Importance of Customer Relationships
Building and managing customer relationships is a crucial organizational function because these relationships translate into increased customer loyalty, better inventory management, and, in general, reduced transaction costs. However, given that building these relationships requires scarce organizational resources, firms typically end up allocating their relationship management efforts toward the customers that bring in the most revenue. This can result in a distribution in which approximately 80% of revenues are concentrated among only 20% of customers (classic 80/20 rule). Managing fewer relationships may be easier and may even benefit the firm in certain situations, but the consequences of such skewed revenue distributions have not been formally examined. In an upcoming article in Journal of Marketing, we develop the idea of customer concentration, which is defined as the spread of revenue among the portfolio of customers to study the consequence of such skewed revenue distribution.
Why Is It Beneficial to Have Fewer Customers?
Having fewer customer relationships is easier for firms without adequate resources to manage these relationships. Firms can allocate resources toward nurturing customer relationships, resulting in the ability to anticipate and fulfill the needs of their major customers. Such customers are also more likely to share resources and work closely with the supplier firm. In summary, a concentrated customer base can be valuable for suppliers that lack internal resources by allowing them to rely on their customers to substitute these deficiencies. An initial public offering (IPO) provides one such context, because firms going public typically lack relevant resources in the initial stages of their life cycle and tend to depend on their customer relationships. IPO firms are also under increased investor scrutiny due to their high failure rates; strong customer relationships should help alleviate these investor concerns, improving IPO outcomes.
Why Might It Be Unwise to Have Fewer Customers?
We argue that having strong relationships with few customers (i.e., high customer concentration) hurts supplier firms’ profitability as a result of their reduced bargaining power relative to their customers and their corresponding inability to translate these strong relationships into profits. Given that major customers are well aware of their importance for the supplier firm, they typically demand lower prices, frequent deliveries of small quantities, product customizations, and extended technical and marketing support. For instance, more than 100 firms boast of having Walmart as their key customer and, at the same time, also complain about the mega-retailer’s profit-squeezing margins and relentless pressure to improve the supply chain. Moreover, having revenues concentrated in a few customers increases the firm’s vulnerability to customer churn. We use the IPO context to examine these conflicting consequences of customer concentration.
What Do We Observe in Our Study?
We analyzed approximately 1,000 IPO firms across 56 industries using robust econometric methods. As we suspected, having a concentrated customer base helps the suppliers when they are going public by improving their IPO outcomes. High customer concentration signals the stability of cash flow (e.g., a supplier signaling that Walmart, the world’s largest retailer, is one of its major customers) to IPO investors, who are predominantly interested in the immediate survival of these firms. However, our results also suggest the adverse effects of having a concentrated portfolio of customers, such that major customers bargain away the value created in the relationship and significantly hurt suppliers’ profitability in the long run. For an average firm in our sample, this translates to an additional loss of roughly $7 million in the subsequent year or about $20.32 million over the next four years.
What Should Managers Do?
Our primary results suggest that managers should strive to evenly spread out the revenue across their customer base and not rely on a few customers for their revenues. An even distribution of revenues improves the supplier firms’ bargaining power and their ability to profit from their customers. However, we acknowledge that many firms may not be able to change their customer mix, at least in the short run, and we explore additional factors that supplier firms can use to mitigate the negative consequences of a higher customer concentration.
Our results highlight two specific actions that supplier firms can take. First, suppliers should invest in their internal organizational capabilities, which allow them to efficiently utilize their limited resources to get the maximum output. We specifically emphasize the three core organizational capabilities: marketing, technological, and operational capabilities. These capabilities improve resource utilization and enable the supplier to learn from its customers, anticipate their needs, offer superior offerings, increase production efficiencies, and, in turn, reduce churn and increase customer dependence. Second, our research also shows that managers should improve the overall quality of their customer base. Low-quality customers (as indicated by their financial well-being and their ability to repay debts) lack the resources themselves and do not offer much value in terms of providing access to resources. Such customers may draw the firm’s attention away from other higher-quality customers.
In summary, supplier firms can mitigate the adverse effects of a concentrated customer base by building organizational capabilities and advancing relationships with customers that have better credit.
Alok R. Saboo, V. Kumar, and Ankit Anand (2017), “Assessing the Impact of Customer Concentration on Initial Public Offering and Balance Sheet–Based Outcomes,” Journal of Marketing, 81 (November).