Your worst nightmare comes true! You get an email on Friday afternoon from your largest customer indicating that they are changing suppliers for “strategic reasons.” They represent 20% of your sales revenue and 35% of your profits.
Common Customer Concentration Risks
In a world of increasing commoditization and focus on cost, it becomes more difficult to manage this customer concentration risk as customers are forced to change suppliers to remain competitive. There are many reasons that a key customer changes suppliers. Some common examples of customer concentration risk include:
- Lower pricing from domestic competition
- Imports from low cost countries
- Acquisition (acquirer of your customer has another preferred supplier)
The obvious strategy to reduce customer concentration is to diversify and increase your customer base. A complimentary strategy, one adopted by many a business savvy entrepreneur, is the Long Term Supply Agreement, or LTSA. A big advantage of a Long Term Supply Agreement is that it can be achieved in a much shorter timeframe than reducing customer concentration. A LTSA will not eliminate all of the risk of losing a key customer, but it will make a significant difference under many scenarios.
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What is a Long Term Supply Agreement?
A LTSA is a contractual arrangement with your key customer that commits them to buy, and you to sell, products or services for a specified period of time under certain conditions. Many times companies have this implied commitment/relationship with their customers, but formalizing the arrangement through a LTSA will protect you when market conditions change, and will result in taking your relationship to the next level.
The key to business success with a LTSA is that it be structured as a win-win arrangement between you and your customer, and that the agreement be flexible enough to withstand the test of time through both long and short markets. If these parameters do not exist, then the chance of the agreement being in place for the long term is low. A successful strategy, and one that significantly improves your chances of “selling” the concept to your customer, is to structure the agreement in a way that parallels how you transact business today.
As an entrepreneur, selling the concept of the LTSA to your customer can be delicate. The key is to educate them on the win-win and flexibility elements of the agreement and begin this introduction with a straight forward one-page concept.
Customers Have Two Concerns When Considering a Long Term Supply Agreement:
- Concern that the supplier will require the customer to buy products or services that they don’t need (typically referred to as Take or Pay).
- Concern that they take themselves out of the market for buying these products or services, which leaves them vulnerable to paying higher prices than their competition.
There are many ways to structure the terms of the agreement to eliminate both of these concerns. Each agreement will be different based on the individual company circumstances, but below are a few concepts to consider:
- Volume or service: provide flexibility to accommodate changes in customer’s demand. Fixed volume or service LTSA are a win-lose proposition.
- Pricing: include a competitive price clause, but make it precise so you’re not faced with matching price for a dissimilar competitive offer.
You will get a wide range of responses from customers when you initially propose the concept of a LTSA. Some customers will request or require an incentive to move forward with the process, we call this the cost of long term supply insurance. A good time to propose the concept of a LTSA is in response to a customer-initiated request for a concession (e.g. price reduction). In most cases you will need to meet this request anyway to maintain your supply position, so why not exploit the opportunity?
These agreements do not have to be overly complex and long legal documents. Language that is more concise and straightforward will always be more accommodating to the customer. Many times a couple of pages in addition to standard terms and conditions should be sufficient.
Start now! This process generally takes a number of iterations and can take some time to negotiate. Begin with developing the one-page concept and review it internally through the eyes of your customer to make sure that it meets the criteria above (win-win/flexible). The rewards are significant and help lay the foundation for your business success.
For more impact, consider taking the concept of a LTSA one step further by recommending that your customer propose the same concept to their key customers. Chances are that some of your key customers have the same customer concentration risk on their end, which could ultimately impact your company.