Winning a big new customer is exciting and has many obvious benefits for a small business. But an over-reliance on one or a few big customers also comes with risks that business owners need to be aware of and manage accordingly.
What is customer concentration?
Customer concentration refers to the way revenue is spread over a business’ customer base. High customer concentration means that revenue is dominated by a few large accounts (or a single account), while a diversified customer base with low customer concentration means that revenue generation is more evenly distributed among customers without a dominant contributor. Generally, a customer base is considered highly concentrated where more than 20% of revenue comes from a single customer. This can leave a business vulnerable as a large proportion of revenue and cash flow is derived from one place.
What are the risks of high customer concentration?
Working with few large customers provides the opportunity to develop long-term relationships and allows for a more personal and tailored service, but there are also risks that should be given serious consideration. These include:
- Revenue dependence:
The loss of a large customer within a concentrated customer base will have an outsized negative impact on revenue and cash flow. The larger a customer is, as a proportion of a business’s entire customer base, the more reliant the business is on retaining the customer, and the higher the financial impact if the customer were to leave. The impact of this is higher for businesses that have a large fixed cost base as operating costs will fall much less than the loss in revenue, squeezing profits and cash flow.
- Reduced pricing power:
Small businesses are often in a weak bargaining position when dealing with large customers. A common example is a food or beverage producer that sells to the big supermarkets. These buyers are very experienced in negotiating with small suppliers and can be aggressive with price as well as other things like payment terms and marketing spend. Often the supplier is so happy to get the big order, they don't push back enough against the buyer in negotiations and the sales end up being much less profitable than originally thought.
Challenges in sourcing capital:
Lenders and investors are very aware of the risks of a concentrated customer base and it will be a key consideration when deciding to provide capital to small businesses. The lender or investor will often ‘stress test’ the sales of a business to determine the impact of losing its biggest customer and too much reliance on one or a few customers can affect how much, and/or the cost of capital is for a business.
Managing your customer concentration
As the old saying goes, don’t put all your eggs in one basket. By diversifying your portfolio of customers, a business can decrease its overall risk and move towards a more sustainable and resilient business model. But, it’s not always that easy… For young businesses that are starting their journey, it’s impossible to have a diversified customer base. By definition, your first customer will give you 100% customer concentration! The trick is to diversify away from this concentration as soon as possible but it may take some time.
Ideally, a business should aim to reduce its reliance on any one customer to less than 20% of total revenue. To achieve this level of diversification, sales and marketing needs to be a focus to attract new customers and you should look to target different industries or locations where possible.
Another popular way to mitigate against the risk of customer concentration is to use Trade Credit Insurance which is an insurance policy that protects your accounts receivable from the default of your customers. The cost of trade credit insurance depends on the type of policy, the quality of your debtors and your business' annual turnover and is viewed by many business owners as an important part of business risk management. For more information on trade credit insurance, contact Australia's leading trade credit insurance broker NCI.com.au.
A case study by Earlypay
One of Earlypay’s invoice finance borrowers is in the freight transport industry and had an over-reliance on one particular customer. The large customer was always pushing for better terms and eventually they moved to another supplier who was prepared to deal with them on razor thin margins. When our client lost this customer there was a big hole in revenue which put the business under significant stress.
Fortunately, our client was able to replace the lost revenue with a number of smaller customers with higher margins and before too long, not only was the revenue replaced, there was a significant boost to profitability and cash flow. Our client was able to turn the set back from losing their biggest customer into a positive by having a more profitable and diversified customer base leading to a more resilient and sustainable business.
Building a resilient business
An over-reliance on one or a few big customers adds significant risk to your business. Although, this risk is not always avoidable, the effective monitoring and management of this risk can be a crucial part of building a business that will be successful for many years to come.
Earlypay provides invoice finance solutions to Australian small businesses to help them grow. Our market leading platform integrates with Xero and MYOB AccountRight as well to make invoice finance easier and more accessible than ever before. To find out more, please contact us on 1300 760 205.
If you'd like to learn how Earlypay's Invoice Finance & Equipment Finance can help you boost your working capital to fund growth or keep on top of day-to-day operations of your business, contact Earlypay's helpful team today on 1300 760 205, visit our sign-up form or contact [email protected].