Business owners should remain cautious when their customer list is relatively short, or a few customers make up the majority of revenue.
Here is a basic outline that can help in determining if concentration risk needs to be an area of focus for your business moving forward.
Common problem
A common problem among many companies is customer concentration. This is when a business relies on only a few customers to generate most of its revenue.
The dilemma is more prevalent in some industries than others. For example, a retail business will likely market itself to a broad range of buyers and generally not face too much risk of concentration. A commercial construction company, however, may serve only a limited number of clients that build, renovate or maintain offices or facilities.
How do you know whether you’re at risk? One rule of thumb says that if your biggest five customers make up 25% or more of your revenue, your customer concentration is high. Another simple measure says that, if any one customer represents 10% or more of revenue, you’re at risk of elevated customer concentration.
In an increasingly specialized world, many types of businesses focus only on certain market segments. If yours is one of them, you may not be able to do much about customer concentration. In fact, the very strength of your company could be its knowledge and attentiveness to a limited number of buyers.
Nonetheless, know your risk and explore strategic planning concepts that might enable you to lower it. And if diversifying your customer base just isn’t an option, be sure to maintain the highest levels of customer service.
Other forms
There are other forms of concentration. For instance, vendor concentration is when a company relies on only a handful of suppliers. If any one of them goes out of business or substantially raises its prices, the company relying on it could find itself unable to operate or, at the very least, face a severe rise in expenses.
You may also encounter geographic concentration. This can take a couple forms. First, if your customer base is concentrated in one area, a dip in the regional economy or a disruptive competitor could severely affect profitability. Small local businesses are, by definition, dependent on geographic concentration. But they can still monitor the risk and look for ways to mitigate it (such as online sales).
Second, there’s geographic concentration in the global sense. Say your company relies on a foreign supplier for iron, steel or another essential component. Tariffs can have an enormous impact on cost and availability. Geopolitical and environmental factors might also come into play.
Major risk
Yes, concentration is a good thing when it comes to mental acuity. But the other kind of concentration is a risk factor to learn about and address as the year rolls along. Contact Rudler, PSC to learn more on how to manage concentration risk in your business. We can assist you in measuring your susceptibility and developing strategies for moderating it. Call 859-331-1717 to schedule a no risk consultation.
RUDLER'S TAX MANAGEMENT & PLANNING TEAM
This week's Rudler Review is presented by Maria Graell, Intern and Dan Tillett, CPA.
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