This article originally appeared in the August 2015 issue of Smart Business Philadelphia.
When a company’s customer base is too concentrated on a handful of large clients, it can make the owner and its management team nervous.
They may fear the bank will limit the amount they’ll advance from any customer accounts receivable that exceed a certain dollar amount or predetermined percentage of sales.
There can also be a significant business impact if a large customer switches to another vendor. And if you consider selling the business, a buyer may discount the purchase price since there is a perceived risk that a customer concentration may negatively impact the company’s future cash flows.
"Business owners often feel that they should be rewarded with greater profitability from large accounts or customer segments due to their higher risk," says David E. Shaffer, director of Audit & Accounting for Kreischer Miller. "Unfortunately, the opposite is often the case. A large account that represents 15 percent of your total sales may only account for 5 percent of gross profit because of the fixed costs you assume, regardless of customer size."
Smart Business spoke with Shaffer about managing the risks that come into play when your company is reliant on a small cluster of larger customers.
What is a customer concentration?
The common definition of a customer concentration is a customer or group of customers that account for 8 percent or more of a company’s total sales.
Customers that have similar characteristics or common ownership may also be considered a concentration.
For instance, if you sell heating and ventilation equipment and one of your niche markets is pharmaceutical companies that require customized knowledge or equipment, you have a customer concentration.
There is increased risk for your banker, your owners and any potential buyer since a slowdown in the pharmaceutical industry could dramatically impact your business.
What can business owners do to mitigate the risk o f a customer concentration?
There are a number of steps your business can take:
- Dilute the percentage of the concentration by increasing sales to other customers or entering new markets.
- Consider an acquisition.
- Make sure your customer relationships are not tied to just one person in your company. Have multiple points of contact who will advocate for you if needed.
- Reduce or limit the amount of sales to the customer concentration. If you find that you need to increase infrastructure or make significant investments to maintain a large customer, you risk losing some or all of the customer’s business if you can’t meet their demands.
- Enhance your relationship with the customer so that you are viewed as a key vendor that cannot be replaced. Keep in mind that this can be very difficult, though, since your customer may not be comfortable becoming so dependent on one vendor.
- Consider a partnering arrangement with the customer. I worked with a company whose largest customer paid 90 percent of the company’s equipment costs, with the only stipulation being that the customer had top priority when placing an order.
- Consider purchasing credit insurance on the customer. This will often alleviate your bank’s concerns and increase the amount available for these accounts receivable. Credit insurance may also give an owner more peace of mind.
Taking steps to manage the risks associated with large customers will help ensure the rewards outweigh the risks. ●
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