The Australian economy is dominated by a few big corporate mother ships and, by global standards, a relatively small pool of industries, making concentration risk a serious issue for domestic businesses.
Concentration risk comes in many forms: customer concentration, product concentration, industry concentration, economic-sector concentration, supplier concentration and finance concentration.
Most businesses have fallen victim to at least one of these forms of concentration in the past decade. The collapse of Australia’s car industry is a classic example of both customer concentration and industry concentration risk. Similarly, the global financial crisis sheeted home the dangers of finance concentration, when businesses with only one financial relationship proved particularly vulnerable.
Importers and exporters, and businesses that rely on imported components, have felt the sting of currency concentration in recent years and businesses with a concentration of customers and suppliers in areas struck by natural disasters such as the Queensland floods have fallen foul of geographic concentration risk.
Supplier concentration occurs when a business relies too heavily on one supplier for key business components. A natural disaster, bankruptcy, or perversely, boom conditions, can all affect the ability of a supplier to deliver, leaving reliant businesses short of inventory or subject to price squeezes.
Risk management plan
Every business should construct a risk-management plan that identifies, measures and monitors concentration risk across all areas.
Such a plan typically lists a company’s top five exposures against metrics such as balance sheet, funds, or net profit as well as the size of key geographic concentrations.
It should also list the business’s top five connected exposures. For example, you can have many customers but if closer examination reveals they are all interrelated through company structures, or even by industry, you have a problem.
Once risks have been identified, businesses should set risk limits and put in place thresholds and procedures that alert them to limit breaches. Set the frequency and types of reports, keeping in mind reports should be more frequent in tough times.
Solutions for hedging risk
SMEs can do many things to manage concentration risk but the first and most powerful step is to diversify.
When it comes to customer concentration, ideally no-one customer should constitute more than 10 per cent of revenue. Similarly, businesses should try and serve at least three industries; have suppliers and customers in a range of locations; at least two financial relationships; and several sources of supply. Importers and exporters can choose from a range of business and currency hedges.
There are several strategies a company can employ to diversify its customer base: develop exit strategies from lower quality relationship; increase prices or tighten terms and conditions; and diversify across the economic cycle to even out cyclical supply and demand glitches.
Sometimes concentration is unavoidable. In such cases, it can be handy for businesses to look at concentration risk as a form of credit risk. As payment terms are usually structured for payment after delivery of a product or services, a business is extending credit to the vendor. When banks manage their portfolio credit risk, they look at things like industry, collateral and creditworthiness. Businesses can do the same. Examine your customers, their industry, their financial position; run credit checks and tier your credit terms based on credit risk; try to obtain insurance and guarantees from clients; and hold extra capital to compensate.