American Tobacco: Managing Mass Production and Distribution of Packaged Products

Of the innovating entrepreneurs who created modern integrated indus- trial enterprises few were more successful than James Buchanan Duke of Durham, North Carolina. Duke’s swift rise to power in the cigarette trade was not based on his technological skills or his advertising talents. He leased his machines and hired the services of advertising agencies and full- time salaried salesmen. His success resulted from his realization that the marketing of the output of the Bonsack machine required a global selling and distributing organization (see Chapter 9). Duke became the most powerful entrepreneur in the cigarette industry because he was the first to build an integrated enterprise.

Before Duke made his gamble in 1885 on Bonsack’s continuous-process cigarette machine, he and his four major competitors were still basically single-function manufacturing enterprises.1 They had begun to purchase, store, and dry tobacco in their own facilities in the bright-leaf tobacco re- gion of North Carolina and Virginia, but only on a small scale. They con- tinued to buy nearly all their leaf directly from tobacco brokers who had their own storing and curing units. In marketing they depended on whole- salers to distribute their output and on advertising agents to carry on their marketing campaign. Before 1885 none had set up branch sales offices operated by their own salaried personnel and managers.

Duke was the first to do so. Even before he had signed the contract with James Bonsack in June 1885 to use his machine to make all his cigarettes, expensive as well as cheap, he began to set up selling and distributing offices in the leading American commercial centers.2 Each included, at a minimum, a salaried manager, a city salesman, a traveling man to cover the outlying areas, and the necessary clerical staff. As Duke began to build a nationwide network, his close associate, Richard B. Wright, made his nineteen- month tour abroad to explore foreign markets. Soon Duke’s firm had contracts with the overseas jobbers and had set up offices abroad to supply and supervise the sale and distribution of cigarettes to them. At the same time Duke put together his extensive purchasing network with its own buying, curing, and storing facilities. He expanded his cigarette factory in Durham and built a large new plant in New York City. To manage this new empire he then established a large central office, not in Durham but in New York City, the nation’s leading distribution center.

By 1890 when Duke and four other leading cigarette firms joined to form the American Tobacco Company, Duke’s four competitors had been forced to build comparable though smaller integrated organizations. For a brief period after the consolidation, the companies maintained their separate administrative organizations. Between 1893 and 1895, however, those of the other four were merged into the structure Duke had fashioned so quickly after 1884.3 Administrative centralization came first with the formation of a single purchasing department. Then the several sales departments were unified.

The resulting worldwide integrated enterprise was managed first from the company’s New York office at 45 Broadway. As business expanded Duke moved his headquarters to a more spacious building at 111 Fifth Avenue in 1898.4 Most of the space in the new building was taken up by the sales department and the buying or what was called the leaf department. By then the heads of the functional departments at 111 Fifth were already career specialists. Thus, John B. Cobb, the vice president in charge of the leaf department, had long worked as a tobacco buyer before joining American Tobacco in 1890.5 William R. Harris, the chief of the auditing department, had been hired by Duke some years before from the Pullman Palace Car Company; and the head of the legal department had been with the Duke firm since the 1880s.

Of the major functional departments at 111 Fifth Avenue, manufacturing had the fewest managers. After the merger there had been a consolidation of cigarette-making plants in the New York City area, while those in Rochester and in Virginia and North Carolina were enlarged. Throughout the 1890s six factories produced nearly all the company’s output, which by 1898 reached 3.78 billion cigarettes.6 Two of these six (one in Durham and the other in Rochester) concentrated wholly on producing the 1.22 billion cigarettes sold to foreign markets. During the 1890s the two plants accounted for almost 100 percent of the cigarettes exported from the United States. Although Duke testified in 1901 that his company always preferred to manufacture at home for markets abroad, he was willing to build factories overseas if the distance or tariffs significantly affected final price.7 In 1894 the company set up factories in Australia. In 1899 it purchased a leading Japanese producer, and two years later it bought manufacturing companies in Germany and Britain.

