in the world. Presently India is among top three producers
of tobacco in the world. Despite lower proportion of total produce being exported Indian exports, it
figures among top 10 exporters of the product in the world. Presently of the total tobacco produce in
India, only 50% is used in the domestic market and of this domestic consumption of tobacco only 16% is
used by cigarette industry.

On the average, cigarettes account for about 85% of tobacco consumption globally, with an even higher
share of almost 100% in large markets like China. In sharp contrast, cigarettes account for shares have
declined from 21% two decades ago to about 14% currently. There is significant opportunity for cigarette
industry to extent and consolidate its position in intentional market due to some recent trend like
withdrawal/reduction of agricultural subsidy and escalating cost in the traditional cigarette exporting
countries.

Political-Legal Environment

The cigarette industry in India continues to operate in a challenging economic environment, particularly
with respect to taxation and regulations relating to communication and consumption. The regulations,
dictated by circumstances in more developed markets, together with prolonged punitive and
discriminatory taxation have had the effect of being directed almost exclusively at cigarettes, thereby
stifling cigarette consumption in India in comparison with other forms of tobacco consumption.

High rates of taxes on cigarettes, in excess of 130% of the net value of the product, have rendered
cigarettes unaffordable to the majority of tobacco consumers in the country. Apart from the adverse
impact on the Exchequer, the reducing base of domestic cigarette consumption discourages investment in
R&D and quality enhancement of tobacco varieties and thereby undermines the export potential of high
value Indian cigarette tobaccos.

It is estimated that contraband cigarette trade in India sets the country back by nearly Rs.2000 crores
annually through loss of tax revenue and unaccounted outflow of foreign exchange.

The Cigarettes and Other Tobacco Products (Prohibition of Advertisement and Regulation of Trade and
Commerce, Production, Supply and Distribution) Act, 2003, (COTPA) is being implemented in a phased
manner with effect from 1st May 2004.

4
MAJOR PLAYERS IN THE INDIAN CIGARETTE INDUSTRY:

ITC: ITC is one of India's foremost private sector companies with a market capitalization of nearly
US $ 14 billion and a turnover of over US $ 5 billion. ITC is rated among the World's Best Big
Companies, Asia's 'Fab 50' and the World's Most Reputable Companies by Forbes magazine. ITC also
ranks among Asia's 50 best performing companies compiled by Business Week.

ITC has a diversified presence in Cigarettes, Hotels, Paperboards & Specialty Papers, Packaging, Agri-
Business, Packaged Foods & Confectionery, Information Technology, Branded Apparel, Personal Care,
Stationery, Safety Matches and other FMCG products. While ITC is an outstanding market leader in its
traditional businesses of Cigarettes, Hotels, Paperboards, Packaging and Agri-Exports, it is rapidly
gaining market share even in its nascent businesses of Packaged Foods & Confectionery, Branded
Apparel, Personal Care and Stationery.

Godfrey Philips: As the second largest player in the Indian cigarette industry, their annual turnover
exceeds INR 1800 crores (approx. US $369.6 million). GPI owns some of the most popular cigarette
brands in the country like Four Square, Red and White, Jaisalmer, Cavanders and Tipper. Over the years
they have also set their own benchmarks in innovation with revolutionary brands like Stellar, the first slim
cigarette and I-gen, the first euro norm cigarette in India.

5
GPI products are distributed over an extensive India wide network of more than 500 distributors and
800,000 retail outlets. With the Corporate Office in Delhi, the Company has offices all across India in
over 8 locations.

Godfrey Phillips India has two major stakeholders, one of India’s leading industrial houses – the K. K.
Modi Group and one of the world’s largest tobacco companies, Philip Morris.

VST Industries Ltd: VST Industries (VST) is engaged in the manufacturing and marketing of cigarettes.
It was incorporated in 1930. The company is an affiliate of British American Tobacco (BAT), UK, which
holds a 32.16% stake in the company.

The company focuses on manufacturing and marketing cigarettes with interests in investments and mutual
funds. The major brands of the company include Charminar, Charminar Special Filter, Charms Mini
Kings and Charms Virginia Filter, XL Filter and Shaan. Its products are targeted at the lower end of the
market and have dominance in the small-sized (less than 60 mm) micro segment. The company is
dependent on ITC for the supply of tobacco. Though the major chunk of revenue comes from sale of
cigarettes, it is also in the business of selling non-manufactured and cut tobacco.

HERFINDAHL INDEX
The Herfindahl index (HI) is a measure of industry concentration equal to the sum of the squared market
shares of the firms in the industry.

