Avoiding High Customer Concentration
Note: Take advantage of the Customer Concentration calculator included in this article
What is customer concentration?
Essentially, customer concentration is a measure of how total revenue is distributed among your customer base. A company serving a large number of small-volume customers has a lower customer concentration than a firm where a handful of large customers account for the majority of its business.
Some industries tend to have higher customer concentrations than others, for instance, retail sales typically generate low concentrations while large project construction firms often have fewer clients, each accounting for a significant share of the company’s sales.
How do you know if your customer concentration is high or low? A rule of thumb holds that if any single customer accounts for ten percent or more of your revenue or if your largest five customers account for 25% or more of revenue, you have a high customer concentration.
There are advantages and disadvantages to both high and low concentrations. Advocates of high concentration point to the ability to develop long-term relationships with fewer large customers and contractual agreements that can be tailored to each client. Customer service can be focused on fewer clients, so more resources may be applied in getting to know and meeting each client’s needs better. Often, large customers will provide valuable input to a supplier to improve products or services because of a vested interest in supplier success. Some companies and their largest customers function similarly to partners in many ways.
On the other hand, high customer concentration carries substantial risks that can far outweigh any benefits in the long term. Of course, it is difficult to turn away business from a large customer, especially in the growth phase of a new business, but the risks involved should be understood before committing to such an arrangement. In fact, a recent issue of Forbes Magazine called high customer concentration one of the greatest risks to the business.
Here is a calculator to evaluate your company’s customer concentration
Customer Concentration Calculator
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Risks of High Concentration
Concentration risks include:
- Losing a customer can have a devastating effect on revenue, profit, and cash flow in a high concentration scenario. While agreements are entered into with the best of intentions, fluctuations in the economy, pressure from the competition, both yours and your customer’s, and many other factors can result in the loss of a key client. Losing any client is undesirable, but losing ten percent or more of revenue at one time can destroy a business.
- When a customer comprises a large share of your business, they can exert downward pricing pressure and wield negotiating leverage not possible for smaller customers. This results in decreased profits and cash flow.
- Large customers tend to divert a disproportionate share of resources away from a larger number of smaller ones, as management often feels a need to, perhaps excessively, cater to the needs of the few or the one top buyer. This diversion makes it more difficult to diversify and concentration may increase over time.
- When prospective buyers, lenders, or investors assess the company’s value or performance, high customer concentration is viewed negatively. Over-dependence on too few customers can lower the value of your company.
It should be noted that the rule of thumb mentioned above should be applied with care. For instance, a company may have no clients representing more than ten percent of revenue but may sell to a group of customers in one industry. Here, concentration risk does not appear to be a problem but arises from the revenue dependence on a single industry, which can present a similar risk to single client dependence. Essentially, it is desirable to spread risk as broadly as possible in a strategy similar to the diversification of a stock portfolio to lower overall risk.
High customer concentration is a high-risk condition and should be avoided. If high customer concentration applies to your company, action should be taken to diversify and spread the risk across more customers and possibly more business segments or industries.
Don’t keep all your eggs in one basket.
Author Marc J Marin