The manufacturing headquarters at 111 Fifth remained small because the processes of production were relatively simple. By the 1890s manufacturing and packaging of cigarettes and most other tobacco products had become fully mechanized and the production technology stabilized. Moreover, the manufacturing office did not have the responsibility either for recording costs or for assuring a steady flow of cured tobacco into the factories and of cigarettes from the factories to the retailers. The auditing department took care of the first of these tasks and the leaf and the sales departments handled the second.

The leaf department supervised and coordinated the activities of the many units responsible for purchasing, drying, and handling the uncured or semicured leaf and for prizing (packaging it in hogsheads, storing, and separating the stem from the leaf) and shipping the cured leaf to the factory.8 Such coordination and control over the curing process was es- sential to assure the delivery of the right amounts of tobacco in the proper quality needed for the different types of cigarettes. Tobacco for the more expensive brands required longer curing and used a somewhat different process than that used for the cheaper ones. Specialized volume buying helped to bring down the cost of raw materials. However, as Richard Ten- nant has pointed out, it did not necessarily give American Tobacco a monopsony position. American bright-leaf tobacco continued to be the major ingredient in British and other foreign made cigarettes.0

By the beginning of the century, the company had twelve drying and packaging houses and nineteen large storage warehouses in North Carolina and Virginia. As the company moved into the plug tobacco business in the late 1890s its leaf department built a similar organization in the Burley leaf district of Ohio and Kentucky. Then as cigarettes using Turkish tobacco became popular, it set up facilities in Turkey to purchase, process, and ship tobacco.

In addition to its large leaf department, American Tobacco had another smaller, centralized purchasing department to buy in quantity packing materials and such supplies as licorice, sugar, rum flavoring extract, as well as machinery, tools, furniture, and stationary used at 111 Fifth Avenue.10 Pasteboard, paper, and tin foil were ordered for the factories through the New York headquarters. After its expansion into other tobacco products, the company found it profitable to organize or buy companies to produce cotton bags, tin foil, tin, and paper boxes. The company soon began to make its own machinery and to produce its own licorice. In these several ways expansion of output at American Tobacco brought an integration of functions rather than a further specialization and subdivision of labor.

“The sales department of the American Tobacco Company,” a 1909 report of the Bureau of Corporations emphasized, “is so organized as to secure a high degree of efficiency. The company has sales agents through- out the United States, each in charge of a specified territory and each de- voting his attention to a particular class of product.”11 The branch offices, similar to those set up by Duke in the 1880s, had become larger and more numerous. Salesmen, both city and traveling, regularly visited all of the wholesalers, including those handling grocery and drugs as well as tobacco jobbers and large tobacco retailers. And by the mid-1890s foreign branches also had their own traveling men. The Tobacco Company’s salesmen proved to be far more effective than those of the wholesaler who still handled the physical distribution to retailers. Indeed the Bureau of Corporations pointed out that company salesmen “solicited no small part of the orders from the retail trade and turned them over to the jobbers without expense to them.”12 This was particularly true in rural areas. As the company moved into new products, the regional sales offices came to have subordinate managers for products as well as for subregions. Each had its advertising manager who coordinated advertising activities with New York. Still another executive became responsible for inventories and for supervising flow of deliveries to a large number of customers.

