How to improve profit margin when sales are growing but profit isn’t

Imagine opening your latest management accounts and finding that sales have risen from £500,000 to £600,000 while operating profit has fallen from £50,000 to £35,000. If you’re trying to work out how to improve profit margin, the key question to ask yourself isn’t whether the business has grown – it’s where the extra revenue went.

Let’s assume that your figures look like this:

Although your sales have increased by 20%, the additional £100,000 of revenue produced only £10,000 of extra gross profit. Higher overheads then turned that modest gain into a £15,000 fall in operating profit.

Winning more work on the same terms would make matters worse. Before chasing another sales target, you need to understand why the work you’ve already won is leaving less behind.

Find out which margin has fallen

Your profit margin is the proportion of sales you retain as profit:

Profit ÷ sales × 100

The answer changes according to the profit figure you use.

Gross profit is what remains after you deduct the direct cost of delivering your product or service. For a retailer, that will usually include stock. A service company may include chargeable labour or subcontractor costs.

If your gross profit margin is falling, it means your selling prices aren’t keeping pace with the cost of the work. Perhaps a supplier has increased its prices, or jobs are taking longer to complete than they used to. The problem may also be the work you’re selling. For example, strong demand for a low-margin service can pull down the result for the whole business.

By contrast, operating profit is what remains after you have deducted both direct costs and overheads. If your gross margin is steady but your operating margin has dipped, the extra cost will be found in your overheads. You might have recruited before the new work arrived, or your running costs could have risen without bringing in enough additional revenue.

If you understand the figures, you’ll know where to take action. A falling gross margin might suggest problems with pricing or delivery costs, while a falling operating margin with a stable gross margin could point towards overheads. Cutting office expenses won’t make underpriced work profitable, nor will raising prices remove a cost that your business no longer needs.

Your average margin may be hiding the problem

An overall margin can look respectable while one part of your business could be weakening it unnoticed.

Suppose one service produces a gross margin of 60%, while another manages 15%. If most of your recent growth has come from the second service, sales will rise while the average margin falls.

Customers can differ just as sharply. A large account may bring in substantial fees but require repeated revisions and a great deal of senior attention. A smaller customer buying a standard service could produce more profit for every hour your team spends on the work.

Break down revenue and direct costs in a way that reflects how you run the business. If you make decisions by service, compare services. If customers place very different demands on your team, compare customers.

That doesn’t mean every low-margin job should be refused. It may lead to more profitable work or make  use of spare capacity. What matters is that you know why you’re accepting the lower return.

Discounts and extra work can eat the profit

A modest discount can remove much more than the same percentage of your profit.

Suppose you charge £1,000 for a service that costs £700 to deliver. Your gross profit is £300. Give the customer a 10% discount and the price falls to £900, but the delivery cost remains £700. The customer saves 10%; your gross profit falls by a third.

Extra work has much the same effect. If your quote covers ten hours but the job regularly takes twelve, those unpaid hours are a discount that never appears on the invoice.

Review what happens when a customer asks for something outside the original agreement. Your team needs to recognise the extra work, record it and raise the question of fees before it disappears into the job. A carefully calculated price offers little protection if the scope keeps expanding.

How to improve profit margin once you know the cause

If your prices haven’t kept pace with costs, an increase may be justified. The effect can also be larger than you expect.

Return to the service priced at £1,000 with a delivery cost of £700. A 5% increase takes the price to £1,050 and gross profit to £350. Provided the cost and sales volume remain unchanged, a 5% change in price improves gross profit by 16.7%.

Customer behaviour is the uncertain part. Model what happens if some customers buy less or leave, rather than assuming the increase won’t affect demand.

If you’re considering how to increase prices without losing customers, a targeted review will often be easier to justify than adding the same percentage to every invoice. Look first at work priced using historic rates or jobs that now take considerably longer to deliver.

Make sure you’re using the right calculation. Margin and markup aren’t interchangeable. If something costs £100 and sells for £140, the £40 profit represents a 40% markup on cost but a gross margin of 28.6% on the selling price. HMRC’s guidance on margins and markup shows how easily the two terms can cause confusion.

Where direct costs are responsible for the decline, price may be only part of the answer. A retailer might negotiate better purchasing terms, while a service business may need to improve scheduling or record chargeable time more accurately.

Overheads deserve the same care. Cancelling something nobody uses is a genuine saving. Conversely, removing a cost that helps you win or deliver profitable work may simply reduce revenue later. Saving £10,000 won’t improve the business if it costs you £30,000 of gross profit.

Use figures that are recent enough to act on

Annual accounts can confirm that your margin fell, but they may arrive long after the damage was done.

Regular management accounts help you work out how to improve profit margin while there’s still time to respond. They let you compare revenue with direct costs and overheads throughout the year, ideally broken down in the same way that you make decisions about the business.

Comparing actual performance with your budget can also reveal where the assumptions no longer match reality. THP’s guide to budget versus actual analysis explains how to investigate those differences rather than simply noting that a target was missed.

There’s no universal margin that every business should achieve. Your target needs to reflect how your business makes money and the return you expect for the work and risk involved. A figure borrowed from a different type of business may give you a benchmark, but it won’t tell you what needs fixing in yours.

Find out where your profit is going

If sales are growing but profit isn’t keeping pace, THP’s management accounts service can help you find out why. We’ll shape the reports around the way you run your business, so you can see which work is earning a healthy return and where rising costs are beginning to cause trouble.

Get in touch today to discuss how regular management accounts could give you a clearer view of your margins before another busy month produces another disappointing result.