This article originally appeared in the March 2016 issue of Smart Business Philadelphia magazine.
Customer concentration can be a very serious issue for small businesses. A business that relies on a few big customers for a majority of its revenue can easily be brought to its knees when one or two of these customers suddenly pull out.
Every business is hurt when it loses a customer, but if a significant portion of the total sales of a business are concentrated in that one customer, the consequences can be disastrous.
“To prevent your business from falling into the trap of customer concentration, you need to understand your customer base thoroughly and rank each of your customers by its margin contribution,” says Olszewski. “Simply ask yourself how each of your customers is contributing to your business’s profitability and growth potential, and how important you are to your clients.”
Smart Business spoke with Olszewski about customer concentrations and ways to mitigate the risk.
Why should you be concerned about customer concentrations?
If you ask a business owner or other invested party how they feel about customer concentrations, they would probably tell you it's something that keeps them up at night. From an academic standpoint, customer concentration is calculated as a customer’s relative size as a percentage of gross revenue.
If you are considering selling your company, it’s important to know that customer concentrations are major concerns for prospective buyers and typically result in a discount of at least 30 percent in corporate valuation. In addition, lenders and financial institutions are quick to identify customer concentrations, which often results in an increased cost and reduced availability of capital.
How should companies manage customer concentration risk?
Focus on profitability rather than revenue. Revenue targets can be all consuming within a company, with good reason. But measuring the profitability of a relationship, the real value created for your business, is essential. The risk you take by catering to a significant customer should be rewarded by greater profitability in that relationship.
Companies must always ensure that customer credit policies are being adhered to and that there is specific attention paid to payment trends of a major customer.
What can companies do to mitigate customer concentration risks?
The obvious answer is to generate sales with other existing or new customers, but that is easier said than done. Successful companies effectively delineate between customer service and the sales force. The natural tendency is for the sales force to revert back and forth between the two roles, making sure the customer gets what they want. However, the amount of time exhausted in identifying and resolving issues distracts from their main role of generating new relationships.
It’s also important to be diversified. There are two main areas of diversification. First is within the customer relationship; don’t tie yourself to any single point of contact. Second is the product or service. Consider selling multiple products or services rather than always selling into the same silo. It is essential to become a “must-have” versus a “nice-to-have” in the supply chain.
What can you do if you find yourself dealing with customer concentrations?
A strategic plan is the most powerful tool to address customer concentration risk and drive growth and profit. Studies have shown that only 40 percent of businesses prepare budgets. A vast majority of these budgets are derived solely from historical results. To greater surprise, less than 10 percent of businesses integrate their strategic plan into the budget.
The greatest opportunities surrounding customer concentrations lie in proactively identifying these customers and the potential impact to your business, and creating a plan to address it. As my father told me, if you fail to plan, plan to fail. ●