Actual control of the flow of 3 to 5 billion cigarettes from factory to retailer via the jobber was retained at 111 Fifth Avenue. Such control was necessary not only to keep the factories operating at a relatively full and steady pace, but also to maintain the quality of the product, for in the days before cellophane wrapping cigarettes quickly became dry and bitter. All orders received by a branch office were telegraphed to New York. Managers there decided which factory would process the order, usually sending it to the one nearest to the customer. Small “mixed orders,” that is, those for small numbers of different types and brands, were filled from a large central “depot” in New York. European orders were distributed from a similar depot in London. Normally, however, the central office sent orders directly to a factory. Orders, “especially those coming from retail dealers and made in the form of drop shipments” (those left at the local train stat’ons for customers), were “sent from a single place to avoid unnecessary delay and expense.”13 Therefore the factories had attached to them assembling and distribution depots where their products and those of other factories were gathered for shipment. With its daily reports from the factories and the depots and its daily statements of “sales by brands by towns,” the New York headquarters kept a continuous check on the flow of cigarettes and the other tobacco products from the factory to the retailers throughout the country and the world.14

The auditing department’s major responsibility was to control costs rather than to control flows. According to Duke’s biographer, that depart- ment’s accounts “were in such detail that each brand showed cost per unit, running into five decimal points, of every item entering into its manufac- ture—tobacco, wrapping of package, casing or sweetening material, shipping cases, down to the straps and nails. Labor in cutting tobacco, op- erating machines, putting goods in cases, and handling them after they were packed was recorded, carried out to the last decimal, even if it was .00035 Per thousand.”15 Comparisons between costs of different factories and within the same factory for a different time period were used by middle managers to evaluate the performance of the different factories and their plant managers and to decide where brands and products could be most cheaply produced.

The Tobacco Company’s cost sheets in the 1890s became as sophisticated as those of Andrew Carnegie. In addition to detailed data on prime costs (labor and raw materials used in manufacturing), “cost records” reported advertising and selling costs.16 Selling costs included salaries and expenses of salesmen and of their office managers. On the other hand, as late as 1915 the company had not yet applied the new techniques of standard costing to the determination of overhead costs. “General & administrative costs” were little more than a percentage of total cost prorated between the selling and manufacturing, but not the leaf departments. In this category, “from 50 to 75 percent,” the Bureau of Corporations report noted, was allocated to selling. Still less attention appears to have been paid to accounting for depreciation and obsolescence. The American Tobacco Company continued to use the railroad type of renewal accounting that allocated major repairs and replacements to the operating accounts.

Even so the middle managers at 111 Fifth were by the late 1890s carrying out their tasks of administrative coordination and evaluation in a most effective manner. The prices of cigarettes declined during the decade, and profits remained impressively high. According to Bureau of Corporation’s investigators, wholesale prices fell from 1893 (American Tobacco’s accounts were first consolidated in 1892) until 1899 in all its markets from an average of $3.02 a thousand to $2.01 (in 1900 k rose to $2.16).17 In the same period costs dropped from $1.74 per thousand to $.89 (in 1900 they rose to $1.00 per thousand.) In the words of the report: “The proportion of the profits to the net price less tax from 1893 to 1900 ranged from 42.4 percent to 55.7 percent.” Duke expected these profits, made possible, in part at least, by the high, steady throughput and stock-turn, to provide him with the basic financial resources he needed to expand the company’s activities at home and abroad.

Although the middle managers and their staffs at American Tobacco became numerous enough to fill a large New York office building, top management remained tiny. It was little more than Duke, his brother Benjamin, and their long-time associate, George Watt. The heads of the other companies who had joined the 1890 merger had less and less to say about the affairs of the consolidation.

For Duke the function of top management was strategic. By 1892 he had formulated a straightforward strategy of growth. The organization he had created and the profits it produced were to be used to conquer the rest of the tobacco industry. In the 1890s pipe tobacco, plug or chewing tobacco, snuff, and cigars still commanded much larger markets than cigarettes. Duke’s plan was first to acquire factories making these other products. Then by driving prices down and spending heavily for advertising he expected to bring the leading producers into his orbit. Once he had convinced the firms to merge with him, he would consolidate their pro- duction facilities and centralize their administration. American Tobacco Company’s sales and leaf departments could then take over the marketing of finished products and the purchasing of the leaf and other materials. The resulting high-volume throughput would increase productivity, decrease costs, and enlarge profits.

