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Five Types of Concentration Risks to Monitor in Real Time

insightsoftware -
December 21, 2020

insightsoftware is a global provider of reporting, analytics, and performance management solutions, empowering organizations to unlock business data and transform the way finance and data teams operate.

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We all know the old adage that says “don’t put all of your eggs into one basket.” In the more modern terminology of business, we could rephrase that to say “be careful about concentration risk.”

When an organization is too reliant on one company or market segment to drive revenue or ensure an adequate product supply, it creates concentration risk. In other words, it increases the likelihood that a single point of failure can have a big impact on sales, the supply chain, or the financial health of the business.

As the coronavirus pandemic first appeared on the scene in early 2020, most businesses experienced the impact of concentration risk in one way or another. Restaurants that were already equipped to handle takeout service fared better than those that were not. Food and beverage manufacturers who were selling their products to both consumers and institutional customers suffered less of a negative impact than those selling to restaurants and institutions alone. On the supply side, similarly, companies that relied upon a single source for critical materials had to scramble in search of alternative suppliers.

Diversification has always been a powerful strategy for avoiding risk. It’s no different when it comes to supply chain, revenue, workforce, and accounts receivable.

There is a slightly less familiar version of the “eggs in one basket” quote that takes an opposite approach to the original. Andrew Carnegie advised that the best plan for getting rich is, in fact, to put all of your eggs in one basket, but he follows with an important caveat: “Then watch that basket!” In other words, there are benefits to concentration, as well as risks.

Smart business leaders must carefully balance the risk and reward associated with concentrating sources of revenue, supply, credit, and so on. To do so, it is critically important to have strong reporting and monitoring tools and procedures in place to ensure that you do not cross pre-defined thresholds and that you can take quick action if and when you have to cross them.

Furthermore, it is valuable to have effective forecasting tools in place that enable business leaders to forecast “what if” scenarios and explore potential high-risk situations as well as to plan ahead with risk-reducing contingencies.

Let’s look at five key areas in which concentration risk manifests itself in today’s businesses.

1. Vendor Concentration Risk

In business, relationships are everything. When you find a vendor that fulfills your need for a product or service at a competitive price with good customer service, you will naturally want to do more business with that vendor. If the vendor offers a discount for higher volume orders, you’re more likely to order future purchases from that particular vendor.

That’s great when everything is chugging along as normal, but when that vendor is negatively affected by unforeseen events, it could spell trouble for your organization as well. When a key vendor encounters financial difficulty (for example, if they are unable to pay their suppliers), that can have a cascading effect that directly impacts your business.

Similar disruption can occur if a key vendor suffers from temporary quality issues, workforce interruptions, natural disasters, or a disruption to shipping and transportation. Something as simple as a fire or localized flood can wreak havoc on your business–unless you have alternatives lined up in advance or have established safety stock to get you through any short-term disruptions.

2. Fourth-Party Concentration Risk

Fourth-party concentration risk is similar to vendor concentration risk, but it is one step further removed. Briefly defined, fourth-party concentration risk occurs when a number of your key vendors or suppliers rely on the same upstream vendor or supplier, which could potentially be a point of failure.

Say, for example, that your company sources electronic parts from three different suppliers. Unbeknownst to you, all three of those suppliers rely on the same company to supply them with critical raw materials. What happens if that single source of materials fails to deliver? With four potential sources of supply, you might assume that you will be covered, but the common point of failure is one step further removed, and you have limited visibility into it.

In this case, it’s important to have due diligence processes in place around key vendor relationships. That can include collecting information about the fourth-party suppliers who service your vendors and documenting that information clearly. By monitoring purchase volumes and identifying potential points of failure, you can keep fourth-party concentration risk in check.

3. Sector Concentration Risk

Some people refer to sector concentration risk as “industry concentration risk.” The latter term, however, implies that sector concentration is really a matter of which industries you sell to. That fails to adequately capture the scope of the potential problems. In fact, sector concentration risk arises from potential disruptions or volatility in key customer markets. If you rely too heavily on a single large customer, an industry, or a product and market category, you may have too much exposure to sector concentration risk.

When the COVID pandemic first emerged, demand fell for some products, while it rose for others. One major producer of cheese based in the northwestern United States was selling to both consumer markets (that is, packaged goods sold through retail grocers) and institutional customers (that is, bulk packaged cheeses for restaurants, cafeterias, and other large-scale food production operations). Because the producer was sufficiently diversified across those two markets, the company was able to shift resources away from the lower demand goods aimed at institutional customers and reallocate them to higher production of consumer products. Diversification proved to be its saving grace.

We have seen other examples of companies that responded to a sharp drop in sales by identifying a new market need and quickly adapting to it. A New England-based producer of retail store fixtures abruptly shifted to the production of Plexiglas barriers that serve as a safety measure to protect workers against the coronavirus, for example.

4. Asset Concentration Risk

Asset concentration risk is a familiar concept for anyone who has invested in financial securities and has applied financial intelligence principles to their portfolio. We are all familiar with the concept of diversification, which dictates that investors should allocate their assets across a range of stocks, bonds, and other investments to avoid excessive damage to their portfolio should one of those assets have a huge decline in value.

A similar principle holds true for businesses that must consider the allocation of financial resources and the risk to various tangible assets in their possession. Although businesses are typically insured against losses caused by fire, theft, flooding, or other such incidents, they remain at risk to fluctuations in value.

Clothing Price Tags

When the value of real estate assets falls, it can have a huge impact on a company’s balance sheet. If an organization intends to continue using that asset (a warehouse, for example), that might not seem like a big deal. When it comes time to tap your line of credit, though (or to apply for a term loan), the loss of value in that asset can have meaningful consequences in the near term.

In the world of supply chain management, in particular, asset concentration risk manifests itself in the form of aging inventory. When companies have poor visibility into stock on hand (including aging information), there is a greater likelihood that inventory will grow obsolete, potentially losing value very quickly.

5. Credit Concentration Risk

Finally, there is the matter of credit concentration risk. This typically happens when a company fails to maintain adequate control of accounts receivable. Very often, this can happen with larger customers who the company allows to continue placing orders in excess of their stated credit limit. Sales managers (or even executive management) approve higher limits because they don’t want to miss out on the customer’s business.

Unfortunately, those situations often bring bad news very suddenly. After hearing repeated promises that the check is in the mail, creditor businesses often find themselves unexpectedly on the short end of the stick. That means waiting a long time to get paid, or writing down some or all of the receivable.

Managing Concentration Risk

The keys to managing all forms of concentration risk are awareness and visibility. Awareness is simply a matter of making sure that these risks appear on the radar screen in discussions with the executive team. That, in turn, should prompt leaders within the business to establish processes for monitoring and reducing those risks. That requires clear visibility, aided by tools that can gather and present information from across the enterprise and alert management when there needs to be corrective action.

Real-time reporting and analysis tools make it possible to consolidate information from multiple sources and present thresholds and alerts in an intuitive and meaningful way. In the case of credit concentration risk, for example, the finance team can monitor DSO and run aged receivables on amounts exceeding a given threshold (or for customers exceeding a certain threshold).

You can, likewise, mitigate inventory exposure to asset concentration risk with aged inventory reports that provide clear visibility into potential obsolescence. You can assess revenue concentration risk and sector concentration risk by periodically reviewing revenue allocation across customers, industries, geographies, and other market segments.

The insightsoftware Advantage

insightsoftware helps finance and accounting teams develop clear visibility into important metrics across their entire organization, increasing efficiency and performance while managing risk. To learn more about how superior reporting tools can help reduce concentration risk for your organization, contact us for more information or a free demo.