0:03 Landing a huge client can feel like the moment your business finally succeeds. But what what happens when that client becomes so important that you can't afford to lose it. Sometimes the customer generating the most money is also creating one of the greatest risks to your business.
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0:28 >> Who are you? And where are you going? [music] What do you want? Hello and welcome to People Making Money. I'm your host, host Kevin Bemmel, and I'm here every Wednesday at 10:00 a.m. Pacific time to talk about finding job hunting and being an employee, starting and running a business, and building wealth, the whole financial side of our lives. And I've been doing them in repertoire this year. Um, and uh
1:06 that's I'm going to be changing the format of this show uh come November. So these are kind of the last few episodes in this format. I hope you've enjoyed it. I think you will enjoy what's coming down the pike even more. So today I'm going to be talking about customer concentration risk. That is the client you cannot afford to lose. So uh this is especially for newer businesses. This is such a difficult issue with which to deal because we basically, you
1:42 know, we're going to grab any kind of business we can get and if an existing customer wants to expand their business with us, hey, that's that's fantastic. At some point, however, having one large client or having a lot of your business concentrated in a handful of clients can become problematic to say the least and it could lead to uh to the the the collapse of your business. So, a as is my practice on the show, I have five thoughts I want to share with you on
2:17 this subject. um by way I think of of misconceptions we've ha we have as as business owners and I I I can tell you I've I've I've been through these issues uh myself and so uh um you know would would very much like to help you avoid them. So first the first uh misconception is if one customer keeps giving me business that's a sign that we're doing well. uh and and it's it's easy to draw that conclusion, right? You have a big customer, they keep giving
2:52 you more and more business and and there is some truth to that. You are doing well. If a if a big customer is giving you more business, uh okay, they're not going to give you more business if you're doing poorly. However, uh when does a great customer become too important in the sense that you cannot afford to lose that company and is is the issue really the size of the account or is it your company's dependency on that account? Right? So how much revenue
3:29 could disappear before your business would have to cut expenses, lay off employees, borrow money, right? So these are all the questions embedded in a situation where you have customer concentration risk. So if you have if if one or a small group of of customers uh are dis sort of loom disproportionately large in the amount of revenue or profit that they generate then your company probably has customer
4:06 concentration risk. And the the danger it it's not that it's bad to have a large customer. it's being dependent on that customer. Okay, so let's say that uh you have a company um and it's generating, you know, $2 million a year uh in annual revenue. Okay, let's say it's a consulting company, just s sort of a um I mean, it could be a plumbing company for that matter. And let's say one customer now produces $800,000 of that $2 million annual revenue or
4:43 40%. So on the face of it, this looks like a great success story. Now, if your profit margin on gross revenue is 40% and you lose that customer, okay, your profit margin went to zero, but you're not going to have to scale back, okay? Because you can still afford to meet all your obligations and continue building. But if your profit margin is, let's say, 10%. Okay. So, you've got, you know, out of
5:19 the $800,000, $200,000 is profit. Okay. So, you lose the $800,000 customer. Um, you lose the $200,000 profit, but you also lose $600,000 of the revenue you need to pay expenses, to pay for to meet payroll, etc. Right? That's 30% of well, it's actually u it's a third of what you need uh in order to run your business. You know, are you going to be able to cut a third of your expenses and
5:54 still be able to operate the way you did before? Probably not, right? So now you're going to have to downsize and and and that that can be very uh jarring to a business, right? So that is the nature of concentration risk. Uh so um a company can be reporting growing sales while simultaneously becoming more financially fragile and that that that is that is the case where more where an
