Recently, Josh Schultz wrote an article about revenue concentration—how to reduce, avoid, and de-risk it.

It got me thinking about the other sources of concentration that could pose a threat to SMBs—vendor concentration, employee concentration, and net income concentration.

In other words, it isn’t just a revenue problem, and companies that lack a high degree of revenue concentration can still face major risks in the other three categories.

So, let’s get into it.

Vendor Concentration

Vendor concentration is a much bigger risk to companies that are under $50m or that work with suppliers who deliver material value in relation to the value of their final product offering. The risk is also greater when the supplier is a large company.

But simply, vendor concentration occurs when companies rely on only one or just a few suppliers to meet their needs. Should that supplier go under, meeting demand becomes difficult to impossible in at least the immediate term.

This sort of risk can change your gross margin overnight, much like what occurred last year following the changes to Facebook ads.

And this type of concentration actually occurs in more businesses than people think. A prime example of this is the bevy of e-commerce companies that heavily rely on Facebook and Instagram ads to power their growth. Another is in plumbing where it’s rather common to order goods from a single source.

Here’s what to do about it.

Rank your existing suppliers in terms of their strategic importance. Then, working from the top of your list, identify at least one to two backup vendors to begin working with. Start by dedicating just a small percentage of business to them. Then, work up to a more balanced percentage over time.

Employee Concentration

Employee concentration occurs when just one person in the business is driving a disproportionate amount of the net income or possesses highly specialized knowledge that would be difficult or impossible to reproduce if they left.

Oftentimes, this form of concentration comes from the owner. But you’ll need to look a little deeper to see where else this can be happening in the business.

Do you have a manager overseeing the core team or just one superstar engineer delivering the bulk of the firm’s market-leading innovations? The best way to find out for sure is by asking questions, talking to your team, and observing.

What’s key to remember here is that employee concentration can show up anywhere in the organization and at every level. It can also be the difference between profit and loss if not managed correctly.

Here’s what to do about it.

Differentially compensate the employees who are driving disproportionate value in the business, and then cross-train additional members of your team to preserve institutional knowledge.

Net Income Concentration

At Scalable, we work with clients who may have customer concentration as defined by the average person. But a closer look at these bigger customers reveals that many of them, proportionally speaking, don’t contribute much to net margin or FCF.

In these cases, the juice isn’t worth the squeeze.

To avoid this, you need to determine each customer’s contribution to net income. In other words, you want to find the net income concentration.

The benefit of doing so is twofold.

First, it allows you to double down on what’s working. Second, it allows you to be more selective about the clients you work with going forward.

Putting It All Together

Here are your top takeaways from this week’s post.

1. Vendor concentration, employee concentration, and net income concentration can put your business at risk just like revenue concentration does.

2. Vendor concentration occurs rather frequently in businesses and is particularly serious when the supplier in question provides a product or service of material value.

3. The best way to deal with vendor concentration is to start working with backup suppliers.

4. Employee concentration can occur anywhere in the business. Ask questions, talk to your team, and observe to identify it.

5. Overcome employee concentration by rewarding your most valuable employees and cross-training to preserve institutional expertise.

6. Determine the percentage of net income that each client contributes to your business to identify net income concentration. Doing so allows you to double down on what’s working.

Hungry for More?

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‘Til Next Time,

Connor