Teen clothing retailer Abercrombie & Fitch is steeling itself for another drop in profit margins in its fourth quarter as rising raw material, labour and freight costs continue to weigh on its business.

"Cost pressures from raw materials and labour costs have only increased as we have gone through the year and transportation costs remain at very high levels," CEO Mike Jeffries told analysts on an earnings call earlier this week.

"We think it is possible that some of these factors, such as cotton costs, may abate somewhat, but that is not something we can count on. We expect to make progress on gross margin in the first half of 2011 overall. However, for receipts later in the season, costs are escalating significantly and visibility beyond that is limited."

The Ohio based company warned its gross margin rate for the season as a whole would be "slightly" below expectations as it booked a 29% hike in third quarter profit to $50.0m, helped by strong international sales and a good domestic performance across all its brands.

But while net sales rose 18% to $885.8m, and same-store sales were up by 7% gross margin narrowed to 63.7% from 64.1% on the back of heavy promotions in a competitive back-to-school environment.

Indeed, average unit selling price was down 11% according to the retailer, whose brands include Abercrombie & Fitch, Abercrombie Kids and Hollister Co.

Chief financial officer Jonathan Ramsden said the 40 basis points drop in gross margin was better than expected thanks to a currency benefit and lower freight costs, but said "a similar level of erosion" is likely in the fourth quarter.

The retailer, which operates 1,106 stores, said that even though cotton costs have escalated, it also sees this as a long-term opportunity.

"We think lots of people are going to take a lot out of their product at this time. We're not," Jeffries said. "We're going to use this opportunity to enhance the product offering and we can get paid for it, particularly in international locations."

He added that a strong relationship with vendor factories - who "have held our hands during this time, been fair with us in terms of what's happening with cotton prices and other increases" - has been key.

"But I think they know that we're there for them for the long-term as they have been there for us and will be there for us, because they are as obsessive as we about creating beautiful product at fair prices."

Measures to bring down average unit costs without sacrificing quality have included purchasing fabric across brands and bundling of similar items.

The retailer also warned that while there is "headwind in terms of cotton and labour prices," it is the latter that is likely to continue to be an issue in the back half of 2011.

"We think there is some possibility that cotton costs may [abate]. Labour costs are likely to continue heading upwards," cautioned Ramsden.