6:29 ever higher percentage of your revenue is concentrated in in one two or three you know clients. Okay. So you you should examine customer concentration risk in several ways. First of all, what is the percentage of revenue from your largest client? In the example I gave, it was 40%. Okay, that's that's one that's one test. The next is what is what percentage of your revenue comes from your five largest clients, right? So, let's say you have uh three three
7:04 other um uh clients that are generating $150,000 a piece. So, collectively those uh did I say three? Four, you have four other clients generating $150,000 a piece. Okay. So, those four together generate 600,000 plus the number one client that generates $800,000. That's $1.4 4 million of your revenue out of two million in your top five clients. Maybe you have 30 clients. Okay? So that means the other 25 generate just 30% of
7:41 your income. So what's going to happen if you lose any of those top five clients? Well, let's go back to the example of your you have a you have a 10% uh profit margin. So, if you lose one of the, you know, $150,000 a year clients, okay, your profit margin has essentially disappeared, but you're going to be okay. But if you lose two of them, okay, you've lost $300,000. Not only has your profit disappeared, but now you've got to cut your expenses by $100,000, right? So, uh, you you and and
8:17 if you if you lost your best client plus one of the other top five, now you've lost almost half your revenue with losing just two clients out of 25 or two what I say two clients out of 30. Right? So, you've lost less than 10% of your clients, but you've lost almost 50% of your revenue. Right? So then look at what is the percentage of gross profit generated by those customers right and and what are the amount what is the amount of accounts receivable meaning
8:54 the money that's owed to you tied to them that's another very important metric because if if most of your accounts receivables are owed by your five biggest clients that puts the business in a very fragile position because if they don't pay, right, they can they can literally put you out of business. Whereas, if one of the other, you know, 25 clients doesn't pay, it probably is not going to have that big an impact. Okay? And and profit um concentration can also be
9:31 particularly revealing. So it could be that of the 25 uh smaller small smaller clients that you have, you know, many of those accounts may not be profitable, right? You have them in order to generate the extra revenue, the extra $400,000 in revenue or or $600,000 in revenue in this case, but those those customers may not be particularly profitable. They may be break evens or maybe they generate one 2% profit. You could have you could have all of your profit concentrated in
10:07 a large client. Okay? And so, you know, it may be that two out of your top five customers at, you know, at $150,000 in revenue a year, actually, they're the most profitable accounts because the cost it takes you to service those accounts, let's say it only costs you $50,000 a year to service those accounts, okay? Each one. So, out of the $300,000 in revenue, it only costs you $100,000 to service them. There's your
10:42 $200,000 um uh you know, profit. So, uh to, you know, to lose those accounts means you're literally losing all of your profitability. And by the way, you your largest account, you may have it as kind of a loss leader just because it generates so much revenue. So, uh, you know, if you're maybe you've got a situation where three of the $150,000, uh, customers are generating $300,000 in profit between the three of them.
11:19 Okay? But you're losing $100,000 on your $800,000 annual revenue client. Okay? So, if you lose those three clients that are generating all of your profit, not only have you lost all your profit, but you're now you're going into the hole because your your biggest client is you're actually losing money on them from the get-go, right? So these are the kinds of issues that you need to examine to understand exactly how stable your
11:56 business is. Right? So don't measure an important customer solely by how much revenue it produces. Measure it by what would happen if that revenue disappears. Okay, that's number one. Number two, they need us as much as we need them. Right? So if you've got a big customer and you're providing a valuable service to them, it's it's tempting to think, look, what are they going to do without us, right? So better to ask yourself the following
12:32 questions. First of all, who actually has the negotiating leverage? Next, what what would you what um yeah, if if this if this big customer proposes unfavorable terms, right? Would you reject it? Could you afford to reject the unfavorable terms? Right? And [snorts] finally, would you make concessions to a customer if that customer represented only 2% of your revenue? Right? Now, the answer to the third one is probably pretty obvious.
