5 warning signs that inflation is eroding your profit margins

When a startup scales quickly, it can face particular challenges, like profit margins beginning to erode due to increased costs. A telltale scenario that this is happening could look like this: Your financial reports indicate that revenue is growing and unit economics appear satisfactory. But you notice increasing employee salaries, higher vendor costs, and delayed customer payments.This is a sign that inflation is gradually eroding profit margins across your business. It can sneak up in the cost of goods sold (COGS), payroll, vendor agreements, and capital expenditures.

Balancing profit margins and inflation is a widespread issue among founders. In fact, a Bank of America survey found that 88% of business owners are affected by inflation, prompting many to raise prices or cut spending. 

Here, we explain five warning signs that inflation is eroding your profit margins and share strategies to mitigate the effect of inflation on your operating margins.

First and foremost, finance leaders should understand the differences among margin metrics. Here’s a quick overview: 

• Gross margin measures the efficiency with which a product or service is delivered. 
• Operating margin illustrates a company’s operational efficiency.
• Contribution margin is the revenue left over after variable costs are deducted.
• Net margin compression reflects the rising costs of producing a good or service that outpace revenue growth, resulting in lower profit margins. 

Here are five signs that inflation is eating into your startup’s profit margins.

1. Your gross margin is declining, even with steady pricing 

If your pricing remains unchanged but your costs are rising, that’s the first indication that inflation is likely eroding your margins and, specifically, causing a decrease in gross profit margin. In this case, inflation can lead to: 

• Rising input costs that outpace pricing power
• Increased supplier prices
• Higher freight and logistics expenses
• Growing costs for staff and contractors
• Expanding COGS, such as software and infrastructure

Take, for example, a SaaS company with stable monthly subscription revenue. As cloud and infrastructure costs rise, the business experiences a declining gross profit margin.

Here are three steps a SaaS startup could take to address this issue:

1. Keep track of gross margin monthly. Pinpoint key areas that are susceptible to inflation. 
2. Renegotiate long-term supplier contracts. Lock in pricing for multi-year agreements to balance future profit margins.
3. Model pricing elasticity. Before applying across-the-board price increases, determine price sensitivity across customer segments. Assess if price increases will offset potential churn. 

2. Operating expenses are growing faster than revenue 

Another hint that inflation is compressing your operating margin is that operating expenses (OpEx) are growing faster than revenue. Most commonly, you’ll see this appearing in these areas:

• Payroll inflation, such as compensation adjustments and contractor rate hikes
• Tool creep or SaaS sprawl (when you have too many tools or overlapping subscriptions)
• Vendor price hikes from annual subscriptions and usage-based billing changes
• Growing costs, including commercial rent, insurance, and compliance costs

These factors could compress operating profit margins even when the gross margin appears stable. For instance, if an e-commerce company sees revenue increase 40% year-over-year, growth may, initially, look strong on paper. However, let’s say that operating expenses increased by 60% during the same period. When reviewing revenue metrics, the company will appear productive, since revenue has increased. But operating margins have shrunk due to the hidden effects of inflation. 

These are three strategies an e-commerce business may implement to address this issue: 

1. Re-forecast with inflation-adjusted OpEx assumptions. Refine your financial model to understand how elevated costs may affect profit margins and runway.
2. Audit vendor contracts and SaaS subscriptions. Use this information to renegotiate pricing and contracts with suppliers. Also, look for redundant tools or unused licences that you can cancel. 
3. Introduce automation where return on investment (ROI) is measurable. Automate tedious and inefficient workflows. 

3. Net profit margin is shrinking despite “record revenue” 

It’s an incredible achievement when a startup reaches a new revenue level. However, inflation may be reducing your net profit margin, possibly due to rising interest rates that increase debt-servicing costs. Plus, if your startup moves into a higher tax bracket, it’ll likely face a higher tax burden. 

Higher capital costs is another factor to pay attention to, especially during periods of inflation. For example, say a wearable technology company reports 25% revenue growth, but its net profit margin declines by 5% year-over-year amid rising operating expenses and financing costs. They could experience record revenue, but a decrease in net profit margin. 

