The Profit Saddle : Do Unit Cost Reductions Yield Increasing or Decreasing Returns ? ( Running title : THE PROFIT SADDLE )

When asked about the impact of unit manufacturing cost reductions on total gross profit, many managers and academics assume that returns will be diminishing, i.e., that the first dollar of unit cost reduction will generate more incremental gross profit than the last dollar of unit cost savings, consistent with economic intuition about diminishing returns. The present note shows why total profits actually increase in a convex fashion under typical demand assumptions, providing increasing returns with each dollar reduction in unit manufacturing cost. These convex returns are captured graphically in the profit saddle, a simple plot of total profit as a function of unit cost and unit price. Further returns derive from learning curve effects, strategic considerations, quality improvements, and channel benefits. Of course, the fixed investment entailed in reducing unit manufacturing costs must be weighed against the increasing 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 policy, product design & positioning, advertising & promotion and channel management. The present note suggests that the traditional view be questioned. We suggest that the marketing function, and new product planning in particular, consider unit manufacturing cost reduction a potent tool in positioning new products for future marketing success. The Profit Saddle: Do Unit Cost Reductions Yield Increasing or Decreasing Returns? How important are unit manufacturing costs in the design and development of new products? Obviously, cost matters, but, typically, the determination of unit cost comes late during the development process, long after many decisions have been taken with respect to the design and feature levels of the new product. After all, how can cost be known until the details of components, parts, manufacturing processes and production volumes have been specified? Yet, there are good reasons to focus on cost reduction earlier in the process, and to let the potential for cost reduction guide the choice of product concept and the allocation of resources for its development. Many questions arise in determining the optimal cost reduction strategy during NPD. For example, should the marketing members of multifunctional NPD teams be concerned with cost-related decisions even though these issues have traditionally been the purview of the engineering and manufacturing functions of the firm? Our analysis shows that, in many cases, marketers should be involved in these decisions from the outset. When should cost reduction be emphasized during NPD? Unlike traditional approaches, our analysis suggests that cost reduction should be considered early in the process, alongside concept selection and the setting of feature levels. What is the profit impact of reducing unit production costs do incremental cost reductions yield increasing or diminishing returns? We show that within a range, contrary to the economic intuition of diminishing returns, cost reduction has increasing returns. Further, how should cost reduction proceed and how much investment in cost reduction is optimal? Of course the answer here is quite complex, but we suggest that careful concept selection, feature-level setting, target costing, design for manufacturability and assembly, set-based methodologies, and the use of postponement, modularity and platforms can all help. In this article, we explore the who’s, what’s, when’s, how’s and why’s of cost reduction during new product development. Our findings regarding the profit impact of cost reduction efforts run counter to many managers’ intuitions. We find that early and effective cost savings efforts may improve the chances of new product success to a greater extent than is commonly believed, and that the payoff from unit cost reduction justify significant investment in “smarter” design and should be made early in the NPD process. In fact, the potential for unit cost reduction may be an important criterion when selecting a new product concept from amongst competing ideas. Increasing or Decreasing Returns? Consider the three possibilities depicted in Figure 1. In the lower curve, investing in unit cost reduction improves total profit in a diminishing fashion. Figure 1: Do unit cost reductions Yield Increasing or Decreasing Returns? Increasing Returns to Unit Cost Reductions Diminishing Returns to Unit Cost Reductions M ax im um P ro fit Unit Cost M ax im um P ro fit That is, the first dollar of unit cost reduction has a larger impact on total profit than the next dollar of reduction. This fits the general economic intuition of diminishing returns. The middle curve depicts a linear relationship between cost and profit, consistent with the idea that unit costs don’t necessarily affect revenues (through lower prices and higher volumes), so the firm reaps additional profits from cost reduction in the form of proportionately higher margins. Finally, the top curve depicts increasing returns, implying that cost reduction produces benefits beyond simple unit margin improvements at existing volumes, and that prices and volumes must adjust to unit cost reductions in order to maximize profit. It is this third scenario, somewhat counterintuitive to many managers, that our analysis supports. A simple proof follows. Assumptions: [A1] Downward Sloping Demand: The quantity demanded, p q , is monotonically decreasing as a function of price: i.e., 0 p q for all p in the support. [A2] Positive Gross Profit: Unit cost, c, is such that positive gross profits can be generated at some positive price, p, in the support of the demand function i.e., 0 c p for some 0 p q . [A3] Unique Profit-maximizing price: The gross profit function, p q c p , is strictly quasi-concave and smooth in p, and therefore has a unique, profit-maximizing price, p*. See, for example, Figure 2.