Revenue growth doesn’t automatically translate into a healthier business. Sometimes profits grow more slowly than revenue; sometimes they stay flat; and sometimes they decline – even as revenue increases. Before making any major changes, it’s important to first understand what has changed in pricing, costs, customer mix, and efficiency.
Why Can Revenue Increase While Profit Decreases?
Revenue can increase while profit decreases for a number of reasons. Quite often, a business’s costs are rising faster than its revenue. Sometimes a business encounters a large, unplanned expense. Other times, businesses see revenue rising due to new sales, but those sales are less profitable.
To determine why profits are decreasing while revenue increases, start by identifying whether the deterioration occurs in gross profit, operating profit, or both.
Consider a hypothetical company:
Year 1
Revenue: $2,000,000
COGS: $1,100,000
Gross profit: $900,000
Operating expenses: $650,000
Operating profit: $250,000
Year 2
Revenue: $2,500,000
COGS: $1,500,000
Gross profit: $1,000,000
Operating expenses: $800,000
Operating profit: $200,000
In this case, revenue increased by 25%, yet operating profit declined 20%. The difference is that the cost of goods sold increased almost as much as revenue, and the slight uptick in operating expenses eliminated any increase in profit.
Reasons Profit May Decrease While Revenues Rise
1. Sales Mix Has Shifted Toward Lower-Margin Products or Customers
Not all revenue is equally profitable. If Product A has a 60% gross margin and Product B has a 20% gross margin, a shift toward Product B can increase sales while reducing the overall margin.
To know whether this is what’s causing your revenue to grow more than profit, compare revenue and gross profit by product, customer, channel, and business line. Separate volume, pricing, cost, and mix effects. Then identify which parts of the business create incremental profit – not just incremental sales. Low-margin products may still contribute toward fixed costs or strategic relationships.
2. Labor Costs Are Rising Faster Than Revenue
Hiring ahead of demand, wage increases, overtime, and increasing use of independent contractors can all make growth more expensive. If revenue rises 20% but labor costs rise 35%, examine whether the additional capacity is producing sufficient value.
To see if this is what’s impacting your business, look at labor as a share of revenue, gross profit per employee, overtime, utilization, and staffing relative to demand. Be sure to distinguish temporary capacity investment from wage inflation, inefficient work, and changes in service requirements.
3. Discounts Are Eating Into Margins
A product sold for $100 with $60 in variable costs has a gross margin (or “contribution margin”) of $40 per unit. Discounting its price by 10% reduces that margin to $30—a 25% decline. You would need to sell more than 30% more units to maintain your gross margin, assuming no other costs change.
To know if discounting is hurting your profits, check your realized prices, promotions, rebates, and margins after discounts. If you think discounts are eating into net margins, evaluate whether additional volume or customer value justifies the per-unit margin sacrifice.
4. Customer Acquisition Is Becoming More Expensive
As any digital marketer will tell you, advertising costs can rise over time. Sales cycles can lengthen, and new channels can attract less valuable customers. Strong sales growth may conceal rising acquisition spending.
Business owners need to track customer acquisition cost by channel, gross profit from new customers, repeat purchases, retention, and payback periods. Also compare acquisition cost with expected customer economic value.
5. Overhead Is Growing Faster Than the Business
Additional managers, software subscriptions, office space, and professional services can erode operating leverage. To know if this is impacting your business, study operating expense trends by category. Check your ongoing expenses that you may have forgotten about. Look for duplicated systems and initiatives that never delivered.
Depending on what you find, you may need to review individual costs to ensure cost structure remains appropriate – don’t just make indiscriminate cuts that could undermine valuable capabilities.
6. Growth Is Making Your Operations More Complicated
Custom orders, extra meetings, small shipments, rework, and special service requirements can make each sale more expensive to fulfill. That’s why businesses should track cost per project or transaction, rework, service requirements, capacity utilization, and profitability by customer. They may need to adjust pricing, service levels, processes, or customer targeting where complexity creates unrecognized costs.
7. Working-Capital Pressure Is Creating Additional Costs
Growth can tie up cash in receivables and inventory. That may not immediately reduce accounting profit, but it can increase interest expense, carrying costs, and risk of write-offs. Indications that this might be a problem can be found by tracking receivables aging, days sales outstanding, inventory turnover, supplier terms, and borrowing costs. Leadership may need to improve collection and inventory planning; distinguish a cash timing problem from a structural profitability problem.
How To Diagnose the Problem
To find out why revenue is growing but profit isn’t, start by doing some preliminary calculations: change in revenue, gross profit, gross margin, operating expenses, and operating profit. Then drill into the largest changes by customer, product, and process.
Once you have these different metrics you can get an indication of why revenue’s going up but profit isn’t. A five-point margin decline may be due to any of the factors named above, but no single financial statement will tell you which. And, depending on which factor is causing profit to stagnate, businesses will need to respond in different ways.
When Is Lower Profit During Growth Acceptable?
Temporary lower profitability may be reasonable when a business is deliberately investing in capacity, talent, or a new market. However, each of these steps should require a sound business case, a definite timeline, and measurable milestones. And it’s important to distinguish between temporary investments and a more permanent trend.
The Bottom Line
If a business’s revenue is rising but its profit isn’t, increasing sales may just make the problem worse. To know how to respond, leaders first need to determine how the economics of their business changed and address the drivers that explain the greatest share of the deterioration.
To learn more about why your business may be under pressure, schedule a free consultation. We’ll review your business data and discuss ways to connect financial and operating data to make better decisions.
