Friday, February 28, 2014

Research Ideas -2 / Should you rely on Major Customers?

Should you rely on Major Customers?

Customer-base concentration, profitability and distress across the corporate life cycle

This paper has been written with Paul Irvine and Shawn Saeyeul Park. The paper focuses on better understanding an age old question in economics and finance. Is it better to depend on a few, large, well-established customers or should you try to expand your customer base? Both strategies have advantages and disadvantages. Dealing with a few large customers could lead to more efficient supply chain management and better visibility into future orders. On the other hand an asymmetrically powerful major customer could demand price concessions, leading to 

​significantly smaller gross margins.  Whether the advantages or disadvantages of relying on a few major customers dominate is entirely an empirical question. Our analysis confirms several well-established facts: We verify that relying on a few, major customers can hurt you as such a reliance leads to lower gross-margins. We also verify that there are benefits to relying on a few, major customers as suppliers with high customer-base concentration have lower inventory costs and better cash and inventory turnover. While these facts have already been well known in the literature we discover two entirely new facts about suppliers that rely on a few, major customers which improve our understanding of how supply chain relationships affect firm profitability and survival. 

First, we find that supplier firms that rely on a few, major customers make much larger customer specific investments evidenced by the much higher rigidity of their costs. Such a rigid cost basis implies that when things are good with their customers (i.e. when their customers are doing well) supplier firms with concentrated customer bases will do even better as they need to spend a lot less for generating an additional unit of revenue. However when times are bad, sales to major customers will shrink and since suppliers with concentrated customer bases are stuck with the fixed investments incurred earlier, in bad times a supplier with a concentrated customer base will suffer considerably more than a supplier firm with a diverse customer base. This is so because suppliers with diversified customer bases have a lot less in fixed investments and as such they can reduce their costs much more efficiently in bad times. This operating leverage effect cuts both ways. 

Second, we find that firms that rely on a few, major customers have a lot more demand uncertainty, not to be confused with demand visibility. In portfolio theory we teach our students that holding a larger number of (hopefully not perfectly correlated) assets reduces the overall volatility of their portfolio. The same idea applies to sales volatility. Relying on a few, major customers may help with demand visibility as the supplier firm could be better informed about upcoming orders. This certainly would reduce inventory holdings. However, such visibility wouldn't decrease the volatility of sales for such a supplier, as shocks affecting the major customers would directly be transmitted to the supplier firm: Relying on a few major customers leaves the supplier exposed, without the possibility of making up for lost sales through alternative channels and leads to significantly larger demand uncertainty (sales volatility).

Thus we find that suppliers with concentrated customer bases are firms with large operating leverage and high demand uncertainty. Such firms have a lot more likelihood of facing "bad" states of the world with no ability to reduce costs in such states and thus are a lot more likely to fail. Should they survive the "bad" states of the world suppliers with concentrated customer bases can enjoy certain operational benefits such as reduced inventory holdings, higher cash turnover as well as higher inventory turnover. We conclude that customer concentration brings both costs and benefits to supplier firms. ​

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