Title: THE IMPACT OF COST REDUCTION ON PROFITABILITY OF

MANUFACTURING COMPANIES IN HARGEISA SOMALILAND.

Authors: Maxamed Hassan Muhumed

Cabdirizaq Mohammed Ahmed

Whatsapp number: 0633818818

Gmail: moh09152269@[Link]

Chapter Two: Literature Review

 CHAPTER TWO: LITERATURE REVIEW

2.1 Definitions and Concepts of the Cost Reduction

Cost reduction strategies are an organization's conscious and orderly methods by which they
can obtain lower the production and other operational costs while still upholding the quality
and efficiency of their products and services (Mwangi & Muthoni, 2020). Speaking in the
scope of manufacturing companies, cost cutting is a vital activity for ensuring
competitiveness and financial strength, especially in resource-limited, volatile, and input
costs increasing environs, as mostly encountered in Sub-Saharan Africa (Akinboade, 2015).

Cost reduction strategies might be generally divided into four big categories, i.e., labor cost
reduction, material cost control, overhead cost management, and distribution/sales cost
optimization.

 Labor Cost Reduction: Workforce is the most probable source of total production
costs, particularly where labor-intensive industries are involved. Measures such as
automation, skill enrichment, and better workforce planning are used to re-energize
the employees while curtailing the workforce and the overtime expenses are common
(Kamau & Wanjiru, 2019). For example, with lean manufacturing as the case, an
organization can use the technique of worker rotation and multi-skilling the workforce
to lower the unproductive time and intensify worker performance (Womack & Jones,
2003). As well, automation can be a solution to more redundant manual activities
which leads to manpower reduction and its concomitant costs.

 Material Cost Control: Materials are the main input in manufacturing and hence the
management of these costs becomes a very crucial point for profit maximization.
Several successful strategies that firms use to control the costs include bulk
purchasing, supplier consolidation, inventory optimization, and waste reduction
through more stringent quality control (Maseko, 2017). Adopting methods such as
Material Flow Cost Accounting (MFCA) significantly helps businesses in locating
material losses and hence, the success of various cost-saving initiatives. Research has
consistently proven that firms with the best material management systems have a
direct link to lower production costs and better profit margins (Karimi & Moturi,
2013).
  Overhead Cost Management: Overhead costs usually involve indirect costs such as
utilities, rent, administrative salaries, and equipment maintenance. The latter are
incurred on resources that are not directly connected to the production process but
they still significantly contribute to the total expenses. Some of the initiatives being
taken by organizations to optimize energy are the adoption of energy-efficient
technologies, reducing administrative expenses, and adhering to the budget while at
the same time ensuring performance (Kamau & Wanjiru, 2019). One of the ways
through which costs can be reduced is by the introduction of preventive maintenance
schedules that machine breakdowns and energy consumption can be cut leading to
energy savings.
 Distribution and Sales Cost Optimization: Distributi.... Essential for the
Profitability of Manufacturing Enterprises. Distribution and marketing-related
expenses, as well as the most costly aspect of production, are the key factors in the
valuation of company profit generation. The most widely accepted and potential
sources of company cost reduction in the discussed sphere are logistics, route
optimization, outsourcing of non-core transportation services, and embracing of
innovative digital marketing strategies (Owolabi & Makinde, 2014). In combination
with this, the integration of technology into sales and customer service results in the
reduction of costs and improved service efficiency.

These cost reduction strategies should commensurate with the wider operational and strategic
goals of the organization. As per Nyambura (2021), the cost reduction campaigns that are
fruitful are those ones that institute a trade-off in expenditure with the requirement of still
maintaining or even improving the quality of the products and the service delivery. Besides,
these techniques have to be long-term solutions that are built into the company's culture and
operations model.

Globally, cost reduction, according to the Chartered Institute of Management Accountants

(CIMA), London, is the accomplishment of a real and long-lasting decrease in the unit cost of
goods produced or services provided, without compromising the ability of the product to
fulfill its intended function. Cost reduction, according to Growth and Kinney (1994), is the
act of lowering current fixed expenses and variable costs by comparing total costs to income
earned, which will either directly or indirectly affect an organization's financial performance.
According to Nwatu et al. (2020), a continuous process of cost and function analysis for the
further economy in the application of elements of production is what makes cost reduction a
planned positive method to lower expenditure and a corrective function.

