Meaning
Reductions in the profit earned per item produced occur when rising input costs or falling market prices narrow the gap between production cost and revenue. Management of unit margin compression requires a detailed analysis of every component of the manufacturing expense. This trend often appears as a production line moves from the early pilot phase to high volume output.
Cost Pressure
Increases in the price of raw materials or energy can quickly erode the profitability of a product. When unit margin compression occurs, the operations team must find ways to reduce waste or negotiate better terms with suppliers. Labor costs also play a role, especially if specialized skills are in short supply.
Scale Efficiency
Improving the yield of a production process can offset the impact of rising costs. Fixed expenses are spread over a larger number of units as the demonstrated rate increases, which helps to fight unit margin compression. Investing in automation is a common response to a shrinking gap between cost and price.
Pricing Floor
Competitive markets often limit the ability of a company to pass on cost increases to the customer. Analysis of unit margin compression helps to identify the point at which a product is no longer viable to produce. The cost of calling for a price hike too early is a loss of market share to more efficient competitors.
Decision makers must balance the need for profit with the requirement to stay competitive in a crowded field. Long term contracts with fixed prices can provide temporary stability but may eventually lead to a total cessation of production if costs continue to climb.
