Making diversification decisions–be it brand extensions, introducing new products, or entering new geographic markets–is hard for large companies. Few new initiatives seem to add significant value compared to what already exists. Yet companies fade without renewal.
We built a highly stylized “diversification simulator” to run scenarios with. The idea is to have as few moving parts as possible in the model. It may look over-simplified, but usually the simplest model give the clearest insight. Here is how it works:
- We have product (or geography) A, which is mature. Assume a low growth rate for it, and a return on sales (ROS) that also corresponds to the cost of capital.*
- We have product B (e.g. a line extension, a product, or a geography) which is a new opportunity. It will grow faster than product A, and will have higher profitability (since it is new, the market is not yet efficient).
- Product B is introduced in year 0 and achieves initial sales corresponding to a share of product A’s sales.
- Product B may cannibalize product A between 0% (no cannibalization, leading to pure market expansion) and 100% (market does not expand at all).
- Product B’s “excess” profitability declines with a half life towards product A’s profitability.**
These are the only variables that feed into the model. From this, a “No Intro” and an “Intro” scenario are calculated and the improvement in value of “Intro” to “No Intro” is shown.
Here are three examples. They all assume product A has sales of 100 units in year 0, grows at 1.5% p.a., and has an ROS of 5%: Product B has sales of 0.5% of product A in year 0 (think of a billion $ brand A, and a new introduction B that achieves $50 million in year 0–often a hurdle that a large FMCG company wants to pass).
- Shown below in the simulator: A line extension B is introduced in year 0. It cannibalizes to 85% (a common level), grows quickly at 15% p.a. and has 5% ROS (same as A because it isn’t truly distinct). The resulting value creation is 4%
- A premium product B is introduced (A being mainstream-priced). It cannibalizes 100%, grows at 15% and has 15% ROS. The resulting value creation is 53%.
- A new country is entered that hasn’t had the product before. There is no cannibalization, sales grows at 15% p.a., and ROS is 15% initially, with a half-life of 10 years. The resulting value creation is 31%.
It would seem that new products (or categories) or new geographies are the better way to go, which often is the case in real life.
The simulator below allows you to simulate your own product/market introduction. Enter inputs in the blue cells.
From this starting point, less stylized models can be built. They may include s-curves, different assumptions about risk and cost of capital, etc.
For more on this difficult topic, contact us by email or call +1-617-399-1300.
* Since it is a mature product, it is on average impossible to make an excess positive or negative return.
** Half-life means: Assume product B has ROS of 15%, and product A has ROS of 5% in year 0. Assume half-life is 10 years. Then the “excess” ROS has declined from 10% to 5% in year 10 (in year 40, profitability drops to the cost of capital because excess returns are never forever).