Cost reduction, according to John (2017), is the practice of reducing waste and streamlining
procedures in order to lower expenses and/or the cost of goods sold. Cost reduction,
according to Nwatu et al. (2020), is the method utilized by businesses to lower their expenses
and boost earnings. They continued by saying that manufacturing companies who are
concerned with how organization items move from one stage of processing to another in such
a way that bank fees and travel expenses are minimized consider cost reduction to be a
crucial component. Regionally, Mamidu and Akinola (2021) studied the effect of cost
management on the performance of manufacturing companies in Nigeria. Secondary data
sourced from the financial reports of the firms was used to analyze the situation. The data
were tested using the Ordinary Least Square Linear Regression model. The result shows that
equity is significantly related to the profitability of the firms while total asset was positively
and significantly related to profitability. Cost management on the other hand has a significant
impact on profits. The study concluded that cost management has a significant influence on
profitability. The study then recommended that company policymakers and transaction
advisors should be keen on making cost management policies to be applied since they greatly
impact the financial performance of the company.

Locally,this study focuses on examining how cost reduction contributes to future business
growth within the Somaliland manufacturing sector. Conducted in the context of Somaliland's
business and entrepreneurial landscape, the research aims to design a cost reduction system
that can enhance the market position of local businesses.

The concept of profit maximization is very useful in selecting the alternatives in planning at
the firm level. Profit forecasting is an essential function of any management. It relates to
projection of future earnings and involves the analysis of the corporate behaviors, the sales
volume, prices and competitors’ strategies etc. The main aspects covered under this area are
the nature and control strategies adopted by managerial decision making as towards attaining
corporate goals with its budget limit. Cost reduction helps firms to improve its profitability
and competitiveness. Jingan (2004) added that cost control has a regulatory effect. For better
performance and better results certain means of control have been evolved. Such cost
instruments are budgetary control and standard costing. Cost reductions are analyzed via
variance analysis.
2.1 Definitions and Concept of the Profitability
Profitability (Dependent Variable)
Profitability is the degree to which a company is a going concern, as it tells the extent of the
business operations regarding revenue and costs over a specific period. It is a very important
performance measure that highlights profits, solvency, and growth potential among others,
especially for the manufacturing enterprises in competitive and resource-constrained
environments (Sartono, 2010). In detail, for small and medium-sized enterprises (SMEs),
profitability not only keeps them alive but also serves as a basis for new products, job
creation, and capital reinvestment.

Many standard indicators are available for assessing the profitability of a business:

 Net Profit Margin: It is a ratio that indicates profitability thus calculates net income
as a percentage of total revenue. This is obtained by the formula: net income/net sales.
It shows the profit of every sales dollar a firm earns. A larger net profit means more
robust cost savings and price policies, indicating operational efficiency (Maina, 2018).
For manufacturing firms, the idea is they identify the degree of production costs and
the administration of operating expenses.

 Return on Assets (ROA): ROA is one of the tools to measure a company's

profitability as it shows how efficiently a firm is using its assets to get the income.
The formula used to derive ROA is net income divided by total assets. A higher ROA
number means the company is using the assets at its disposal efficiently and is more
productive (Karimi & Moturi, 2013). The asset base is largely the domain of the
manufacturing sector that is heavily invested in machinery and infrastructure.

 Return on Investment (ROI): The calculated value of an investment's profit or loss

as a percentage of its cost is ROI. Also, the term refers to the set of technological,
infrastructural, and process changes in the industry. It is a practical metric to check for
the impact of the capital devoted towards the firm's business that is not the only
source of profit that works for the firm's desire (Mutua & Kimani, 2021.).

Profitability is influenced by both internal and external factors. Internally, cost management,
productivity, quality control, and capacity utilization are critical drivers. Externally, market
conditions, input prices, and competition affect a firm’s pricing power and cost structure.
Several studies across Africa and globally confirm a strong positive correlation between
effective cost reduction strategies and improved profitability among manufacturing SMEs
(Mwangi & Muthoni, 2020; Nyambura, 2021).

Thus, in manufacturing contexts like Hargeisa, Somaliland, where firms face unique
challenges such as limited infrastructure, fluctuating input costs, and regulatory constraints,
the ability to implement robust cost reduction strategies can significantly influence their
profitability outcomes.

2.2 Theoretical review

2.2.1 Cost reduction theories (Independent variable)

Cost reduction strategies encompass a wide range of managerial, operational, and financial
practices aimed at minimizing production and operational costs without compromising
product quality or organizational efficiency. These strategies are particularly vital for
manufacturing firms, where tight margins, competition, and resource constraints make cost
optimization a critical determinant of organizational sustainability and profitability (Drury,
2013).

