Cannibalization and capital budgeting

In capital budgeting, cannibalization (also called product cannibalization) occurs when an investment in a new product or project would eat away at the cash flows earned by an existing product.

Capital budgeting decisions must be taken by adopting a holistic approach, i.e. it should consider the impact of a business decision on the overall profitability of the business, and not just one product. Hence, it is important to measure the impact of a new product on an existing product. This is often done by calculating the cannibalization rate.

Cannibalization rate

Cannibalization rate is simply the ratio of revenue lost to total revenue added by the product:

$$ \text{Cannibalization Rate} = \frac{\text{Revenue} \text{Lost}}{\text{Total Revenue Added}} $$

In calculating capital budgeting measures such as the NPV and IRR, the gross cash flows of the new project being introduced must be reduced by the cannibalization rate.

However, it should not be a mechanical exercise but an analysis which also considers the strategic position of a business and the potential actions of its competitors. A business should not desist from introducing a new product due to cannibalization consideration if it expects its competitors to introduce a new product anyway. In fact, self-cannibalization is important to maintain competitive advantage in many industries, for example, technology companies, etc.

Example

Crispy Potatoes specializes in manufacture of potato chips and other potato products. It is currently producing and selling two versions of chips: Salty and French Cheese which earn $20 million and $10 million per annum. It plans to introduce a new product called Spicy which it expects to generate $8 million. However, market surveys suggest that 20% and 5% of the customers would substitute Spicy for Salty and French Cheese respectively.

If the price per unit is the same, the total loss of revenue would be $4.5 million (=$20 million × 20% + $10 million × 5%). This would result in a cannibalization rate of 56.25%:

$$ \text{Cannibalization Rate} = \frac{\text{\$4.5} \text{million}}{\text{\$8} \text{million}} = \text{56.25%} $$

Since 56.25% of the revenue earned by Spicy would be offset by revenue lost from sales of Salty and French Cheese products, the NPV would be lower and the investment would be feasible only if initial investment is not too high.

by Obaidullah Jan, ACA, CFA and last modified on

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