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Published: May 11, 2012

 
 

Suppliers Benefit from Having Just a Few Big Customers

What they lose in bargaining power, they more than make up for in efficiencies, profitability, and stock gains.

Title: Customer-Base Concentration: Implications for Firm Performance and Capital Markets (Fee or subscription required.)

Author: Panos N. Patatoukas, University of California at Berkeley

Publisher: The Accounting Review, vol. 87, no. 2

Date Published: March 2012

Are big-box retailers and giant manufacturers getting something of a bad rap? The media has accused these behemoths of putting the squeeze on their suppliers, which are often dependent on and even organized around the huge orders they get. Big customers have unfair bargaining power, the story goes, and can force their smaller suppliers into making concessions such as lowering prices or extending trade credit.

But this paper, which the author calls the first to provide large-scale empirical evidence on the link between customer-base concentration and firm performance, concludes that suppliers that serve only a few big customers actually perform better, in terms of bottom-line profitability and stock prices, than firms with a less concentrated customer base. Although they may indeed have to make concessions, these suppliers appear to develop more efficient operations from coordinating and collaborating along the supply chain, improvements that more than cancel out any disadvantages that come from dealing with powerful customers.

The findings are based on a comprehensive sample of supply chain relationships from 1977 to 2006. Combining several databases, the author examined 45,442 business-to-business relationships during the 30-year period. To measure the concentration of customer base, the author determined the number of major customers interacting with a supplier and the relative importance of each to the firm’s annual revenue. The average supplier had 1.8 major customers, relied on each for 22 percent of its annual sales, and was linked to each big player for 4.4 years.

After controlling for several factors — including firm and industry characteristics — the author’s regression analysis revealed a rosier bottom line for firms with more consolidated customer bases. On average, firms with just a few major customers performed 2.2 percent better in terms of return on assets and 4.7 percent better in terms of return on equity than did companies with less concentrated bases.

Suppliers with more concentrated bases actually reported lower gross margins (the proportion of each dollar of sales revenue that the company reaps as gross profit), the author found. But gross margins didn’t tell the whole story. These suppliers also spent less on selling, general, and administrative expenses per dollar of sales; held less of their assets in inventory; and had shorter cash conversion cycles, meaning they turned resources into cash flow more quickly. In short, they had higher operating margins.

“Suppliers with more concentrated customer bases experience…enhanced asset utilization and, on the whole, tend to be more profitable,” the author writes.

A time-lag analysis was conducted to show a cause-and-effect relationship, proving that changes in customer-base concentration led to changes in supplier performance. As the author notes, “efficiencies achieved through enhanced production coordination and inventory management, cooperative advertising campaigns, and marketing alliances with major customers are likely to flow gradually through a supplier’s financial reporting system.”

Investors are apparently aware of the benefits, the author found. The average difference in stock performance between firms ranked highest and lowest in customer-base concentration was 7.6 percent. This implies that investors tend to revise their evaluations of a company in light of the signals it sends about changes to its customer base — they interpret consolidating the customer base as good, and diversifying as bad.

The author warns that when considering changes to the customer base or supply chain relationships, managers should pay particular attention to the general and administrative costs incurred below the gross margin line, which are a “significant portion of the total costs of producing a product and delivering it to a customer.”

 
 
 
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