Lean Manufacturing theory

Without a doubt, lean manufacturing is the most popularly and widely studied cost-reducing
strategies in manufacturing. Rooted in the Toyota Production System, lean manufacturing
focuses on the elimination of activities that do not add value to the end product and are most
likely understood as waste (Ohno, 1988). Womack and Jones (1996) said, "Lean means doing
more with less," that is, less human effort, less equipment, less time, and less space while
delivering exactly what the customer wants. The five basic principles of lean define the value,
map the value stream, create flow, establish pull, and pursue perfection (Womack & Jones,
1996). Empirical research has shown that lean implementation significantly lowers lead time,
reduces inventory costs, and increases operational flexibility (Shah & Ward, 2003), all
resulting in decreased operational expenditures.

Just-in-time production theory

Closely aligned with lean practices, Just-in-Time (JIT) production is another pillar of cost
reduction endeavors in organisations. JIT produces only what is needed at the moment, and in
the quantity required (Sugimori et al., 1977). Therefore, this system minimises the costs of
holding inventories, while saving it from the risks of obsolete, excessive stock, and tying up
capital in materials (Schonberger, 1982). Studies have concluded that firms utilising JIT
systems reduce storage and logistics costs at the same time improve cash flow and
responsiveness to market demand (Sakakibara, Flynn, Schroeder, & Morris, 1997).

Theory of Kaizen and Continuous Improvement

Kaizen, the Japanese philosophy of continuous improvement, emphasizes small, incremental

changes in processes to reduce inefficiencies and enhance productivity (Imai, 1986). Unlike
top-down innovation strategies, Kaizen encourages worker-level participation in identifying
inefficiencies and proposing practical solutions. Cumulatively over time, these changes can
bring significant reductions in production costs (Liker, 2004). It contains itself within the cost
leadership strategies because it enhances creating a culture of operational excellence at
minimal major capital investments.

Theory of Six Sigma

Six Sigma is a data-driven approach to quality management with the intention of reducing
process variations and defects (Pyzdek & Keller, 2014). The Six Sigma methodology in
general, especially its DMAIC (Define, Measure, Analyze, Improve, Control) cycle,
constitutes systematic identification and removal of the causes of defects and inefficiency in
processes. The billions of cost savings that Citrus, GE, and other industrial leaders have
attributed to Six Sigma implementation are interesting watersheds (Harry & Schroeder,
2000). The cost savings directly come from reduced scrap, less rework, fewer warranty
claims, and less variation in processes.

Activity-Based Costing (ABC) theory

ABC is another managerial tool that can support large-scale cost reductions. ABC really and
closely ties overheads and indirect costs to the actual activities and resources that
consumption is consuming during production itself by being much closer to the actual
operations (Kaplan & Cooper, 1998). The granularity of this view allows managers to see and
focus on intensive activities or process redesigns or eliminations. Compared to conventional
costing methods, ABC is a more realistic reflection of the actual cost of production, then
allowing better decision-making on cost control as well as strategic pricing (Drury, 2013).
Theory of Constraints (TOC)

The Theory of Constraints (TOC) postulated by Goldratt (1984) presents another avenue
along which cost reduction can take place at the bottlenecks existing in the systems. Theory
maintenance attests that any systems performance limits is that of its most constraining
element (the bottleneck) and that what improvements can be made must focus on the removal
of that constraint. Such an action would come to increase throughput, lessen work in progress
inventories, and lower overall costs of the firms (Goldratt & Cox, 2004). TOC focuses more
on throughput than direct cost reduction, which offers a strategic way of getting cost
efficiencies without sacrificing total output.

the key cost factors and processes which have a direct relation with profit performance.
Profitability is a subdiscipline of the economic measurement of each activity with respect to
costs and benefits.

By TQM theory

A TQM paradigm is an overall system for long-term success through customer satisfaction
via all members of an organization. Quality improvement policies are treated as core values,
leading eventually to cost reduction through reduced waste, rework, or customer complaints
(Deming, 1986). TQM systems usually maintain process efficiency and product quality with
continuous feedback loops, cross-functional teams, and statistical tools. This culture of
quality goes along with cost containment by minimizing the cost of poor quality (Juran,
1999).

Value-chain Optimization theory

The value-chain concept developed by Porter (1985) is the strategic analysis of activities
involved in the production and delivery process so that opportunities for costs could be
identified. By disaggregating the firm into its strategically relevant activities-inbound
logistics, operations, outbound logistics, marketing, and service-managers can identify high-
cost processes that do not add value to the customer. Value-chain optimization may include
others' outsourcing, process automation, or workflows' redesign to cost less.
2.2.2 Profitability theories (Dependent Variable)

Profitability may serve as one of the most fundamental measures of business performance
and sustainability. In manufacturing firms, it reflects the efficiency with which inputs are
converted into outputs and the refinement of strategic decisions like cost control and process
optimization into actual financial gains. Empirically, profitability is often treated as one
dependent variable affected by various internal or external variables, among them being cost-
reduction strategies (Narayana, 2020).

