13 Oct How to Mitigate the Risk of Customer Concentration
To first understand how to mitigate the risk of customer concentration, you first must understand what customer concentration means. Customer concentration is a measure of how total revenue is distributed among a company’s customer base. This is calculated by dividing the individual customer sales in a given period by the total company sales in the same period. If a company sells to many customers, it would be considered to have a low customer concentration. Whereas, if a company sells to a few customers, it would be considered to have a high customer concentration. For example, if a company has five customers that represent 50% of its annual sales, it would be said that this company has a high level of customer concentration.
Companies that are said to have high customer concentration will tend to have a higher risk factor versus companies that have low customer concentration. The reasoning for this is that if a customer that accounts for 15 percent or more of a company’s annual revenues and the company were to lose that customer, the company would lose a significant portion of its sales. Naturally, if the risk factor for customer concentration is high, there will be a negative impact on a company’s valuation.
While there are several ways that business owners can mitigate the risk of customer concentration to increase the value of their business, below are the most common methods.
- Dilute the Customer Concentration
The first and most obvious solution is to dilute the percentage of customer concentration by increasing the number of customers the company provides its products and services. Business owners can simply do this by implementing a marketing and sales team strategy to reach a larger customer base.
- Long-Term Contracts
Another way a business can mitigate the risk of customer concentration is by entering into a long-term contract that guarantees revenue or exclusivity with its customers that generate the large percentages of its sales. If a company has a long-term contract with its larger customers that guarantees revenue or exclusivity, then there is less of a risk factor assumed in the business’s valuation. In this scenario, it would be assumed that these clients plan on continuing being a customer of the company for future years to come, and therefore, could count on recurring revenue. If there is no contract guaranteeing revenues or exclusivity, then there is nothing preventing the customer from getting your products/services from another company.
- Make Yourself Indispensable
If these first two methods cannot be easily attained, then make yourself indispensable to the client. One of the most basic and fundamental objectives of a business should be addressing the needs of its customers and solving a problem for them better than anyone else. Companies that provide services or products that are discretionary (nice to have, but not necessary) are going to have a much more difficult time getting and retaining customers. However, the higher the pain point you solve, the more indispensable you become. Consider making changes to your product or service so you can move up the “urgency/importance” ladder of your customers’ need, while increasing your market value.
Business owners should examine the relationships they have with their customers in order to account for the risks and impacts they could face in the future due to customer concentration. Overall, the best way to mitigate the risk of customer concentration is to try to ensure that no single customer is responsible for 10 to 15 percent of a company’s annual sales. If a company has any customers that do account for 10 to 15 percent or more of its sales, it will likely have a negative impact on the valuation of the company. If this isn’t possible, consider implementing long-term contracts and/or finding ways to make yourself indispensable to your clients.