Here are three ways a tech company could improve its net profit margin: 

1. Revisit the financing structure. Review equity and debt to achieve an ideal capital structure and prevent erosion of the net margin. 
2. Model interest sensitivity. Run various simulations to see how soaring interest rates or borrowing costs may affect net profit. 
3. Proactively extend the runway. Obtain additional financing or adjust the budget to maintain operational flexibility and preserve liquidity. 

4. You’re discounting heavily to maintain sales volumes

Inflation could influence your startup’s pricing power, as well as customers’ purchasing behavior. When customers become price-sensitive and attempt to negotiate for better prices, your team may feel compelled to lower prices to maintain sales velocity. 

But, when you run promotions for an extended period, the discounts will shrink your contribution margin, since every sale generates less profit. Simultaneously, your customer acquisition cost (CAC) may rise if marketing costs remain the same or if you offer discounts to attract new customers. 

These are three simple steps a startup could take to address this issue: 

1. Implement a segmented pricing strategy. Customize prices by customer segment to maintain pricing power and avoid turning off price-sensitive customers. 
2. Use value-based pricing, rather than reactive discounting. Set your prices based on the true value of your products and services. Consider offering bundles or tiered pricing to customers. 
3. Educate the sales team on pricing strategies. If your startup offers commissions to salespeople, design compensation to balance margins and sales growth.

5. Your cash flow feels tight, even though margins look decent

Inflation can also affect operating costs and working capital. It can strain cash flow and shorten runway, creating financial challenges. You’ll notice this when more customers are opting to pay later, inventory costs rise, and/or suppliers are demanding shorter payment terms. Even though your startup’s margins look stable, you may still face cash-flow volatility and runway compression.

Here three ways a business can improve its cash flow:

1. Shorten receivables. Consider sending automated reminders to customers and shortening payment timelines.
2. Improve visibility into real-time spend. Monitor your expenses to identify areas of overspending and manage variable costs. 

Centralize financial data for faster decisions. Streamline payments, accounting, and budgeting data into an integrated system (like Mercury) to make better financial decisions. 

Not exactly sure what’s eroding your profit margins? Here’s how to determine whether the decline is due to external effects of inflation or internal inefficiencies.

You can use various benchmarks to determine whether margin pressure stems from inflation or inefficiency. You may need to adjust pricing to preserve your margins when market-wide costs trend upwards. Or, you might focus on improving your company's operations when you notice signals of internal inefficiencies, such as customer complaints or declining productivity. 

To learn how startup and business leaders are navigating the shifting tides of capital, technology, and operational costs, read our 2025 startup economics report.

To help your high-growth startup to achieve long-term success, implement practical strategies that measure the future impacts of inflation. Here are four strategies founders can use to build a more resilient company:

1. Set quarterly margin stress tests. Test different scenarios to see how your company will perform when gross margin declines, how long the runway will last, or if costs increase. 
2. Schedule vendor renegotiations. Evaluate all the services your company uses from various suppliers every 6 to 12 months. Negotiate based on usage, or change plans.
3. Conduct pricing reviews. Schedule semi-annual or annual reviews to evaluate your pricing strategy, and adapt as needed to ensure stable, healthy margins.
4. Model runway sensitivity scenarios. Create sample scenarios to test inflationary pressure. Be sure to test for slower revenue growth and additional fundraising time. 

How does inflation affect profit margins?

Inflation raises costs across all aspects of a business, including raw materials, infrastructure, labor, and manufacturing. Revenue typically takes time to catch up, which may reduce gross profit margin.

What is the effect of inflation on operating profit margin?

Operating expenses — such as salaries, subscription costs, and utilities — are prone to inflation. These costs may exceed revenue growth and could compress the operating profit margin.

Why is my gross profit margin declining? 

Your gross margin declines when COGS increase, but your product or service pricing stays the same. For example, that could happen when your shipping or material costs rise while your pricing remains stable.

What causes a decrease in net profit margin?

Net profit margin narrows when total costs increase more quickly than revenue. The reasons for this may include internal inefficiencies, inflation, or higher borrowing costs.

How can startups protect margins during times of inflation? 

Startups can adjust prices, improve productivity, renegotiate supplier contracts, and run scenarios in financial models. These strategies can help startups manage inflationary pressures.