Profitability theory definition

Profitability refers to the ability of a firm to generate earnings in relation to its expenses and
the other relevant costs incurred during a specified period (Brigham & Houston, 2019). It is
an output-oriented financial construct that covers different indices, including gross profit
margin, operating profit margin, return on assets (ROA), return on equity (ROE), and net
profit margin. In manufacturing, these indices serve as a complete measure of how well the
organization controls cost drivers and processes affecting profit performance. Profitability is
a subdivision of economics with respect to an area that deals with the measurement of each
and every possible activity concerning its costs and benefits.

Financial Ratios Generally Associated with Profitability

Measuring profitability usually involves the use of some key financial ratios, which include:

1. Gross Profit Margin (GPM): Measures the efficiency of production in terms of sales less
the cost of goods sold (COGS). A higher GPM thus indicates being in control of costs in the
manufacturing process (Horngren, Sundem, & Stratton, 2005).

2. Operating Profit Margin (OPM): Is limited to assessing the core operations of business
by deducting operating expenses from gross profit, thus directly influenced by operational
efficiency and lean practices (Drury, 2013).

3. Net Profit Margin (NPM): Percentage of revenue left as net income after all expenses,
taxes, and interest have been deducted. This ratio represents a comprehensive view of
profitability (Brigham & Ehrhardt, 2017).

4. Return on Assets (ROA): Measurement of how well a company uses its assets to create
profit. It indicates how well a firm uses its assets, which is especially crucial for capital-
intensive manufacturing firms (Ross, Westerfield, & Jordan, 2016).
5. Return on Equity (ROE): The return generated on the shareholders' equity. It acts as a
key indicator by which investors judge the firm in terms of financial health and growth
potential (Brealey, Myers, & Allen, 2019).

Determinants of Profitability in Manufacturing

Profitability in the manufacturing sector is determined by a mix of cost structures, market

conditions, technological capabilities, and managerial practices. Cost reduction strategies can
greatly influence the cost structure and, thus, the bottom-line performance (Porter, 1985).
Profitable firms put a premium on the efficient use of resources, reducing anything that can
be conceived as waste, and optimizing workflow. Firms that succeed in implementing lean,
Six Sigma, and other cost-reduction methodologies can positively affect cost reduction as
well as product quality and customer satisfaction, in turn, positively affecting sales and
revenue generation (Ittner & Larcker, 2001).

Cost Reduction and Profitability: The Relationship

Numerous empirical studies have been conducted on the relationship between profitability
and the practice of cost reduction. Fullerton, Kennedy, and Widener (2014) show that firms
using comprehensive lean strategies show great improvement in profitability measures,
particularly the OPM and ROA. Along those lines, Hendricks and Singhal (2001) showed that
firms that have successfully implemented quality improvement programs such as Six Sigma
experience superior financial performance, due to reductions in defect rates and customer
complaints.

Accounting Based Strategies make the following arguments: "The implementation of

Activity-Based Costing historically generates more accurate cost information, enabling better
pricing decisions and allocation decisions that ultimately enhance profitability" (Kaplan &
Cooper, 1998). JIT systems also lower inventories, holding, and transaction costs, all of
which help enhance net margins and asset turnover ratios (Callen, Fader, & Krinsky, 2000).

Strategic Importance of Profitability

Profitability is vital for strategic decision-making beyond the realm of financial reporting. It
affects capital investment choices, pricing choices, and the competitive position. Sustained
levels of high profitability allow reinvestment into innovation, technologies, and development
of the skill base-all of which further enhance productivity and competitiveness in the market
(Barney & Hesterly, 2015). In this sense, profitability, in itself, is not just an indicator of
success, but rather a feedback loop that induces continuous improvement and realignment of
strategy.

Theoretical Perspectives

Theoretically, profitability can be examined from the standpoint of Resource-Based View and
Porter's Value Chain Model. The RBV asserts that a competitive advantage-and thus superior
profitability-is realized through firm utilization of VRIN resources (valuable, rare, inimitable,
and na) (Barney, 1991).

Cost reduction strategies can be viewed as capabilities that heighten the efficiency of
resource use, which similarly affects profitability. On the other hand, Porter's (1985)
analytical framework posits that cost leadership via operational efficiency enables firms to
realize higher margins in the form of competitive pricing or improved cost structures, thus
enhancing profitability.