Herfindahl index is defined as the sum of the squares of the market shares of each individual firm. As
such, the index can range from 0 to 10,000, moving from a very large amount of very small firms to a
single monopolistic producer. Decreases in the Herfindahl index generally indicate a loss of pricing
power and an increase in competition, whereas increases imply the opposite.

The US uses the Herfindahl index to determine whether mergers are justifiable; increases of over 100
points generally provoke scrutiny, although this varies from case to case. The Department of Justice
considers Herfindahl indices between 1000 and 1800 to be moderately concentrated and indices above
1800 to be concentrated.

For instance, two cases in which the six largest firms produce 90 % of the output:

• Case 1: All six firms produce 15% each, and

• Case 2: One firm produces 80 % while the five others produce 2 % each.

6
We will assume that the remaining 10% of output is divided among 10 equally sized producers.

The six-firm concentration ratio would equal 90 % for both case 1 and case 2, but in the first case
competition would be fierce where the second case approaches monopoly. The Herfindahl index for these
two situations makes the lack of competition in the second case strikingly clear:

• Case 1: Herfindahl index = 6 * 15%2 + 10 * 1%2 = 13.6%

• Case 2: Herfindahl index = 80%2 + 5 * 2%2 + 10 * 1%2 = 64.3%

This behavior rests in the fact that the market shares are squared prior to being summed, giving additional
weight to firms with larger size.

HERFINDAHL INDEX OF INDIAN CIGARETTE INDUSTRY

To study the impact of ITC in the Indian Cigarette industry, we have selected the time period from 1991
to 2008. 1991 is particularly significant in the Indian economy for the reason that the Indian economy was
liberalized from the year 1991, and since then there has been significant economic growth in the Indian
economy as compared to the previous years. It can be seen that the Herfindahl Index of the cigarette
industry in India has increased continuously from 0.448 in 1991 to 0.712 in 2008. This clearly shows that
the cigarette industry in India is approaching monopoly with ITC as the key player in the Industry.

7
 Table 1: Herfindahl Index of Cigarette Industry

If we plot the graph of percentage market share of ITC in the Indian cigarette industry, we observe that
the percentage market share has been continuously increasing from 62.81% in 1991 to 83.64% in 2008.
This expains the increase in the Herfindahl Index of the industry consistently from 1991 to 2008, clearly
Indicating that the industry is tending to a monopoly with ITC as the market leader.

Table 2: The above graph represents the increasing Herfindahl index with ITC's market share

ITC vs other competitors

8
It can be seen that the market share of cigarettes for ITC has been increasing consistently in
comparison to its nearest competitors, Godfrey Philips and VST Industries, whose market share
has been decreasing consistently, throughout the period 1991 to 2008. Only in 1992, the market
share of ITC fell by a small margin whereas the market share of the competitors correspondingly
rose by a small margin. This reaffirms the findings shown previously, relating to the change in
the Herfindahl Index of the cigarette industry in India, ie ITC is a price maker among all the
firms in the industry and the cigarette industry is clearly dominated by ITC and is tending
towards monopoly.

ADVERTISING AND CIGARETTE INDUSTRY

Tobacco kills 2500 Indians daily. So cigarette smoking and other tobacco use impose a large and
growing public health burden. Given this, the Bloomberg Global Initiative to Reduce Tobacco
Use is engaged in an integrated set of efforts to reduce tobacco use by: increasing tobacco taxes
9
and prices (and curbing smuggling);changing the image of tobacco use by banning advertising
and promotion of tobacco products and supporting counter advertising and other public
education efforts.

As a natural extension of the global trend, the Government of India has imposed restrictions on
various forms of advertising of tobacco products over the years:-

• Amendment to the Cable TV Act1995

• I&B ministry bars telecast of liquor and cigarette ads in 2000

• On 1st May 2004, the Cigarette and Other Tobacco Products Act 2003(COTPA) was
passed the section 5 of which states that:

 No person shall advertise and take part in any advertisement which directly or
indirectly suggests or promotes the use of tobacco products.

 All types of advertising are prohibited by law – surrogate, brand stretching, special
promotional schemes and sponsorships.

 Restricted display of tobacco products is allowed in films.

• Graphic pack warnings since 2008/09.

• Restriction on public smoking.

Effect of these restrictions on the consumption of cigarettes:

• Despite such regulations, cigarettes in India continue to see a small growth for the last 7
years. The reasons for sustained growth are as follows:

 India is demographically very strong.65% of the population is below the age of

35; potentially this is a big segment of younger consumers with rising disposable
incomes and a lower aversion to smoking.