13:07 It's probably like, nah, probably not. I mean, it's it's not worth it. But if a customer is generating 40% of your revenue, you may feel like you have to make concessions in order to be able to survive. Right? I'm in a situation with that right now where I'm negotiating a lease uh on behalf of of a client and the the the the prospective tenant um you know he keeps coming back with ways to frankly reduce the um desiraability
13:43 of having him as a tenant and he's I I I finally you know told the person who's the intermediary between the two of us, you know, I'm one step away from walking away because what what the tenant is trying to achieve right now would put the ability to run the property at such risk, it it it wouldn't be worth having them as a tenant, right? So these are the these are the kinds of uh issues we need to look at when we have uh when we when we
14:20 already have uh customer concentration risk. So it's having you know having a lot of revenue concentrated in one or just a handful of customers that that's not the only problem. The other problem is how much leverage they now have over your business. So, a major customer, they may require uh they may or they may request or demand lower prices, longer payment terms, faster delivery, dedicated personnel, customized products or services or or additional work
14:55 without additional compensation. So, I know someone who was in a food business and uh he was doing really well and then you know he landed what he thought was going to be the dream contract which was a contract to supply Walmart. The problem is is that Walmart is so huge and you know they they place such large orders that they they can financially engulf a company and they have such a huge place in the marketplace. They can negotiate
15:32 very favorable terms for them. It's one of the reasons why they can uh offer such great prices. But the terms that their suppliers get make profit margins thin if they exist at all. And in fact there this this particular person had a problem with uh the wall with Walmart supplying Walmart and it and it put his company out of business. Right? So when we get into a situation where one or just a handful of customers have such
16:08 you know our um control in essence such a huge amount of our of our company's revenue they may also then start to control how the company operates. So uh so you know and and it rarely does it happen all at once. It's more of a gradual thing. So, you know, the the customer asks for a concession and management decides, well, the immediate cost of saying no is greater than the cost of making the concession. So, all right, we'll make this concession, but then they ask a few months later for another concession and
16:43 another concession. And over time, a bunch of small concessions add up to the point where now the the customer is no longer profitable. In fact, it may be costing the company money and yet the company still needs that revenue in order to meet payroll etc. And so now the company is in a very precarious situation. So the the uh you know in the in the example that I was giving of the $2 million revenue company, you let's say you have a company that you know a client that's
17:19 generating that $800,000 or 40%. So, the client may ask for a 10% discount and you think, well, okay, you know, it's only $80,000. You know, it's a good customer, they generate a lot of revenue. Okay, you know, we'll give it. Um, and it seems like you're only jeopardizing $800,000 in revenue. But then, you know, a couple months later, they say, you know, we want to go from paying net 30 to net 60 days, right? They want twice as long to pay. And so now you're having to carry the costs of servicing them over a longer period of time. Next, they wanted
17:56 dedicated employees. So they it's always the same person handling their their matters, right? So it it you know the the you know the rest not the restrictions but the requirements become greater and greater over time and they reduce your ability to effectively run your business. So when you cannot say when you cannot comfortably say no to a client or a customer that customer has acquired more economic power or over your business than you may realize and
18:32 now you've created a big vulnerability. Okay that's number two. Number three uh rapid growth. our our company is growing rapidly, so the company must be getting financially stronger, right? And again, it that that seems like it would be true, right? Let's say you doubled revenue over a two-year period. Your company must be getting stronger. You you doubled your revenue, but where is from where is the new revenue coming? That's the first question you should ask. The second is is our customer ba
19:10 our customer base growing along with revenue. Okay. And third is our are our revenue sources becoming more diversified or is it simply more more revenue coming from one or two customers. Right? So, let's let's take a situation that that the one we've been doing where we've got, you know, $2 million in revenue. Um, uh, 800,000 coming from the the number one client, another 600,000
19:45 coming from the next four. So, that's, you know, 70% of the revenue and all the rest is coming the other the other 30% is coming from the other 25 customers. So let's say over the next two years revenue grows to $3 million. Well, that's fantastic. That's 50% revenue growth over two years. Well, where is that from? Where has that revenue come? Did it come from the top five clients? So now essentially you've, you know, you've you've got $600,000 still being
20:20 generated by the bottom 25, but now you have uh $2.4 million being generated by the top five. And so now uh you've got 80% of your revenue concentrated in your top five customers as opposed to 70% before the revenue growth. that is making your company more fragile. On the other hand, let's say that the million dollars in revenue growth came from your from the bottom 25%. So now you get 1.4
20:55 million from the top five, but 1.6 million from the bottom 25, right? So now your concentration risk has gone from 70% to under 50%. So your risk is declining in that in that case, right? You're not as dependent as you were two years before on those top five clients. Those are the kinds of issues at which you want to look, right? So revenue growth and divers diversification of revenue sources are not the same thing. Right?
