Margin compression refers to the decline in a firm’s profit margins or when the gap between revenue and costs is narrowing.
What is margin compression?
Margin compression is the tightening or narrowing of your profit margin. In other words margin compression means you are leaking profits as your costs increase or your revenue declines. If you notice margin compression it’s a pretty good sign you need to run some cost and/or price analysis.
In this video, Founder and CEO, Chris Arndt, covers some common mistakes we see that lead to margin compression and cash flow chaos for ecomm, wholesale distributors and manufacturing:
Skip the watch and read this edited transcript instead:
3 Common Margin Compression Mistakes
A lot of wholesale executives point to rising supplier costs or inflation as the main reason their margins are shrinking—or at least, they think that’s why. But where do I actually see margin compression coming from inside the operation itself?
Yes, supply chain costs are up, but in my experience, most of the shrinkage actually comes from operational blind spots and inefficiencies you don’t even know about.
Margin Compression Mistake #1: Cash tied up in inventory
One of the biggest culprits is inventory holding costs—having too much cash tied up in inventory. That’s a fairly well-known issue.
But if you’re running with a lot of inventory backlog, you’re committing one of my manufacturing accounting myths.
But there’s a metric that not enough companies track: GMROI, or Gross Margin Return on Investment.
GMROI measures the return you get on your inventory investment. It helps you make better trade-offs so you keep your higher-margin products well-stocked while avoiding overstocking lower-margin products. Because that’s where cash disappears fast—holding tons of low-margin products that eat up working capital and don’t return much profit when they finally sell.
Margin Compression Mistake #2: Landed Costs
Another area that quietly erodes margin is landed costs.
Tariffs are hugely affecting ecomm and manufacturers’ landed costs right now. I know clients who signed contracts to sell products at $10 a unit, then tariffs went up, and it cost them $20 to buy that same product. So they’re literally losing money on every sale because of contracts they signed before tariffs changed.
Related Read: Trump Tariffs and your Landed Costs
This is why tracking the true landed costs of your materials is critical. It’s not just your supplier cost, it’s the tariffs, the freight, the hidden expenses that creep in over time.
Margin Compression #3: Overestimating DTC Profits
Margin also disappears when you’re not allocating the real cost of fulfilling orders by channel. Most businesses today sell across different channels: direct-to-consumer and wholesale. There’s this infatuation with DTC because your product margin looks better on paper. You’re selling at your top retail price, and your cost is lower, so your gross margin looks great.
But if you’re not factoring in the extra costs—direct labor to pick and pack single orders, higher customer support costs—your DTC channel might not be as profitable as you think. When you ship pallets wholesale, it’s efficient. When you ship ones and twosies direct, it takes a lot more labor and overhead.
If you aren’t allocating those costs properly, you’re probably overestimating how profitable DTC really is, and you may be undervaluing your wholesale channel.
Related Read: How to Write a Price Increase Letter
Even customer support can quietly drain margins. While it’s usually treated as an overhead cost rather than impacting gross margin, your support costs can skyrocket when you deal with many small customers. More tickets, more complaints, more returns.
So you don’t necessarily need better vendors to get better pricing. You just need better visibility into your financials and your true cost structure across all your channels. Use this flowchart to help guide your decision making on whether it makes sense to stick with DTC:
How Can Ecomm and Manufacturing Companies Improve Financial Visibility?
You might think you need a big ERP overhaul or a fancy new system. That’s often an excuse to delay action. The reality is you can start right now even if you’re on the worst system imaginable.
All you need is a copy of your bills and a spreadsheet. Take one purchase order. Track the product costs, freight bills, duties, and taxes. Total it up. That’s your landed cost. Divide by units to get cost per unit.
Then pick a sale—one DTC, one wholesale—and see what you sold the product for. Subtract your landed cost. That’s your real margin.
Next, estimate how much labor time it took to receive, stock, and fulfill that order. Multiply by your labor rate. Subtract that, too. Now you’re looking at a much truer contribution margin—and you can do all of that today without waiting on a new system.
If you’re not sure where the leaks are, that’s not your fault—but it is your problem. The fix is to start measuring what matters. Need help getting a the right system in place? Learn more about our NetSuite for Retail and ecomm and NetSuite for Wholesale Distributors accounting services.
The Cash Flow Trap of Fast Growth
Your revenue chart might be up and to the right, but your bank account could be begging for a break. Revenue doesn’t equal cash—especially when growth costs more upfront than it returns.
Related Read: Get our ecommerce cash flow fix kit
The biggest use of cash when scaling? Buying inventory. The longer the lead time between paying suppliers and getting paid by customers, the worse your cash crunch.
If you don’t have leverage with suppliers, you might be paying 100% upfront. Then end up waiting months for production and shipping before you can sell. The faster you grow, the more that timing hurts.
The second cash drain is customer acquisition costs (CAC).
Say it costs you $500 to acquire a customer. They spend $100 a month at a 50% gross margin. It takes 10 months to break even. If you’re acquiring 100 new customers a month, you’re spending $50,000 in cash this month that you won’t recoup for nearly a year.
It’s simple math: the faster you grow, the more cash you burn.
Dead Stock and Inventory Turnover
Many founders track days in inventory or inventory turnover as if those metrics tell the whole story. But those are often vanity metrics.
What matters is breaking your inventory down by product segment and looking at turnover for each segment separately, especially in the context of gross margin.
This is where GMROI comes back in. You want to keep minimal inventory on low-margin products and prioritize sufficient inventory on high-margin ones. Running out of a low-margin item doesn’t hurt much. Running out of a high-margin item costs you real profit.
Better Cash Flow Forecasting
Finally, forecasting. I’ve seen plenty of spreadsheet forecasts that look beautiful—colorful charts, fancy formulas—but by the next day, they’re outdated.
You don’t need something pretty. You need something simple and connected to your ERP or accounting system in real time. Whether you’re on NetSuite or QuickBooks Online, there are tools that link your forecast to live data so it stays relevant and useful.
If you want help digging into your numbers, or you’re not sure where to start, book a free consultation. We’re happy to look under the hood and show you what to measure so your growth doesn’t turn into a cash flow nightmare.
