Innovation and cannibalization

 

Cannibalization Hey BSF

How should we treat cannibalization when considering value and urgency? I have been asked this a number of times, usually in the context of quantifying the Cost of Delay. The issue at hand is whether you should take into account the likelihood that a new product or feature might “eat” the profits currently enjoyed in some other part of your business. If the product or service being proposed leads to a higher margin and better profitability, no problem. Where it gets much harder is when the new product or service actually generates a lower margin, lower profitability.

Should we take into account cannibalization, or not?

The short answer? I would usually ignore the impact of cannibalization, even though this seems completely wrong at first.

Of course, if the profit of a new product is less than the profit of the product it is displacing then the benefits are negative – it is value destroying, not value adding. All else being equal, this is absolutely true – but what needs to be considered is the wider marketplace. If you don’t cannibalize your own sales, you run the risk that a competitor comes along and does it for you. Paradoxically, a new, lower margin product can actually help protect your revenue and market share. In some cases it can even expand the total size of the market. A lower price point could attract new customers and you may discover that there are even new uses for your cheaper product or service.

Good examples of companies doing this are those mobile operators who offer their infrastructure to “Virtual Network Operators” (like Virgin Mobile or Tesco Mobile). Intel made a similar move with their low-end Celeron processors. In each of these cases, they are effectively giving away margin, eating into their own profits. Why would they do this?

Avoid disruption – Eat yourself

The reason companies do what seemingly makes no sense is to protect themselves from disruption at the low-end. If they don’t, they leave themselves vulnerable to what Clay Christensen calls “The Innovator’s Dilemma“.

What Christensen identified is that incumbents have a natural tendency to flee upmarket, leaving them exposed to disruption by a new entrant or competitor with an initially inferior product. Because it isn’t as good, the incumbent tends to ignore it (or even laugh at it). They happily allow the new entrant to take what might be seen as less valuable or even troublesome customers, while they focus on the high-margin customers (with their more sophisticated needs). They feel safe. Complacent even. The problem for the incumbents is that the new entrant doesn’t stand still. It get’s better and (often with the help of improving technology) they start to eat away at more and more of the incumbent’s market share. What starts off as “not good enough” has a tendency to improve over time, iterating quality along lines that the incumbent is generally not focused on, in their blind spot.

Because of this, you need to be careful that your ideation and prioritisation or scheduling system doesn’t inadvertantly encourage innovator’s dilemma. Avoiding disruption is why I generally prefer to consider straight revenue (rather than profit) – and ignore any negative effects that might arise from cannibalization. Going after only high profit ideas tends to leave you exposed at the low-end. It is of course necessary to combine this with a check that each idea satisfies a minimum benefit cost ratio – we obviously don’t want to build stuff that costs more than anyone expects it to return.

Another option here is to monitor your portfolio’s spread across each of the four buckets of value. If it is too heavily weighted in one area (say “Reduce Cost”) you can adjust by more heavily weighting other areas (like “Increase Revenue”) in order to encourage more of a bi-modal or barbell investment strategy.

What about Urgency?

The wrinkle though is the timing. Which urgency profile should we use? Typically, the impact of delay when faced with a potential cannibalization situation is most likely to look like the curve with a permanent impairment of market share. What we don’t know is when a competitor is likely to enter the market. In that case, it can be better to act early and disrupt yourself – rather than provide an umbrella for a competitor. The risk is that they can gain an asymmetric position in the market and solve some of the challenges like brand recognition and distribution.

One approach can be to build the cheaper lower margin product and offer it with clear marketing differentiation. Then you have a feedback signal you can monitor that tells you whether your lower margin offering is good enough now to serve more customers. Apple have done this for years with the n-1 iPhone strategy — continuing to sell last year’s model alongside the new and improved model. When last year’s model starts selling in greater volumes this suggests that it is becoming “good enough” and that their risk of low-market disruption is increasing. It is effectively the canary in the coal mine.

If you don’t?

There are lots of examples of the risk you take if you attempt to avoid cannibalization, but this story is a good one:

Bausch & Lomb invented the soft contact lens but failed to launch it because the firm did not want to lose the lucrative business of selling the drops that hard lenses require. As a result, Johnson & Johnson swept into soft lenses, and the market for hard lenses (and their drops) disappeared.

The key to cannibalization is to move quickly, listen to the market and embrace it when it comes. Much better to disrupt yourself and potentially grow the total size of the market than to try to protect your profits, put your head in the sand and wait for someone to eat you alive.

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