 India has a low per capita cigarette consumption (141 sticks) compared with the
global average.

• The ban took heavy toll on outdoor ad agencies, hoarding suppliers, charity organizations
who rely very much on the tobacco companies' sponsorships.

10
  Tobacco-spends on outdoor, excluding retail signage, is about 10 per cent of the
outdoor spends in the country. The Indian outdoor industry is about Rs 6000
million and tobacco advertising on outdoors accounts for Rs 600 million
approximately. This is the projected loss to outdoor advertising agencies because
of the ban.

 With drying up of a staggering advertising budget of 125 crore for ITC, ad

agencies like ITC's agencies Lowe, O&M, JWT and Initiative Media, and
Rediffusion, which handles the account of Godfrey Philip India were facing the
heat. Luckily for these agencies, this period (2004-2009) coincided with a
tremendous growth of the telecom sector and rising income from that sector
neutralized the losses from tobacco industry.

Effect on tobacco companies:

• The revenues of majors like ITC and Godfrey Philips have remained steady despite the
bans much to the surprise of industry experts.

• These companies saw the ban coming and diversified their portfolio into hospitality,
garments and biscuits.

• An interesting observation that could be made in the wake of this ban is that, it could
ultimately prove to be a blessing in disguise for big and established players like ITC.
Their brands have got higher brand-recall value and they won't need much of advertising
to push their products further. At the same time, smaller tobacco companies and new
entrants would find it extremely difficult to establish themselves in this changed scenario.
So the ban may be contributing to monopolisation of the tobacco industry.

• Surrogate advertising like “Godfrey Philips Bravery Awards” is a way out for tobacco
industry to indirect advertising through a media-hyped CSR activity.

It was in 2004 that the company disassociated its trademark ‘Wills’ from its cigarette portfolio
and changed brand name ‘Wills’ to its old name Navy Cut. But now ITC's trademark ‘Wills’ is
predominantly present in diverse categories such as personal care products and fashion retailing
sector (Fiama Di Willis). An interesting report released by ITC claims the pictorial warning on
cigarette packs hardly have an impact on the demand as 70% of the cigarettes were sold loose.

11
 Taxation policy on tobacco products
Tax on tobacco products comprise of 2 parts:

1. Excise tax

2. VAT

Some facts related to tobacco consumption and taxation in India:

• Cigarettes contribute only 14% of the tobacco consumption in India; rest is consumption
of bidi, snuff and other tobacco products. In the rest of the world, production of cigarettes
is 90% of total production of tobacco related products.

• Cigarette smokers pay almost 85% of the total tax revenues generated from tobacco.

• India has one of the highest rates of taxation among countries imposing a specific tax on
cigarettes. In fact 55 per cent of the price of cigarettes in India represents excise.

• Cigarettes contribute nearly 10 per cent of total excise to the exchequer.

Taxes are evaluated on two basic criteria:

1. Efficiency

2. Equity

Taxation efficiency means that tax revenue should be maximized with a minimum change in
consumers’ choices of various goods or services. This efficiency loss is also called the “excess
burden of tax” or “deadweight loss.

Equity in taxation means that there should be an equal tax treatment of equal individuals
(horizontal equity), or unequal tax treatment of unequal individuals (vertical equity).
12
Analysis on the effectiveness of the taxation policy on tobacco products in India:

An excise tax can be imposed on products and services if they have one or more of the following
characteristics (McCarten and Stotsky, 1995):

a) Production, distribution, and sales can be closely supervised by the government. This
ensures little chance of tax avoidance during these processes.

b) Demand is price-inelastic (i.e., as price rises, consumption falls by less than the
percentage rise in the price). Revenue is therefore increased regardless of the rate of
consumption.

c) The product or service is considered a luxury rather than a basic necessity. Not only does
consumption of luxury goods and services rise as income rises, but it rises even faster
than the rise in income. Here the income elasticity of demand is greater than one,
meaning the greater the consumption, the even greater the revenue.

d) Consumption lacks “merit” (i.e., a person’s lack of control over him/herself is increased)
or causes negative externalities. This provides a populist reason (economic rationale) to
institute a tax.

There are at least three purposes or reasons for imposing a tax on tobacco products:

1. Raise revenue: Tobacco taxes are very efficient at raising revenue. Typically there is a
large, captured consumer market paying taxes because they cannot either quit smoking
due to addiction, or they are not price sensitive due to lower taxes. Further, the
enforcement and collection of these taxes is easier than for other taxes, such as those
based on income.