21:32 So if a company grows u from$1 to $2 million in sales, the example I or from $2 to $3 million in sales, that appears to be impressive, but it really depends on from where that additional revenue came, right? And and here's the problem. Large accounts can consume management's attention, right? And so everybody gets busy servicing and focused on the largest customers and the smaller ones start to feel like they're not being handled properly. They're not being
22:07 serviced properly and so you start to lose those smaller customers. That exacerbates your concentration risk. Right? So um success can in fact create its own concentration problems or it can exacerbate existing uh concentration problems. So uh this is the you when you're when you're dealing as your company grows you want to keep track of from you know precisely from where the
22:42 growth is coming. So whenever revenue increases, ask a second question. Did our customer or client diversification increase with it? Okay, let's take a quick break. When life brings unexpected changes, managing inherited property shouldn't add to your stress. Magnum Properties specializes in probate and trust real estate management. We handle the complexities while you focus on what matters most. From property maintenance
23:17 to tenant relations, from legal compliance to maximizing value, we're your trusted partner through every step. Magnum Properties, Inc., turning property challenges into peace of mind. Call us today at 213-264-4396 or visit magnumprops.com. Okay, number four. Um, we work for them for 10 years. They're not going anywhere. Right? That
23:52 is a big misconception. So, the fact of the matter is there are important questions to ask when you have long-term customers. First of all, what circumstances outside my control could end the relationship? Meaning, I didn't do anything, but the relationship still ends, right? Does a rel does a long relationship actually guarantee future business, right? And how quickly could you replace the lost revenue? So when I
24:27 had my real estate company prior to joining the Navy, uh it it turned out that about 50% of my income, actually more than that, 60% of my income, I think it was, was concentrated in one client and I had very very good close relationships with that client. Okay. and but it was primarily through uh the chief appraisal officer and then he retired [laughter] and the the the um client which was a a
25:03 large lender they decided they didn't want to work with small companies like mine anymore and so overnight bang that revenue disappeared and I did not have a good plan for replacing it Right. So that that that was how I learned about concentration risk basically. Right? You know it what do they call it in the fire. Right? So uh there are many reasons why um a customer can leave that have nothing to do with your performance. First of all, the the
25:39 the company could be acquired or it could merge with another company and that that you know as a result of the merger they decide to use, you know, a a vendor or a you know, a consultant or whatever that the other company had rather than continuing to use you. Number two, they could get new management and new management may come with its own relationships and you're out. Uh number three, the company can have financial difficulties and so you know that that company ends up failing or having to downsize and they stop
26:15 using uh you know outside suppliers. Uh it could just have budget cuts, you know, because they're anticipating leaner financial times and so they start cutting back. They could have a change of strategy. they're changing direction and so what they were using you for before is not relevant to the future of the business. They could also just be consolidating vendors. So maybe they have two or three preferred vendors who do what you do and they decide, you know what, rather than continuing to deal with three vendors, we're going to choose one. And for for whatever reason,
26:52 they don't choose you. It's not that you did a bad job. It's just maybe the another vendor is willing to give them better terms, maybe take more concentration risk or something like that, right? They may also decide to bring the function inhouse. Again, you've done nothing wrong, but they decide, hey, we can we can handle this in-house much less expensively or we can have more control over this function if we bring it inhouse. Okay. They may also um have a new purchasing policy and and also corporate headquarters could just
27:27 decide to change things and if you're dealing with a subsidiary or a division, you know, you're out of luck, right? So all of these are things that can happen that have nothing to do with your performance or necessarily your relationship, but they end up with you losing that big customer. So what what makes um concentration risk particularly dangerous is that um it is often times completely out of your control that you lose that customer. Right? There was
28:03 nothing I was out look I was a small company. I you know I wanted to be a small company and in fact one of the reasons they the this lender originally brought me in is because I was a small company I could react very fast. I could give them excellent service and very tailored service and they liked that because oftentimes they were competing against other lenders for a piece of business. And so, you know, there were times when they needed me to do do my work in, you know, 48 hours or or, you