2.3 Imperical Studies

Various research studies were carried out on cost reduction measures and their impact on
profitability. (Siyanbola & Raji, 2013) on their study of the impact of cost reduction
onmanufacturing industries’ profitability. Findings from their research showed that cost
reduction has a significant and positive impact on profitability of manufacturing companies in
Nigeria. In their research budget was considered as the basic tool for achieving effective cost
reduction and their study was conducted in West Africa, on West African Portland Cement
Company (WAPCO) and made use of Pearson correlation for data analysis.

Questionnaires were used as research instruments. Akeem (2017) study on the effect of cost
reduction and cost control techniques in organizational performance, findings revealed that
there is a direct relationship between cost control, reduction and profit.

Thus, the study concluded that for an organization to ensure more profit growth, there is need
to control and reduce cost to an acceptable limit. A descriptive survey research was adopted.
Questionnaires were used as research instruments. Also, (Abdul & Isiaka, 2015) study on the
relationship between cost management and profitability, a study of selected manufacturing
firms concluded that the relationship between cost management and profitability is
statistically significant. Questionnaires were randomly distributed to manufacturing
companies in Nigeria and data collected were analyzed using descriptive and non-parametric
statistics.
  Labor Cost Reduction Strategies

Labor costs represent a substantial component of total manufacturing expenses. Studies

consistently show that enhancing labor efficiency, reducing excess staffing, and implementing
lean manufacturing strategies positively impact profitability. For instance, Mwelu et al.
(2014) conducted a study on manufacturing firms in Uganda and found that lean
manufacturing significantly improved profit margins. Similarly, Alaaraj and Bakri (2019)
reported that lean practices led to financial improvements in South Lebanon's manufacturing
sector. Nigerian researchers such as Adesina and Tiamiyu (2025) have emphasized the need
for workforce automation and effective labor management to reduce payroll expenses and
boost profitability.

 Material Cost Reduction Strategies

Materials and production inputs are another key area where cost savings can enhance
profitability. Techniques like target costing, value engineering, and material flow cost
accounting (MFCA) have been found effective in this regard. Al-Hattami, Kabra, and
Lokhande (2020) demonstrated the usefulness of target costing in minimizing material costs
in manufacturing firms. Fadjarenie, Rachmadani, and Tarmidi (2024) provided empirical
evidence from Indonesia indicating that MFCA helps in identifying and reducing material
waste, thus improving profit outcomes. Egbide et al. (2019) also showed that Nigerian
manufacturing firms experienced growth through strategic material cost management.

 Sales and Distribution Cost Reduction

Sales and distribution costs can significantly erode profitability if not properly managed.
Empirical studies from Nigeria have shown that excessive marketing and distribution
expenditures negatively affect net profit margins (Nurudeen & Ajibola, 2024). Sekyi (2022),
in his study on Ghanaian manufacturing firms, emphasized the role of aligning pricing
strategies with cost control to enhance growth, which indirectly points to improved
profitability. However, literature on this topic outside of Africa remains limited, highlighting
a potential area for further research.

 Overhead and Administrative Cost Reduction

Overhead costs, including administrative expenses, utilities, and facility maintenance, are
often overlooked but can drain profits if unmanaged. Studies indicate that robust budgeting,
 standard costing, and variance analysis can help control overhead. Said, Mahad, and Mahad
(2019) found that eliminating inefficiencies through structured cost control significantly
enhanced profits in Somali manufacturing firms. A report by Espel et al. (2020) emphasized
that technology-enabled cost reductions in administrative functions can lead to savings of up
to 20%.

 Comparison of African and Global Contexts

While African studies tend to focus on traditional cost control mechanisms such as budgeting,
lean practices, and target costing, global literature also explores advanced techniques
including MFCA, automation, and AI-based cost management. For instance, the South
African context (Mchavi & Ngwakwe, 2025) supports the use of target costing in improving
profitability, aligning with findings from other regions such as Oman and Indonesia.
Globally, research tends to include more technologically advanced strategies for cost
reduction, as indicated in consultancy reports and case studies.

2.4 Conceptual Frame Work

2. Independent Variable: Cost 1. Dependent

Reduction Variable: Profitability

 Labor Cost Reduction  Net Profit Margin (NPM)

 Material Cost Reduction  Return on Assets (ROA)

 Sales and Distribution Cost  Return on Investment (ROI)

Reduction

3. Mediating Variable: Contextual Factors

in Hargeisa

 Limited infrastructure
 Scarce skilled labor
 Import reliance and exchange volatility
 Competitive pressures