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What is Product Cannibalization?
Product cannibalization is the process in which a new project or product eats away the cash flows earned by an already existing product. That means, when a new project or product is launched, it may take the cash flow away from an already running product or project. Business decisions must include the cannibalization effect into consideration because ignoring this may lead to huge losses sometimes.
Capital budgeting decisions are taken keeping profitability and market share of products and they should include a holistic approach.
A new product or project must not negatively impact an already available product or project which is running profitably till the present time.
The impact of a new product is, therefore, necessary to estimate the profitability of a new product and to see whether it eats away the profitability or cash flows from another project.
The cannibalization rate is therefore a very important concept for companies going to launch a new product or a project.
Cannibalization Rate
Cannibalization rate is the ratio of the Revenue lost divided by Total Revenue added.
$$\mathrm{Cannibalization\:Rate= \frac{Revenue\:Lost }{Total\:Revenues\: Added } }$$
While calculating the Capital budgeting measures, such as Net Present Value (NPV) and Internal Rate of Returns (IRR), the gross cash flows of the new project must be subtracted by cannibalization rate.
Although cannibalization rate must be considered before launching a new product, the market scenario and the action of potential competitors must be considered while launching a new project or a product. So, it should not be a mechanical approach.
A business should not shy away from launching a new product or a page due to cannibalization if its competitors launch a similar product anyway.
Self-cannibalization is crucial to maintain a competitive edge in many industries, such as the technology industry.
Example
Sweet & Saucy specializes in producing biscuits of various types. It is currently selling two versions of biscuits: "Sweet and Crunchy" and "Salty Beauties" that earn INR 20 million and INR 10 million per annum.
Now, the company is planning to launch a new product "Salty Butter" which it expects to generate INR 8 million.
However, analysts say that the launch of Salty Butter will eat away 20% and 5% of "Sweet and Crunchy" and "Salty Beauties", respectively.
If the prices remain the same, the total loss of revenues would be −
INR 20 million × 20% + INR 10 million × 5% = INR 4.5 million
Therefore,
Therefore, the launch of the new version is feasible only if the product launch costs are not too high.
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