28:38 know, 96 hours, two or three days, do very complex valuation work for them so that they could out compete another another lender, right? Uh larger organizations oftentimes just don't have that kind of uh customer service, right? uh but you know when they but then they decided that you know that wasn't that wasn't as important as it as it was before and they wanted to go with large a large a large large only large companies right so you know what was my competitive advantage at first wasn't any longer so
29:17 uh you know one of some of the things to examine um is if I've got if you've got this concentration risk So what are you going to what is your plan for replacing that revenue, right? Um how long like if you lose that customer, how long can you operate at a reduced revenue level, right? Uh how much cash do you have on hand? Uh what expenses can quickly be reduced? Right? And and how quickly can you replace the lost business? Right? Those are all issues that you should
29:53 examine when you have concentration risk in order to mitigate the impact of losing a big client. Right? So don't spend all your time, you know, predicting whether your largest customer will leave. Spend it determining what you will do if it does, right? And and prepare for that eventuality. Okay, that was number four. Number five, if concentration is dangerous, we should reduce our business with our biggest customers, right? Isn't that the solution? Well, some questions to ask
30:30 that that may that may lead to a better uh decision. Why voluntarily give up profitable business? Okay. or even a large chunk of business that maybe you kind of operate at a break even, but it allows you to maintain a larger business, larger staff, so you've got more people available in order to service other customers. Next, um can can our concentration risk uh be reduced without shrinking that account? Right? So, in the case of the $2 million
31:05 consultancy with the $800,000 client, I mean, if if if you let's say you reduce your work for them by 25%. So, now you're only getting $600,000. Well, you've now lost $200,000 in revenue, is is there a better way to deal with the concentration risk than than shrinking the size of your business? And then how can [clears throat] how can your company become less dependent while at the same time preserving a valuable relationship? That really is the crux of it. Okay. So
31:42 rather than thinking of downscaling, think of how do I manage this risk in a way that's best for my business, but also all of my customers, including the largest one. Right? So the ex the objective usually is not to make the largest customer smaller. That almost that's almost never going to be the case. Now, [snorts] if you're operating that large customer at a loss, it may be doing that. So, again, when I had my real estate company, um I I took on one particular client and she made up at the
32:19 time, I think about 25% of the revenue I was getting from managing properties. Here's the thing. I was taking a big loss on running her buildings. And I I realized that after about two or three months I you know she had she had negotiated you know too good a deal for herself and also she was a real pain in the neck to deal with and my my staff just frankly hated her right and but I had a six-month or a one-year contract right
32:55 so I couldn't just break the contract right I I would have liable. So, frankly, I manipulated the situation to get her to say, "I don't want to do business with you anymore if you, you know, don't do X, Y, or Z." And I said, "Well, I'm not going to do X, Y, or Z." She said, "Well, then I I'm just going to have to fire you." I said, "Great. Your records will be on your doorstep in within two hours." Right? At the time, my dad worked for me. And when I told him, you know, to and my mom did, too.
33:31 My my parents were, crazily enough, my parents were divorced at the time. And when I told my dad, I said, "Hey, go go go, you know, I'm going to call mom. I'm going to have her, you know, box up all the records and close them out and uh please just go pick that up from mom and go drop it on the the, you know, former customer's doorstep." He's like, "Excellent." You know, it was like happy day for everybody because in the end, I was losing too much money. the while it was a big chunk of revenue, it was costing me so much to service that account, I was better off just getting rid of the account. But that's that's usually rare. Usually, uh, you know,
34:08 we're we're we're not losing a ton of business. And so, we want we we we don't want to make the business I mean, we don't want to make the amount of revenue we get from the customer smaller. What we want to do is make the rest of the business larger so that the the concentration risk is diluted and if we do lose that big customer it won't have as large an impact. Right? So um companies can reduce concentration risk by continuing business development even
34:44 when the current business is strong. And that's really the challenge for any small business is we they tend to swing from getting a bunch of new business. Okay, from business development, okay, now we got to do the business when we do no business development. Oh, but wait a minute, now we don't have any new customers coming in. Okay, we got to And they kind of seessaw back and forth between business development and taking care of clients, right? The really what we need to work for is continuous business development even as we we you know create ever uh higher levels of
