Pedestrians in Toronto, 2013 (Source: Wikimedia Commons)
Ideas for Leaders #619

Serving a Few Major Customers Vs Many Diverse Customers

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Key Concept

Contrary to the accepted wisdom, manufacturers with a small number of major customers benefit from collaborative practices that lead to less demand uncertainty and greater inventory efficiencies. Manufacturers with a large number of disparate customers are the ones who must keep higher inventory level for longer periods of time, resulting in more inventory write-downs and reversals.

Idea Summary

“Are you a good witch or a bad witch?” Glynda asks Dorothy in the classic movie, The Wizard of Oz. For manufacturers seeking to efficiently manage their inventories, the same question lingers over the issue of customer concentration: is customer concentration — serving a small group of major customers rather than a large number of diverse customers — a good thing or a bad thing for inventory efficiency?

The answer to this question is not easy. On the one hand, a small group of major customers will have more leverage to put pressure on the manufacturer. They can insist that the manufacturer keep a high level of inventory and for longer periods of time to ensure that they have access to product at will.

On the other hand, a small group of major customers is more likely to work closely with the manufacturer, collaborating on ways to increase inventory efficiencies. For example, major customers might share processes and technology that enable more efficient demand and supply planning. This reduces the challenge of demand uncertainty. Another example of manufacturer/customer collaboration is ‘vendor-managed inventory’ or VMI, in which manufacturers manage the inventory of their customers (i.e. they decide when to supply their customers).

Given these two opposing scenarios, two researchers from UC Berkeley’s Haas School of Business analysed data from Compustat and (after 1995) the SEC Edgar database to determine whether customer concentration positively or negatively impacted inventory efficiencies. The data covered the period of 1977 to 2006.

Specifically, the researchers investigated four inventory efficiency variables:

  1. inventory holdings (how much inventory the manufacturers were required to hold)
  2. inventory holding periods (how long the manufacturers were required to hold the inventory)
  3. inventory write-downs (an accounting process triggered when the market value of inventory falls below the cost of the inventory, a sign of excess inventory)
  4. inventory reversals (a decline in inventories in excess of 1%, another indication of excess inventory). Because inventory write-downs could only be calculated from the SEC Edgar database, launched in 1995, the researchers used inventory reversals to measure excess inventory for the period prior to 1995.

Although the researchers suspected at the start of the project that the positive and negative impacts would balance each other out, the data analysis told another story: in general, manufacturers can achieve inventory efficiencies through their relationships with a limited number of major customers.

Specifically, the researchers found that increasing customer concentration by only one standard deviation (SD) led to a significant 7% decrease in inventory holdings and a 6.3% decrease in inventory holding periods.

The data also showed that the same one SD increase in customer concentration reduced the likelihood of inventory write-downs and inventory reversals (by 44% and 47% respectively).

In sum, customer concentration unequivocally resulted in a positive impact on inventory inefficiencies, as evidence by the reduction in the levels of inventory, the length of inventory holdings and the likelihood of write-downs or reversals.

The researchers deepened their analysis to separate the three different types of inventories: raw materials, work in process (the manufacture or assembly of the finished good has started), and finished goods. They found that customer concentration made managing raw materials inventory more efficient, but this gain was offset by issues with work-in-process inventory. In short, the gains in efficiency were mostly captured through finished goods inventory.

Business Application

One might assume that a small group of major customers might use their leverage to force manufacturers to hold high levels of inventory for longer periods of time. This study shows that it’s time to set the old assumptions aside. Especially for finished goods inventory, which would seem more susceptible to customer pressure, less customers results in more inventory efficiencies. Powerful major customers prove to be collaborators not bullies.

One final piece of analysis reveals the power of collaboration on inventory efficiencies. The researchers studied the valuation of companies with a smaller number of customers, focusing on their Tobin’s Q ratio. Once again the results were unequivocal, with customer concentration leading to higher Tobin’s Q ratios.

 Although recognizing the drawbacks of customer concentration, investors clearly believe that the positives outweigh the negatives: a clear lesson for executives and business owners. 

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Idea conceived

  • February 2016

Idea posted

  • August 2016

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