the effect of customer concentration on firm risk, growth and corporate diversification
Normaziah Binti Mohd Nor is a PhD student in the Department of Finance and Accounting. Her supervisor is prof.dr. R. Kabir from the Faculty of Behavioural, Management and Social Sciences.
This thesis undertakes three independent research projects on customer concentration related to risk, growth and diversification of firms. Customer concentration refers to the degree of how a firm’s total sales revenue is distributed among its customer base. A customer is considered a major customer when its purchases account for at least 10% of a firm’s total sales. The customer concentration phenomenon is drawing increased attention by regulators, practitioners and researchers. The U.S. regulators mandate public firms to disclose key information about major customers in their financial statements. Corporate managers consider the major customers when choosing their strategies and financial decisions alongside the shareholders and bondholders. Also, researchers from various disciplines are trying to understand the causes and effects of customer concentration theoretically and empirically.
A theoretical explanation for the impact of customer concentration is primarily based on the resource-based theory, resource dependence theory (stakeholder bargaining power) and agency theory. The resource-based theory is used to understand how firm’s access to unique resources can help to gain competitive advantages. Competitive advantage is a concept closely related to rent generation. Such an advantage does not necessarily lead to a higher level of firm performance. It all depends on how much of the rents created by competitive advantage are expropriated by stakeholders. Agency theory whereby the interest of managers differs from shareholders has commonly used to understand the managerial rationale behind the financial and strategic investment decisions that benefit them but have far-reaching implications for company shareholders and other stakeholders.
The resource-based theory suggests that firms relying on major customers gain competitive advantage through unique relationship specific investments (RSIs). These investments can increase economies of scale and improve operating efficiency. Major customer–supplier ties often involve the firms committing into relationship-specific investments which are valuable, rare, and difficult to imitate. Major customers are considered as a complementary means of traditional corporate governance mechanism to monitor the manager behavior to act in the best interests of the company. They are especially effective at disciplining managers because they can threaten to withhold future business, weakening or even destroying the supplier. Nonetheless, relying on major customers can reduce a firm’s profitability because the relative bargaining power of the customer pressurizes the firm to lower prices, delay payments and make risky relationship-specific investments. Our empirical findings show that customer concentration entails both costs and benefits for firms. While the impact of major customers on corporate performance has been widely examined, its impact on the variability of firm performance and the rate of firm growth has hardly been examined in the literature. Also, no one has explored the interaction between customer concentration and corporate diversification.
Our analysis data are based on U.S. manufacturing firms from 2007 to 2015. The ordinary least square (OLS) method is used as the main regression technique. Fixed effects regressions and 2-stage least square (2SLS) regressions are also used to address the issue of omitted variables, individual heterogeneity and endogeneity or reverse causality.
The main objective of the first research project is to examine the effect of customer concentration on risk (the variability of firm performance). Examining the volatility of sales, operating returns and stock returns, we find that as customer concentration increases, firm risk also increases. Firms with major customers face higher risks because of increases in risky relationship-specific investments, bargaining power of customer, demand uncertainty, and credit risk. Relationship specific investment is risky because the value of investment is worth within the relationship only and it cannot be sold without significant loss. Greater bargaining power of customer affects the stability of operating incomes because major customers often demand lower prices, purchase irregularly, and delay payments. Firms with major customers face high demand uncertainty because they have relatively undiversified sources of revenue, that prevents them from easily finding alternative sales opportunities. When a major customer experiences financial distress, declares bankruptcy, switches to a different supplier, or decides to develop products internally, the firm faces the risk of losing substantial future sales and the inability to collect outstanding receivables (credit risk). Firms also face high financing cost because banks and investors view customer concentration bring a significant of risk.
We also investigate the interaction effects of corporate governance because of its importance in managing the risk as well as the customer relationship. We find that ownership concentration and relationship age moderate the adverse effect of customer concentration risk. Owners with large shareholdings are particularly concerned with the increase in firm risk that arises from customer concentration. Therefore, they are more likely to engage in increased monitoring effort thereby reducing the firm risk. A long firm-customer relationship implies that the firm has accumulated a large amount of experience with the customer, and is thus less prone to any opportunistic behavior by the customer.
The objective of the second research project is to examine the relationship between customer concentration and firm growth. Our results show that customer concentration accelerates firm growth. Several reasons exist. First, major customer firms enjoy high growth than non-major customer firms due to better operating and financial performance coming from increase in economies of scales and improved efficiency. Second, major customers can transfer value to suppliers along the supply chain from their relationship-specific investments. Third, major customers play a complementary role to traditional corporate governance mechanisms.
We further analyze how CEO traits affect the relationship between firm growth and customer concentration. According to the upper echelon theory, a firm’s strategic choices can be influenced by the characteristics of CEO / top managers. Their personal characteristics for example age, education, experience and tenure may influence the key decisions taken by firms. In this study, we focus on the founder CEOs and age of CEOs, which are important personal characteristics of executives. Founder CEOs are risk averse, preserve more their private benefits of control, and are more likely to pursue self-interest rather than shareholder interest. Younger managers have more career reputation concerns and therefore motivated to increase the firm growth because the realized gain from the firm growth may benefit them in longer employable periods. We find that founder-CEO has a positive effect, while CEO age has a negative effect on firm growth. But, when founder-CEO and CEO age are interacted with customer concentration, we find that founder-CEO continues to show a significant negative effect, but CEO age has no significant effect. The results suggest that the positive effect of customer concentration on firm growth is less pronounced for firms managed by founder-CEOs.
The final research project considers the role of the major customer in the firm’s industrial diversification decision. It begins with examining whether corporate diversification is affected by customer concentration. We find that customer concentrated firms are less likely to diversify. The arguments are as follows. First, concentrated customer-based firms increase their focus on their core abilities and unique resources to gain competitive advantages from relationship specific investments. Second, major customers have a great deal of bargaining power and cause firms in weak position to make strategic investments decisions. These firms are forced to make customized product and to stay focused as a result of commitment to this specific investments, and have no room for other expansion activities. Third, major customers act as a corporate governance mechanism to monitor managers who have incentives to diversify for their own benefit rather than the interests of the firm. More diversified firms are exposed to severe agency problems that can lead to inefficient resource allocation and information processing problems between multiple business divisions.
We also observe that customer concentrated firms prefer unrelated diversification to related diversification. At high level of customer concentration, firms choose unrelated diversification. The finding is in line with the risk management argument. Firms might prefer unrelated diversification as a precaution against the loss of a major customer and the ability to exploit resources, and raise capital to deal with disruptions in major customers. Finally, we show that firms choose to diversify when they obtain market power over their customers by producing un-substitutable and specialized products. Generally, the results of the final research project suggest that the concentration of a firm’s customer base significantly affects corporate diversification policy.