35:21 service or products for our customers, right? And and that again that was a a lesson hard learned when I had my first company. And so I've I've built in to my current company ways to continually be marketing even as I grow and take on new customers, new clients. Right? So another way to uh handle concentration risk is to develop uh customers in different industries or markets. Right? So let's say um you're a consulting
35:56 company and and you consult in uh technology and health care and consumer products. you know, there are times when one of those sectors may not be doing particularly well, but so for example, you know, consumer products, right? Sometimes they don't do so well. So, you may lose some revenue there. But if you're diversified in industry, you're not going to, you know, the loss of revenue you you uh you suffer will not be as great as if all your business were in consumer products, for example. Right? Um so that's that's another way
36:33 of dealing with concentration risk. Also it's critical that you maintain a pipeline of prospective customers. Okay. As the business leader that is your primary responsibility, right? Because that's what keeps the business vital or Okay. Um next um build recurring revenue from other sources. Right? So if you are a consulting business and you get your revenue from you know hourly consulting
37:09 fees what other things can you do to diversify where from where your income comes right and and that could be maybe there's some kind of product you can sell maybe you can do some seminars or I you know you have to get creative obviously you know your businesses better than I do but how can you diversify your income streams. Okay? And in fact, I did a show of um earlier this year just on that topic. So, go check that out on on on my YouTube channel or on Spotify or Apple Podcast. Okay. Next,
37:45 maintain adequate cash reserves, right? So, don't be running your business, you know, hand-tomouth, you know, monthtomonth. Revenue comes in and immediately goes out. Make sure you have revenue on hand. And backing that up, have some kind of line of credit so that if you if you start running short on cash reserves, if you have to, you can borrow. Okay? And then negotiate appropriate contract terms and and termination provisions, right? So, if you're going to take on a large client,
38:22 um, and you feel that there may be some concentration risks there, maybe you need to have a way out so that the concentration risk doesn't destroy your company. And then finally, and this is among I think the most important is avoid excessive fixed costs that depend on one customer's revenue. Right? In general, avoid fixed costs, okay? But especially those that are dependent on an in one specific client because if that client leaves now you have those fixed costs stay but you don't have the
38:58 revenue from which to pay them. Right? So if your largest client disappeared on Friday, what are you going to do on Monday morning? Okay. And the reality is you need to answer that question long before Friday comes up, right? So if you've got a I I used this example earlier. If you've got that $2 million company and over the next two years the revenue goes goes to $3 million, your company is growing in revenue. But if the million dollars in revenue is coming
39:33 from your top five customers, the company has become more fragile. If it came from your bottom 25 customers, your company is growing more solid. So keep a close eye on not just from where the revenue is coming, but also how your client divers diversification or your market diversification is working. Right? So you don't necessarily uh solve customer concentration by making your biggest customer smaller. In fact, rarely is that the case. You make you
40:09 solve it by making the rest of your business bigger and so thereby shrinking the percentage of the concentration risk. So, couple of closing thoughts. The customer writing your biggest check may be one of your company's greatest assets. In many ways, probably is. But the more you depend on that check, the more important it becomes to understand what happens when the check no longer comes. Right? So the question every business owner should periodically ask isn't simply who is our biggest
40:46 customer? It's could our business survive without that customer. Right? Okay. So, uh, let's see. Schedule of shows. Mon, these are all Pacific time. Mondays at 10 a.m., trust in Estates weekly. Tuesdays at 10 a.m., business lessons from the military. Wednesdays, like today at 10:00 a.m., people making money. And then every other Thursday at 5:00 PM, join me at Jiggers's Place for a cocktail and a schmoo. And we'll talk about all kinds of great uh things like books and movies and relationships and
41:22 ideas, all that kind of great stuff that makes life so worth living. Oh, I forgot to I forgot to mention, how have you dealt with concentration risk in the past? Are you dealing with it now? Look right down below the screen. You'll see links to social media. Drop a comment in there. I'd love to hear your thoughts on this topic and I'm happy to respond to uh to what you say or questions that you ask. Um and so let's see that just leaves me to thank you very much for joining me today. Always appreciate it and signing off as I always do. Marie darling, you are my
41:59 bell. Courage and all.