Impact of inventory cannibalisation on a retailer selling substitutes

The reasons customers substitute, are well understood from an economic perspective. However, its exact impact on retailer's inventory and profit is not, when customers substitute as a result of a shortage. Shortage of one product may lead to demand spillover, due to substitution, resulting in shortages for the second product. We call this inventory cannibalisation. This is a store level, retailer observed phenomenon that is a direct result of customers' willingness to switch between substitutes due to stockout of one product. Many retailers are experiencing stockouts related to substitution, resulting in a significant loss of revenue. We model a retailer's selling two substitutes, facing price-sensitive stochastic demand. Our model incorporates cannibalisation explicitly and generalises the existing literature on inventory substitution. We perform analytical and numerical analysis to study the impact of stockout-based substitution and the related inventory cannibalisation on retailer's decisions. We find that the impact of cannibalisation is felt most acutely by the retailer for products with low degree of substitution.