Revenue up, profit down: how to find the cause

Price, mix, costs and fixed overhead: the four leaks that drain profit while revenue grows, and how a margin bridge reveals them.

In this topic: Planning and control 11

It was a busy year. More customers, more orders, record revenue. And yet the accounts show less profit. It feels contradictory, but it happens all the time, in owner-managed companies and in business units of large groups alike. The cause almost always sits in a few recognisable leaks. If you know where to look, you can find them in an afternoon.

Start with the right measure: gross margin and net margin

Do not start with the bottom line. Start with gross margin: the share of revenue left after the direct cost of goods or services. If gross margin falls, the problem lies in price, discounts, purchasing or product mix. If gross margin holds and net margin still falls, the problem lies in the costs below it: staff, premises, overhead. That one split halves the search area.

The four leaks

1. The price you actually receive

The list price is not the price you keep. McKinsey calls what remains after all discounts and incentives the pocket price, and shows how on-invoice and off-invoice items let margin leak away unnoticed (source: McKinsey, February 2003). Think of volume discounts, free delivery, retrospective bonuses and payment discounts.

2. A different mix

If growth comes mainly from low-margin products, services or customers, revenue rises while profit falls. A change in sales mix also moves the break-even point (source: OpenStax, February 2019). The average hides this; you only see it per product or customer group.

3. Costs not passed on

Purchasing, wages and energy go up, the selling price stays put. McKinsey notes that companies lose margin when they pass on cost increases too late, and that agreed indexation is often not applied in practice (source: McKinsey, June 2019).

4. Fixed costs that grew along

Extra staff, larger premises, another vehicle: growth brings fixed costs that stay when revenue pauses. A cost structure heavy in fixed costs makes profit sensitive to swings in revenue (source: OpenStax, February 2019).

And sometimes: growth that costs money

New customers often need more attention, customisation or discount than existing ones. Your growth itself may be unprofitable. How to find out per customer is explained in which customers cost you money.

Compare with the industry

Is the cause in your business or in the whole sector? The sector data show how cost lines develop by industry, so you can see whether others face the same pressure.

The margin bridge: from last year to this year

The strongest way to find the cause is a margin bridge. Start from last year's profit and explain the difference with this year step by step: what came from price, what from volume, what from mix and what from costs. This split into price, volume and mix effects comes from variance analysis as described by Shank and Churchill (source: The Accounting Review, October 1977), and it is still used in pricing research today (source: Journal of Revenue and Pricing Management, 2021).

A bridge ends discussions. "The market is tough" becomes "the discounts to our three largest customers cost more than the entire cost-saving programme delivered". But a bridge points to causes, not decisions. Researchers note that a profit bridge cannot on its own determine which actions to take (source: Journal of Revenue and Pricing Management, 2023). That takes your knowledge of customers and markets.

What to do with your prices afterwards is covered in announcing a price increase. For monthly follow-up of margin and costs, good management reporting is the instrument.

The margin bridge step by step

You know the leaks and the logic. Below you will find the full method to build a margin bridge, a worked example, the tips that make the work much faster and the pitfalls that point an analysis in the wrong direction.

How can revenue rise while profit falls?

Usually through discounts, a shift towards low-margin products, cost increases that were not passed on, or fixed costs that grew along with revenue. A margin bridge shows which effect is largest.

What is a margin bridge?

An analysis that explains the difference in profit between two periods step by step, for example through price, volume, product mix and costs. It is often shown as a waterfall chart.

What is the mix effect?

The effect on profit of a shift in sales between products or services with different margins. If the low-margin share grows, average margin falls even when prices stay the same.

Where do I start looking for the cause?

With gross margin. If it falls, the problem is in price, discounts, purchasing or mix. If it holds, the problem is in the costs below it, such as staff and premises.

Sources

McKinsey: The power of pricing (February 2003)
McKinsey: The commercial response to cost volatility (June 2019)
OpenStax, Rice University: Principles of Accounting, Volume 2 (February 2019)
Smith: Journal of Revenue and Pricing Management (2021)