What is supplier concentration?
Supplier concentration means that your company is making most of its purchases from a few key suppliers. There is no universal guideline on what would be considered a reasonable level of supplier concentration, however, if you are purchasing about 40% from one supplier, this might be considered too high.
It is a very common situation for small / privately-owned businesses as sourcing from fewer trusted business partners can save a lot of internal resources. In the short-term, when the supplier relationships are already established, relying on a small number of key suppliers might seem like a good solution.
Why is supplier concentration important in a transaction context?
Buyers always look at risk when assessing a company for sale. Supplier concentration is one of the risk factors that are examined in a due diligence process as it can adversely impact the cost base and the ability of the company to grow. Typical questions that a buyer will ask are: What if your main supplier goes bankrupt, cannot deliver the necessary output or is sold to one of your competitors and stops supplying your company? Would your main suppliers want to continue working with your company if it was sold? What if your main supplier puts your company under price pressure? How fast can you switch to a different supplier? What are the costs of switching suppliers?
Can supplier concentration be a deal breaking or value driving point?
If a supplier falls out, your company might not be able to produce / distribute its products. Finding an alternative supplier in a crisis might be costly. Similarly, if your supplier requests a large price increase, you might be facing increased input costs. Both situations lead to higher costs and lower your EBITDA and might negatively impact your revenues. If there is a level of uncertainty, supplier concentration lowers the price of your business and can become a deal breaker.
How to address supplier concentration?
In the short term, try to lower at least supplier dependency by having back-up suppliers, even if you are not using them on a regular basis. This keeps your supplier concentration unchanged, but enables switching suppliers in crisis. Secure the current suppliers with written contracts. In the contracts, avoid change of control clauses and unfavourable conditions as termination on short notice or adverse price adjustments. When thinking about a transaction, make sure that your suppliers would be happy to continue working with you after your company is sold to a new owner.
In the long-term, diversify your supplier base where possible to decrease supplier concentration. This would also be beneficial to your bargaining power with suppliers and flexibility in situations of increased demand.