One common cause of vulnerability, particularly in small businesses, is dependence.
Dependence arises when a business has a high level of reliance upon a single source, whether that is a source of revenue, supplies, skills or services. Banks refer to dependence as ‘concentration risk’ because the risk of a business encountering difficulties is heightened as a result of the concentration of reliance of some component of the businesses’ activities on a single source.
The most common forms of dependence are found in customer dependence (where a business has one major customer or a small number of customers that represent a large proportion of the sales of the business) and supplier dependence (where the business relies on one key supplier that supplies either the majority of the requirements of the business or business-critical supplies). Other forms of dependence range from industry dependence (where a business services only one industry) to dependence on a key staff member with unique skills or knowledge.
There are multiple risks arising from dependence. The most commonly encountered difficulties arising from dependence include:
· large customers exercising a degree of price control small dependent suppliers: businesses are confronted with the threat of losing of sales contracts or sales volumes unless they hold or reduce their prices
· large customers unilaterally extending their payment terms to small suppliers: slower payments by large customers assist the cash flow of the large customer but hurt the cash flow of the small supplier resulting in cash flow stress for the smaller business
· losing a key customer to a competitor: when a key customer is stolen by a competitor, businesses lose future revenue, have a stronger competitor to contend with and run the risk of margins being squeezed by competition as the competitor seeks to squeeze them out
· failure of a key customer: when a key customer fails businesses risk losing not only the money already owed to the by the failed business but also future sales. Additional costs may also be incurred in seeking to recover money owing and in finding replacement customers
· the failure of a critical supplier: If a key supplier fails businesses risk disruption to their supply chain resulting in lost sales and potentially in the loss of customers to competitors when they are unable to meet customer needs.
· loss of customers when key staff defect: this is a common problem for professional firms, investment advisers, portfolio managers, investment banks and banks where customers are loyal to key staff and follow the staff to a new firm
Events such as these can result in a major disruption to business activities, revenue and cash flow.
Every business is subject to some level of concentration risk, and even the largest businesses can be caught out. For many years business across the world have basked in the economic growth of China which has voraciously consumed an ever-increasing volume of western goods, often at premium prices. The volume of demand and willingness to pay top dollar has resulted in a focus on the Chinese market and customer dependence for many businesses. The decision by the Chinese government to restrict imports of Australian wine, coal, seafood, barley and other products severely disrupted entire industries in Australia because of the high dependence on the Chinese market that had arisen over a number of years. This is a spectacular example of the potential consequences of concentration risk.
Most business have a high degree of industry dependence. There are many examples of entire industries experiencing a downturn, although these are usually temporary and driven by macro-economic events. Sometimes industry downturns are driven by other factors (for example, COVID lockdowns and restrictions resulted in major disruption to the travel, tourism and hospitality industries). On occasions, industry downturns are permanent, driven by changes in government policies (for example, the removal of tariff protection for the car industry resulted in the shutdown of all car manufacturing in Australia) or consumer behaviours (remember video rental stores?).
On a micro level, many small and medium businesses rely on a single, large customer. Industries such as building subcontractors, mining services and transport all commonly have a high degree of customer dependence. On some occasions dependence exists in the relationship with an intermediate party, such as a tourist business that is dependent on a key booking agent.
Dependence is an often-overlooked risk to business. The important thing for business managers is to be aware of the nature and extent of the dependence in their business and to consider how their business may be impacted by dependence. Wherever possible, the level of dependence should be reduced by seeking alternative customers, building relationships with alternative suppliers or otherwise taking steps to reduce dependence. Where dependence cannot be reduced, or cannot be reduced quickly, managers should assess the potential impacts of dependence on their business and develop contingency plans to respond to the emergence of unfavourable events arising from dependency risks.
Steve Lloyd
Disclaimer
This article contains information and comments that reflect the opinions and ideas of its author which are general in nature and do not take account of the individual circumstances of any specific individual or entity. Strategies outlined in this article may not be relevant to the circumstances of every reader or every entity and are not guaranteed or warranted to produce or result in any particular outcomes. Relevant laws and regulations vary from jurisdiction to jurisdiction and from time to time. Readers are advised to seek independent legal, financial or other professional advice that is current and tailored to their individual circumstances and geographic location. No warranty is made as to the accuracy and completeness of the information contained in this article. Both the author and Survive in Business Pty Limited specifically disclaim any liability or responsibility for any loss, damage or risk incurred to any party as a direct or indirect consequence of the use, application or reliance upon any of the contents of this article.