Ethiopia’s manufacturing industry is at the onset of development though there are recent upsurges in the number of firms. This study examines the effect of productivity improvement of the manufacturing sector on the macro economy, sectoral output, factor and household income and welfare of households. In order to investigate this, the study utilized the recursive dynamic computable general equilibrium (CGE) model. The recently updated 2005/06 Ethiopian SAM was used to calibrate the CGE framework. Three policy simulations of high, medium and low TFP growth rates were simulated on agro processing, non-agro processing and overall manufacturing activities. The study demonstrated that the manufacturing sector is a key driver of economic growth in particular; the findings suggest that productivity increase in agro processing, non-agro processing and overall manufacturing sector largely increases real GDP and sectoral outputs. Moreover, both rural and urban households are well-off in all the policy simulations. The study further extends its recommendation for Ethiopia to develop a strong industrial policy aimed towards promoting both agro and non-agro processing industries.