While a diverse customer base can help mitigate revenue risk, what happens when that base gets a little too narrow? Customer concentration risk is the level of revenue risk a company’s portfolio holds as a result of relying on a small pool of customers.  While it might seem appealing to have a few big clients, such a level of dependence can expose the business to significant risks.

If more than 20% of your revenue comes from a single customer, you have a high customer concentration. As with anything, there are benefits and risks associated with high customer concentration.

Benefits

• Develop long-term relationships with a few large customers
• Less contractual agreements and overhead per dollar
• Greater focus on customer service and customer needs

Risks

• Loss can devastate revenue, profit, and cash flow
• Customer holds pricing and negotiating leverage, which can decrease revenue
• Diverts disproportionate amount of resources away from smaller customers

The most immediate threat is the potential for a massive revenue drop. If a single customer, or a small group, accounts for a large portion of a company’s sales, losing them creates a significant financial hole.

A prime example of a massive revenue drop occurred when American Tire Distributors lost almost 33% of annual sales in a span of 2 months in 2018. In this situation, American Tire saw two of its largest customers form their own retail distribution venture (Goodyear Tire & Rubber and Bridgestone formed TireHub). A few months later, American Tire filed for Chapter 11 bankruptcy protection on October 4, 2018.

Also in 2018, automotive information services company Tweddle Group, announced that its largest customer, which accounted for roughly 40% of total sales, decided not to renew a significant contract. A short time later, the company completed an out-of-court restructuring.

As reported by Allianz Trade; How do you know if customer concentration is too high? Here’s the formula:

• Identify the top customer and the amount of revenue the company earned from that customer in the past year.
• Divide that amount by the total revenue for the year.
• Multiply that number by 100.

For example, if the business earned $2 million in gross revenue last year and the top customer was responsible for $250,000, that customer accounts for 25% of the revenue. The calculation is provided below:

250,000 ÷1,000,000 = .25 x 100 = 25%

What if no single customer accounts for 20% of revenue? That’s good, but a watchful eye is still necessary.

A critical aspect of credit reviews is identifying the risks associated with a high customer concentration. This can quickly jeopardize a company’s creditworthiness if a key customer doesn’t renew a contract or goes out of business.