2. Correct for externalities: A tobacco tax helps defray the external costs of tobacco
consumption, such as diseases contracted by non-smokers and the costs to treat such
diseases. This argument is called “negative externalities.”

3. Discourage use of the product: Tobacco is considered a product without merit; it is

addictive and destructive, and therefore is arguably not productive for the greater
economy. Tobacco taxes discourage consumption, most particularly among the poor, the
young and new tobacco users, and provide opportunity for more productive spending and
investment elsewhere.

Now we will analyze each of the purposes in greater detail and try to find out their effectiveness.

Raising revenue:

13
The “Ramsey Rule” states that tax rates should vary inversely with the elasticity of demand for
products (holding the elasticity of supply constant). So, tax goods with relatively inelastic
demands more heavily, and tax those with relatively elastic demands less.

The Ramsey Rule argues for relatively high taxes on cigarettes and other tobacco products. In the
short-run, at least, the demand for tobacco products is relatively inelastic in most countries.

When revenue generation is a goal, governments should favour excise taxes on goods with large
sales volumes, few producers, inelastic demand, easy definability, and a lack of close substitutes.
Tobacco products fit most or all of these characteristics. Taxes raise the price consumers must
pay for tobacco products. The higher the price, the less people buy. So institute high tobacco
taxes to:

1. Encourage smokers to quit or reduce their smoking.

2. Discourage ex-smokers from starting again.

3. Deter non-smokers from starting.

(Note: this applies equally to all tobacco products)

The less elastic the demand, the less effective the tax in reducing tobacco consumption, but the
greater the gain in tax revenues. WHO reports have shown that tobacco consumption is inelastic
in the short run. So for the short run, the Government can raise taxes to increase revenue.

However, there are criticisms of the form of taxation on following grounds:

• Tax policy for bidis, which accounts for a major portion of tobacco consumption (up to
70-80%), is not well developed. According to existing law, manufacturers producing less
than 2 million bidis a year are exempt from excise duty. This has two runoff effects:

1. Bidi manufacturers show production units and figures in fragments or as home-based

units so the government loses a lot of revenue due from the excise duty.

2. A difference in tax rates on tobacco products does cause consumers to change

consumption from high tax (and priced) products (cigarettes) to low tax (and priced)
products (bidis). This is an example of substitution effect and this reduces the impact of
increasing taxes to reduce overall consumption.

Correction for negative externalities:

14
Economists use the term “negative externalities” when referring to the costs imposed on people
other than the immediate consumers of the goods and services (like healthcare costs of passive
smokers). These costs are reflected in the price of cigarettes and other tobacco products by taxing
the tobacco products. This is a way of internalizing the externalities to the immediate consumers.
Increase in prices due to tax (such taxes are called pigouvian taxes) leads to reduced
consumption which in the long run reduces the externalities associated with the product.

Discouraging the use of tobacco products:

The total health cost entailed by major tobacco-related diseases like cancer, lung disease and
heart disease was estimated to be about Rs 30,833/- crore (US $ 7.2 billion) for the year 2001-02.

Three components of the economic cost of tobacco use are:

(1) Direct healthcare expenditures for inpatient hospitalisation or outpatient visits

(2) Expenditures incurred for transportation other than ambulance and lodging charge of
caregivers

(3) Wage income lost to the whole household due to inpatient hospitalisation or outpatient visits.
Items 2 and 3 comprise indirect morbidity costs.

A fourth and important component of the economic cost of tobacco is the cost of premature
deaths from tobacco use.

We conclude by agreeing that taxes help in decrease consumption of tobacco products but is
accompanied by a tendency to shift from higher priced products (cigarettes) to lower priced
substitutes. So the entire spectrum of tobacco products should be taxed without focussing only
on cigarettes. It is important to note here that there is a high economic cost associated with
increasing production of bidis in the form of poor working condition of bidi workers and high
incidence of child labour.

15
REFERENCES:

1. CMIE Databases.
2. www.itcportal.com
3. www.godfreyphillips.com
4. www.vsthyd.com
5. www.dacnet.nic.in, website of the Department of Agriculture and Cooperation, Govt of
India.
6. www.fao.org, website of FAO.
7. Managerial Economics, 6th ed, Dominick Salvatore
8. ITC Annual Report, 2009.
9. Godfrey Philips Annual Report, 2009.
10. VST Industries Ltd. Annual Report, 2009.

16