The Midlands is the only UK region to have recorded three consecutive quarters of falling employment, despite business picking up at the end of 2005.
According to the PKF SME Index - a quarterly survey of 800 SMEs operating in the manufacturing, construction and service sectors - employ-ment was down from 48.3 in Q3 to 47.5 at the end of the year.
Marks above 50 indicate expansion and marks below 50 indicate contraction on the previous quarter.
However, after two difficult quarters, PKF said business picked up slightly at the end of the year for Midland SMEs, with growth in output and higher levels of new business orders.
Business output increased to 52.6 - the second lowest in the UK and below the national average of 54.1. However, PKF stressed that, after a tough year, the trend was once again going in the right direction.
The level of new business orders in the Midlands also picked up considerably from 46.7 to 53.3 - just a fraction below the national average of 53.9.
The PKF survey also suggested that the construction sector was busy on year end completions.
Manufacturers enjoyed the strong demand for Christmas orders from retailers and the Ministry of Defence and the service sector cited the "Christmas festive mood" and the end of year rush to spend annual budgets.
Robert Hudson, the partner specialising in growing businesses at PKF in Birmingham, said: "It has not been an easy year for business in the Midlands and it is encouraging that there is improvement on two of the key economic performance indicators - output and new business.
"However, as costs continue to rise one of the big challenges for the region this year will be to find the right balance between passing on rising energy costs to customers and running the risk of being uncompetitive or absorbing them and cutting deeper into profitability."
Input cost inflation in the Midlands was the highest in the UK at 62.1, a further rise from 60.5 in Q3. The high costs of fuel and energy continue to affect every industry sector and Midland SMEs have the second largest gap between their input costs and their output prices.