The Impact of Unit Cost Reductions on Gross Profit: Increasing or Decreasing Returns?

Abstract

When asked about the impact of unit manufacturing cost reductions on gross profit, many managers and academics assume that returns will be diminishing, i.e., that the first cent of unit cost reduction will generate more incremental gross profit than the last cent of unit cost savings, consistent with the economic intuition about diminishing returns. (The product's appeal to the market is assumed to remain constant.) The present paper shows why gross profits actually increase in a convex fashion under typical demand assumptions, providing increasing returns with each additional cent of reduction in unit manufacturing cost. The intuition is that if q units are sold at the current price, the first cent of unit cost reduction increases the gross profits by q cents (keeping the price at the current level). But further cost reductions bring about greater pricing flexibility so that the optimal price decreases, thereby increasing the quantity to q'. Thus, the last cent of cost reduction produces an incremental profit of q' cents, where q' > q. The convex returns are captured graphically in the "profit saddle," a simple plot of gross profit as a function of unit cost and unit price. Decreasing unit costs produce additional returns from learning curve effects, reduced per unit channel costs, quality improvements, and strategic considerations. Of course, the fixed investment entailed in reducing unit-manufacturing costs must be weighed against the returns from doing so, suggesting some optimal level of unit cost reduction efforts. Cost reduction has traditionally been the purview of the manufacturing function within the firm, and has been emphasized in the later phases of the product-process life cycle. Marketing managers, on the other hand, have focused on generating sales revenues through pricing, product positioning, promotion, and channel placement. The present paper suggests that the traditional view be questioned. The marketing function, and new product planning in particular, may want to consider unit manufacturing cost reduction a potent tool in pricing new products for marketing success.