The effect of magnetic steel degradation due to punching on the performance of fractional-kW electrical machines in terms of torque and iron losses is investigated. In order to model the punching effect, the BH curve of the steel is represented as a function of the distance from the cut edge in addition to field intensity. Similarly, the iron losses formula is expressed as a position-dependent function. The modified model for BH curve and iron losses are identified by fitting the proposed relations with measured values obtained via standard Epstein frame test as an inverse optimization problem. The new BH curve expression is incorporated into magnetostatic FE equations. Then, the performance of two different synchronous machines, i.e. with permanent-magnet or reluctance rotor, are analyzed using FE simulations. It is observed that flux density distribution in magnetic core will be considerably distorted particularly in regions which are not heavily saturated. In terms of global quantities, the average torque decrease by 0.5-2 percent, while iron losses can undergo an increase of 50-70 percent.