Results reflected subdued expectations for orders and output

But CBI Scotland predicted it may face problems over the next three months and urged Chancellor Gordon Brown to avoid increasing business taxes.

The quarterly Scottish Industrial Trends Survey also reported a fall in confidence.

Although 11% of respondents were more confident about the overall business situation, 21% were less optimistic.

CBI said the results reflected subdued expectations for orders and output over the coming quarter and renewed pressure on profit margins.

The study also reported a slow growth in the volume of export orders, thanks to strong demand in overseas markets, while domestic demand also strengthened over the past quarter.

The Bank of England should also keep rates on hold for the foreseeable future Iain McMillan, CBI Scotland

But it forecast domestic orders were not expected to increase over the next three months.

Iain McMillan, director of CBI Scotland, said the results presented a mixed picture.

He said: "The improving confidence of Scottish manufacturers has been dampened by a combination of factors, including higher energy and commodity prices, and we are starting to see profit margins being squeezed further."

On what must be done to combat the problem, Mr McMillan added: "The Scottish Executive needs to ensure that it uses the powers it has to set public sector imposed costs at competitive levels.

"Increases in environmental charges and the level of business rates are too high.

Inflationary pressures

"In addition, the chancellor must avoid further increases to business taxes in next month's pre-budget report.

"The Bank of England should also keep rates on hold for the foreseeable future as there are little signs of inflationary pressures which would require rate rises."

The CBI said firms experienced fast increases in costs as a result of higher levels of oil and commodity prices than those recorded at the time of the last survey.

Output volumes rose at their fastest pace since April 2000, buoyed by the continued strength in demand.

But firms expect this growth in volume of output to slow to a halt in the next quarter.