Choice of Cost Reduction Mode in a Contract Manufacturing Supply Chain with Substitutable Products

Cost reduction investment is relevant for manufacturers to achieve competitive advantage. This article investigates the choice of cost reduction mode in a supply chain with one original brand manufacturer (OBM) whose product incurs common and dedicated costs and one contract manufacturer (CM) offering substitutable products. The CM sharing OBM's investment spillover may be worse off with strong spillover. A costly common component may not lead the OBM to reduce common cost, especially when its investment substantially spills over to the CM. This spillover causes intense competition so that the OBM reduces dedicated cost; this choice also applies to a costly dedicated component. The OBM is incentivized to reduce common cost if the common component is costly and the spillover is weak. This article further analyzes the case that the CM invests in cost reduction and finds its mode choice opposite to the OBM's because of the direct benefits of cost reduction. Even with a costly dedicated component and strong spillover, the CM does not necessarily reduce dedicated cost but it reduces common cost. The OBM's and CM's investments may create a win–win mode.