All it takes is a simple division computation to reveal a customer’s relative size in terms of gross revenue. If calculated properly, a customer concentration may be confirmed.
The business may have a customer concentration risk if one or more of its customer’s total revenue for the year represents 8% or more of all its customers’ revenue for the same year. To many business owners, this concept may sound counter intuitive.
For many feel the more business done with one customer the better.
While it is generally good for customers to increase their purchases of goods and services with a business, unless the remaining customers do so in similar fashion, the growing concentration of revenue from one (or more) customer(s) creates risk to the entrepreneur.
How to calculate customer concentration
- Divide the revenue from your top customer for the last twelve months (or calendar year) by the total gross revenue of your business for the last twelve months (or calendar year).
- If this amount from 1 above is less than eight percent (0.08), you do not have a customer concentration risk. You can relax!
- If this amount is equal to or greater than eight percent (0.08), you have a customer concentration risk with this customer.
- Repeat the calculation with each of your customers using their gross revenue one-by-one from the greatest to least gross revenue in a given year until the calculation is less than eight percent (0.08).
- Every customer with gross revenue which exceeds eight percent (0.08) of your business’ total gross revenue represents a customer concentration risk for your business.
Business owners should also look at the top customers/clients that represent the majority of its revenue to determine if there is an industry concentration. If more than 25 % of a business’ income comes from a single industry, this can be problematic as well.
Should that industry fall into hard times or out of favor, the business could suffer. And that’s true even if no single customer represents a large portion of the business’ revenue.
Determining if a customer concentration and industry concentration exists in a business is an important part of the exit planning process for one very simple reason. When selling a business, the savvy business buyer will determine if one or more customer or industry concentration risks exists and if so, they will discount their offer price.
Learn more about how to manage the risks associated with customer concentration.
Latest posts by Holly Magister, CPA, CFP
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