These plans, enthusiastically endorsed by senior managers, were strongly opposed by the other owners.18 The major stockholders besides the Dukes were the owners of the companies that had merged with Duke’s firm to become American Tobacco in 1890. They, particularly W. H. Butler and Lewis Gintner, saw no reason to sacrifice current dividends in order to expand the existing organization.

Duke first won the fight with his board. He then moved forward to carry out his plans using his economic power with ruthless determination. By 1898, with the formation of the Continental Tobacco Company, capitalized at $75 million, and then with the merger of that company with Liggett & Myers in the next year, Duke was close to his goal. He controlled over 60 percent of the smoking and chewing tobacco business. The formation of the Atlantic Snuff Company in 1898 and in 1900 the larger American Snuff Company, capitalized at $35 million, gave him an even greater dominance in that industry.

This campaign was, however, more expensive than Duke anticipated.

Many of the tobacco manufacturers vigorously resisted his attack. Cigarette profits were not enough to cover the costs. For the first time Duke had to look to the capital markets for funds. In 1895 the company’s common stock was listed on the New York Stock Exchange.19 Early in 1898 Duke allied himself with Oliver H. Payne, one of Rockefeller’s early associates. Later that same year when Duke acquired a rival combination headed by leading New York financiers, he took several of these men onto the board of the American Tobacco Company as well as on that of the new Continental Tobacco Company.20 They included Thomas Fortune Ryan, William C. Whitney, Anthony N. Brady, and P. A. B. Widener, all of whom had made their fortunes in street railways. With Payne, they became Duke’s close financial allies. These investors, however, never became involved or took an active interest in the day-to-day operations of the American Tobacco Company.

Duke’s enlarged empire was soon being managed out of 111 Fifth Avenue. The leaf department at this time expanded its facilities into the Burley tobacco-growing regions of Tennessee and Kentucky. Of the merged firms only R. J. Reynolds continued to have its own purchasing department. This was because its basic brand of navy sweet plug used a special leaf. The sales department at 111 Fifth Avenue set up separate offices for plug, smoking, and snuff, but American’s depot and reporting systems were used to coordinate and control flows of the acquired businesses. The manufacturing department instituted, where possible, continuous-process automatic packing and labeling machinery. And of course the auditing department extended its sway over the recently incorporated properties.

Once these new businesses had been integrated into American’s structure, Duke continued to expand his enterprise on two fronts. One was to enlarge his companies’ overseas trade, especially in products other than cigarettes. The other was to move into the cigar business, the only do-r mestic American tobacco trade not under the dominance of the American Tobacco Company.

In the first he was successful.21 He began by frontally attacking his fore-most competitor, the British firm of W. D. & H. O. Wills which had been the first European manufacturer to adopt the Bonsack machine. Duke entered Wills’s home market by purchasing Ogden’s Ltd. for over $5 mil- lion. Wills countered by carrying out a merger of thirteen British tobacco producers to form the Imperial Tobacco Company.

After some sharp but brief skirmishes Imperial and American made a deal. Duke sold Odgen’s to Imperial. The two firms then formed the British-American Tobacco Company in which American held two-thirds and Imperial one-third of the $5.2 million worth of stock issued. In addition American Tobacco received 14 percent of Imperial’s ordinary shares from the sale of Odgen’s. This transaction made it the largest stockholder in Imperial, second only to Wills. American and Imperial then gave British- American the world markets. Imperial would continue to sell only in the United Kingdom and American only in the United States and its dependencies. Duke became chairman of the board of British-American, and until he retired as chairman in 1923 concentrated most of his time on enlarging British-American’s trade.

