To start, take a look at this graph:
The line itself is an intuitive representation of the obvious with respect to customer concentration risks on two levels:
- The fewer customers a firm has, the more exposed that firm is the risk variables related to those customers, and,
- That there is a diminishing return to the reduction of those risks as each additional customer is added.
Since every company starts with its first customer or client, concentration risks are unavoidable in the beginning. It is also true that winning customers is a key challenge for most firms and that once a prospect has been converted into to customer, firms tend to make extraordinary efforts to carefully nurture and attempt to expand those relationships – sometimes at the expense of winning additional customers. The best firms, however, strike the necessary balance between servicing existing customers for retention and dedicating resources to winning additional customers. This balance not only benefits the firm’s growth profile, but in doing so reduces the all important customer concentration risks.
The difficult part in addressing this challenge is how to identify the less obvious risks (and their magnitude) that contribute to concentration risks and applying the appropriate judgment to mitigate them.
Many firms – both young and old – tend to exhibit a “Tangible Bias”. The Tangible Bias is an unscientific phrase I once heard to describe the phenomena of firms tending to address those risks that appear more tangible to the exclusion of those that are less clear and/or more difficult to quantify. Firms tend towards the Tangible Bias often because the tangible risks (i.e. creditworthiness of the customer, tightness of contract and payment terms, etc.) seem to be more a clear and present risks than those that seem less quantifiable while at the same time the less quantifiable risks often tend to exhibit a somewhat binary risk profile (i.e. the risk appears remote from a probability point of view but at the same time are significant when they do occur).
And Managers of firms – especially the best ones – tend to over estimate their abilities more broadly and their risk management skills specifically and/or rationalize that somehow their specific challenge is somehow unique (phenomena economist sometimes refer to as the Hubris Bias and the Confirmation Bias).
In combination, this often leads Manager’s to rationalize their practices. But although less quantifiable, the less “tangible” risks are real nonetheless. Change in key personnel, periodic “re-proposing” of the business, change in customer business strategy – and many others – are all commonplace – and sooner or later tend manifest in a way that can present significant risks.
We are firm believers in the idea that firms should nurture and expand relationships with key customers – and also manage the related and tangible risks in those relationships carefully. We are also firm believers – as the empirical evidence is overwhelming. There is simply no substitute for diversification of risk. And the most common – if not the undisputed best – way to minimize customer concentration risks is to quickly acquire and develop additional significant customers.
Costs are borne by firms in two general ways – the actual costs incurred in day to day operations and also the risks inherent in their profile and strategy – concentration risk often being a very large one. The best Managers focus intensely on both of them – equally – and are always challenging their instinctive biases.