The margin problem hiding in plain sight

Most mid-sized businesses manage margin at the gross line. Buyers negotiate cost of goods, sales negotiate price, and the board watches the percentage between them. That line is visible, owned and reported every month.

The real trouble starts below it. Freight, warehouse handling, small-order costs, expedites, retrospective rebates, returns, credit notes and the cost of long payment terms are scattered across overheads, distribution budgets and balance sheet lines. Each one looks modest and nobody seems to be accountable for the end-to-end view. And because they are allocated as averages, the business cannot see which customers, channels or products might be causing them.

Where it hides

A helpful way to see the problem is to follow a pound of list price down to what you actually keep. McKinsey's work on the pocket price waterfall described a lighting supplier whose on-invoice deductions left average invoice prices 32.8% below list, with off-invoice items such as cash discounts and rebates taking a hit of further 16.3 percentage points. The average pocket price ended up at about half of the list price. That is an extreme case, but the mechanism is common: every concession is agreed by someone with a good reason, and nobody adds them up.

Let's now look at the cost side. A customer who orders little and often, insists on timed deliveries to many sites, returns a high share of what they buy and pays at 90 days can absorb most of the gross margin they appear to generate. None of that shows up in the gross margin report.

A worked example

The numbers below are illustrative, not drawn from any client.

Take a distributor turning over £60m at a 32% gross margin, so £19.2m of gross profit. After overheads and distribution it reports an operating profit of £3m, a 5% margin.

Now suppose three small things are true. Price realisation has slipped by 1% of revenue through extra rebates and free delivery thresholds that nobody revisited. Distribution and handling costs rose 8% in a year but were recovered from only half the customer base. Returns credits crept up by half a percentage point of revenue.

Operating profit falls from £3m to under £1.9m, a drop of more than a third, while gross margin percentage on the monthly pack barely moves. McKinsey's rule of thumb that 1% of price is worth around 8% of operating profit applies to an average large US company. At a 5% margin, a point of price is worth closer to 20% of profit.

Why 2026 makes it worse

The cost lines that live below gross margin are the ones rising fastest. Logistics UK reported in July 2026 that vehicle operating costs rose more than 12% in the year to April 2026, with diesel up 36%, insurance up 7% and driver employment costs up almost 8%. Prime warehouse rents for large units averaged £13.38 per square foot, up 13% in a year.

Labour costs are moving as well. The National Living Wage rose to £12.71 an hour from April 2026, and employer National Insurance is charged at 15% above a £5,000 annual threshold. Warehouses, contact centres and returns operations feel that directly.

Meanwhile the ONS reported that producer input prices rose 8.3% in the year to September 2026 against output prices up 4.6%. Manufacturers are absorbing part of their cost increases, which means the margin cushion that might once have hidden the leakage is thinner.

What to do first

Four actions, in this order.

Build a price waterfall for your top 30 customers. Include every on-invoice and off-invoice concession. The commercial director owns it; finance builds it. Two to three weeks with existing data.

Allocate distribution, handling and returns costs to customers by activity, not by revenue share. Drops, lines, pallets and credit notes are usually enough to start. Operations and finance together, four to six weeks.

Put a name against the total. Someone senior should be accountable for the gap between gross margin and contribution, with a monthly view of it.

Fix the policies, not the symptoms. Minimum order values, delivery charges, rebate structures and payment terms are where most of the money comes back. Customers accept changes more readily than teams expect when they are offered a clear choice of service levels rather than a blanket increase.

None of this requires new systems. It does require someone to look below the line the business is used to watching.