The film begins in Detroit, Michigan in 1963, as an amateur Black girl group known as The Dreamettes enter a local talent competition. Backstage, the three girls - full-figured lead singer Effie White (Jennifer Hudson), Deena Jones (Beyoncé Knowles) and Lorrell Robinson (Anika Noni Rose) - meet Curtis Taylor, Jr., an ambitious Cadillac dealer with plans of breaking into the music business. Placing himself as their manager, Curtis arranges for the Dreamettes to tour as backup for a regional R&B star, James "Thunder" Early (Eddie Murphy). The tour takes the company - also including Effie's songwriting brother C.C. (Keith Robinson) and Jimmy's manager Marty (Danny Glover) - across the country on the "Chitlin Circuit."
Hoping to help Jimmy and the girls cross over to mainstream audiences, Curtis starts his own record label, Rainbow Records ("The Sound of Tomorrow"), out of his car dealership's office, and makes C.C. his head songwriter. However, when Rainbow's first single fails after a white pop group releases a cover version, Curtis and his sidekick Wayne (Hinton Battle) turn to payola .By paying the right people, Curtis manages to get Jimmy and the Dreamettes to the top of the Billboard Hot 100 and into a headlining gig at the Apollo Theater. Offstage, Effie is quickly becoming infatuated with the slick-talking Curtis, and Jimmy - a married man - begins an adulterous affair with Lorrell, who becomes equally as lovesick as Effie.
Marty becomes increasingly frustrated by Curtis' plans to make Jimmy's image more pop-friendly, to the point that he walks out on Jimmy, both his client and best friend. However, when Curtis finds that he cannot completely remake Jimmy Early into a pop act, he shifts his attention back to the Dreamettes. Feeling that Effie's voice is too "churchy" and her figure too large to attract white audiences, Curtis appoints the slimmer Deena as the lead singer of the Dreamettes.
With the aid of new songs and a new more glamorous image, Curtis and C.C. transform The Dreamettes into The Dreams, a top selling pop act whose popularity rivals that of The Beatles. However, the betrayed Effie does not take kindly to being reduced to Deena's backup and begins acting out, becoming even more unruly when Curtis's affections also turn towards Deena. When Effie, feeling ill, does not turn up to rehearse for the Dreams's debut in Las Vegas, Curtis replaces Effie with his secretary, Michelle Morris (Sharon Leal). Effie (who has just learned she is pregnant) arrives at the Caesar's Place venue just as Michelle does, and after a nearly violent argument, finds herself without her group and without Curtis. This is the scene where Effie bursts into the classic "And I Am Telling You I'm Not Going."
The film jumps ahead to the early 1970s. Effie is broke and has become an alcoholic, raising her seven-year-old daughter Magic (Mariah I. Wilson) alone on welfare in the burnt-out inner city of Detroit. On the other hand, Rainbow Records has moved to Los Angeles, where it prospers with Deena Jones & the Dreams - as the group is now known - and many other pop acts. Curtis and Deena are now married and, wanting to expand the Rainbow empire into film, Curtis plans to have the unwilling Deena star in a Black prequel to Cleopatra. Hoping that the struggling film project will never get off the ground, Deena begins secretly meeting with other studios to take a part in another film.
Jimmy Early's star has long faded, and Curtis has little interest in revitalizing his career. Unsatisfied with both his wife and his long-term mistress Lorrell, Jimmy turns to drugs for affection. C.C., although in an ironic relationship with Michelle, continues to reach out to Effie, who stubbornly ignores the letters and money he sends. Eventually, Effie swallows her pride and, with Marty's help, returns to singing and secures gigs at a small Detroit club.
In 1974, Rainbow Records hosts a tenth anniversary TV special featuring its roster of stars. Midway through his performance of a pop-friendly love song, Jimmy, tired of his white-washed image, breaks out into a wild James Brown-esque funk number and drops his pants on live TV. Curtis terminates Jimmy's contract, and Lorrell, weary of their eight-year affair, leaves Jimmy behind as well. Several days later, Jimmy dies of a drug overdose.
Angry over Jimmy's death and frustrated with Curtis' attempts to "drain the soul" out of his music to create a "new sound" (disco), C.C. walks out on the company, going back to Detroit to find Effie. The two siblings reconcile at a wake for Jimmy and work together to produce Effie's comeback single, "One Night Only". Just as the record begins gaining radio play, however, Curtis strikes: using payola, he forces radio DJs to play a disco cover of "One Night Only" by Deena Jones & the Dreams instead of Effie's original. Deena finds out about Curtis' payola schemes, and calls Effie and C.C., who arrive at the Rainbow offices with Marty and a lawyer. Hoping to avoid being reported to the FBI for payola, Curtis works out a deal with the lawyer: Rainbow Records will fund a new label for C.C., which will allow Effie's record national distribution. Curtis confronts Deena, only to find that Effie's victory has inspired Deena to leave Curtis and make it on her own. She and Effie also finally reconcile after years of being estranged.
As a result, Deena Jones & the Dreams give a farewell performance at the same Detroit Theater where they first met Curtis, Jimmy, and Marty twelve years ago. At the conclusion of the concert, Effie joins Deena, Lorrell, and Michelle onstage, and the reunited Dreams give one final performance of their signature song, "Dreamgirls". Fittingly, it is Effie who sings lead, while the other three ladies sing back-up.