Relationships with major customers are conventionally considered to be an impediment to supplier firm performance. Reportedly, major customers pressure their dependent suppliers to provide concessions such as lowering prices, extending trade credit, accelerating delivery times, and carrying extra inventory. The popular press often highlights the “evils” of customer-base concentration by reference to the case of Wal-Mart and its history of squeezing out every last penny from its dependent suppliers (e.g., PBS Frontline 2004). However, research on relationship marketing and operations management suggests that suppliers to major customers may be able to achieve efficiencies in the form of decreased selling and administrative expenses, and enhanced product distribution (e.g., Jackson 1985; Cowley 1988; Kalwani and Narayandas 1995). In addition, major customer relationships can foster information sharing along the supply chain and help supplier firms streamline production and enhance working capital management (e.g., Kalwani and Narayandas 1995; Kinney and Wempe 2002).
In this paper, I examine whether and how customer-base concentration affects supplier firm performance and stock market valuation. To this end, I compile a comprehensive sample of supply chain relationships in virtually all two-digit SIC industries over the thirty-year period from 1977 to 2006, and introduce a measure to capture at the firm-year level the extent to which a supplier?s customer base is concentrated. My concentration measure, labeled CC, is an application of the Herfindahl-Hirschman index and encompasses two elements of customer-base diversification ? namely, the number of major customers with which a supplier firm interacts and the relative importance of each major customer in the firm?s annual revenue.
In contrast to the conventional view of major customer relationships, I find a positive contemporaneous association between CC and accounting rates of return, which suggests that suppliers with concentrated customer bases enjoy efficiencies. A detailed investigation of operating performance drivers reveals that efficiencies accrue to more-concentrated suppliers in the form of cost savings and enhanced working capital management. Specifically, more concentrated suppliers spend less on selling, general, and, administrative (SG&A) expenses per dollar of sales, hold less inventory as a fraction of total assets, and experience higher inventory turnover, as well as shorter cash conversion cycles. Accordingly, although more-concentrated suppliers report lower gross margins, they experience higher operating profit margins and asset turnover and, on the whole, tend to be more profitable.
A causal link between customer-base structure and performance implies that changes in customer-base concentration are associated with changes in supplier firm performance. Indeed, efficiencies achieved through enhanced production coordination and inventory management, cooperative advertising campaigns and marketing alliances with major customers, are likely to flow gradually through a supplier?s financial reporting system. To help assess the existence of a causal link, I investigate the lead-lag association between changes in firm performance and changes in customer-base concentration (?CC). Consistent with a cause-and-effect relationship, I find that ?CC is a strong leading indicator of one-year-ahead changes in profit margins, asset turnover, and overall firm profitability. In particular, I find that increases in customer-base concentration are subsequently followed by efficiency gains in the form of reduced operating expenses per dollar of sales and enhanced asset utilization.
In order to address concerns of a spurious correlation between ?CC and subsequent changes in firm performance, I implement a two-stage regression approach. In the first stage, I remove the component of ?CC that is correlated with measurable characteristics of not only the supplier firm but also of the supplier firm?s customer base ? including market capitalization, book to market ratio, age, sales growth, distress risk, the number of reported business segments, and product market share and competitiveness. In the second stage, I regress one-year-ahead changes in firm profitability on the residual portion of ?CC which is by construction orthogonal to the characteristics considered. I find that residual ?CC is a strong predictor of subsequent changes in firm profitability; therefore, the lead-lag association between changes in firm performance and changes in customer-base concentration is robust to spurious correlations.
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