Product Cannibalization

Product cannibalization refers to the phenomenon whereby a new product introduced by a firm competes with and reduces sales of the firm's existing products. On one level, it can be argued that this is a negative incremental effect of the new product, and the lost cash flows or profits from the existing products should be treated as costs in analyzing whether or not to introduce the product. Doing so introduces the possibility that of the new product will be rejected, however. If this happens, and a competitor now exploits the opening to introduce a product that fills the niche that the new product would have and consequently erodes the sales of the firm's existing products, the worst of all scenarios is created - the firm loses sales to a competitor rather than to itself.

Thus, the decision whether or not to build in the lost sales created by product cannibalization will depend on the potential for a competitor to introduce a close substitute to the new product being considered. Two extreme possibilities exist: the first is that close substitutes will be offered almost instantaneously by competitors; the second is that substitutes cannot be offered. • If the business in which the firm operates is extremely competitive and there are no barriers to entry, it can be assumed that the product cannibalization will occur anyway, and the costs associated with it have no place in an incremental cash flow analysis. For example, in considering whether to introduce a new brand of cereal, a company like Kellogg's can reasonably ignore the expected product cannibalization that will occur because of the competitive nature of the cereal business and the ease with which Post or General Food could introduce a close substitute. Similarly, it would not make sense for Compaq to consider the product cannibalization that will

Product Cannibalization: These are sales generated by one product, which come at the expense of other products manufactured by the same firm.

occur as a consequence of introducing a Pentium notebook PC since it can be reasonably assumed that a competitor, say IBM or Dell, would create the lost sales anyway with their versions of the same product if Compaq does not introduce the product.

• If a competitor cannot introduce a substitute, because of legal restrictions such as patents, for example, the cash flows lost as a consequence of product cannibalization belong in the investment analysis, at least for the period of the patent protection. For example, Glaxo, which owns the rights to Zantac, the top selling ulcer drug, should consider the potential lost sales from introducing a new and maybe even better ulcer drug in deciding whether and when to introduce it to the market. In most cases, there will be some barriers to entry, ensuring that a competitor will either introduce an imperfect substitute, leading to much smaller erosion in existing product sales, or that a competitor will not introduce a substitute for some period of time, leading to a much later erosion in existing product sales. In this case, an intermediate solution, whereby some of the product cannibalization costs are considered, may be appropriate. Note that brand name loyalty is one potential barrier to entry. Firms with stronger brand name loyalty should therefore factor into their investment analysis more of the cost of lost sales from existing products as a consequence of a new product introduction.

Lessons From The Intelligent Investor

Lessons From The Intelligent Investor

If you're like a lot of people watching the recession unfold, you have likely started to look at your finances under a microscope. Perhaps you have started saving the annual savings rate by people has started to recover a bit.

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