Discussion Issues and Derivations
What is the cost of using excess capacity?
Firms often use the excess capacity that they have on an existing plant, storage facility or computer resource for a new project. When they do so, they make one of two assumptions:
1. They assume that excess capacity is free, since it is not being used currently and cannot be sold off or rented, in most cases.
2. They allocate a portion of the book value of the plant or resource to the project. Thus, if the plant has a book value of $ 100 million and the new project uses 40% of it, $ 40 million will be allocated to the project.
We will argue that neither of these approaches considers the opportunity cost of using excess capacity, since the opportunity cost comes usually comes from costs that the firm will face in the future as a consequence of using up excess capacity today. By using up excess capacity on a new project, the firm will run out of capacity sooner than it would if it did not take the project. When it does run out of capacity, it has to take one of two paths:
&Mac183; New capacity will have to be bought or built when capacity runs out, in which case the opportunity cost will be the higher cost in present value terms of doing this earlier rather than later.
&Mac183; Production will have to be cut back on one of the product lines, leading to a loss in cash flows that would have been generated by the lost sales.
Again, this choice is not random, since the logical action to take is the one that leads to the lower cost, in present value terms, for the firm. Thus, if it cheaper to lose sales rather than build new capacity, the opportunity cost for the project being considered should be based on the lost sales.
How should we treat product cannibalization in capital budgeting?
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.
Product Cannibalization: These are sales generated by one product, which come at the expense of other products manufactured by the same firm.
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 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