These legal and financial arrangements had only a small impact on day- to-day operations. The same men in the same offices and factories contin- ued to purchase leaf, process it, ship it, and sell the American-made ciga- rettes in foreign markets. As world demand grew British factories came to supply a larger share of production. The new company intensified efforts to replace independent sales jobbers or agents with salaried managers. When coordinating flow from distant factories became difficult, these managers often set up local ones. Thus in China where British- American Tobacco had created an extensive distributing network, the company soon had its own factories. Before 1914 it was using locally grown bright leaf tobacco whose seed it had imported from North Carolina. Despite the legal changes instituted by the Supreme Court’s antitrust decision against American Tobacco in 1911, British-American Tobacco remained until the 1920s more of an American than a British owned and managed enterprise and so the worldwide tobacco business stayed more in American than in British hands.

If overseas expansion was a continuing success, the move into the cigar business proved to be a costly failure. As Richard Tennant, the most careful student of the modern American tobacco industry points out: “The struggle for the cigar industry was the one case in which the Trust’s methods met with complete defeat.”22 Despite the strongest of marketing efforts, including the creation of an expensive nationwide retailing organization (United Cigar Stores Company with nearly 400 retail stores), and despite the most destructive of price wars, American Tobacco never obtained more than 14 percent of the nation’s cigar trade.

Duke’s mistake was his failure to appreciate fully that the American Tobacco Company could use little of its existing organization to make and sell cigars. The processes of both production and distribution were dif- ferent. Plug, smoking tobacco, and snuff all used high-volume continuous processes of manufacturing and packaging. Their leaf came from the same areas in southeastern United States, and they were sold to much the same markets and through much the same jobbers as cigarettes. Cigars, on the other hand, were produced by skilled workmen in small batches. Their leaf came from Cuba, Puerto Rico, and scattered areas in the northeastern United States. It was cured quite differently from other types of tobacco. Finally, cigars traditionally had been sold by their makers in small lots to retailers. Like wines the many different brands had distinctive tastes and flavors. Each appealed to a different type of customer. Cigars were not a product that could be mass produced and mass distributed, nor could the raw materials be purchased in bulk. Since these processes did not lend themselves to high-volume throughput, administrative coordination did not reduce costs and so raise barriers to entry. Neither massive advertising nor effective organization could bring the dominance of a single firm in the cigar business.

The experience of the American Tobacco Company provides several important lessons for understanding the rise and function of the large en- trepreneurial enterprise. First, the massive output made possible by ap- plication of continuous-process machinery to manufacturing caused and indeed almost forced the creation of a worldwide, integrated organization. The resulting managerial hierarchy permitted its creator to dominate first the cigarette and then the rest of the tobacco industry, except for cigars. The founder fully realized the importance of his organization. According to his biographer, he always considered that his major task was to find and bring forward competent managers.23

The middle managers housed in the central office building at 111 Fifth Avenue formed the core of this integrated enterprise. These salaried ex- ecutives supervised, evaluated, and coordinated the functional activities under their command and coordinated the work of their departments with others. They made possible a continuing, high-volume throughput from the buying of the leaf to the ultimate consumers. Where the processes of production and distribution permitted such high-volume flows, this type of organization was the key to success and dominance; but where, as in the case of cigars, the processes did not, such an organization provided no special advantages.

The experience of American Tobacco was repeated in the same decade, the 188os, by other pioneer enterprises that used comparable methods of production to make comparable low-priced packaged products. The makers of matches, breakfast cereals and other grain products, canned soups, milk, pickles and other foods, soap, and photographic film (all the foregoing were semiperishable except matches) built similar organizations. So too, in the 1890s, did Coca Cola, Wrigley’s chewing gum, and Fleish- mann’s yeast. These firms had extensive buying departments, global sales organizations, and manufacturing concentrated in a few large plants. Middle managers at their main offices played much the same role as that at American Tobacco. In all cases top management continued to be the domain of the founder, his close associates, and their descendants. Like the Dukes they concentrated on discouraging competition and expanding their own output by a fuller and more effective use of their existing managers and facilities.

Source: Chandler Alfred D. Jr. (1977), The Visible Hand: The Managerial Revolution in American Business, Harvard University Press.

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