Don’t discount (too much) at the top

inventory - John Wagner

In a past column, we covered customer concentration, and we pointed out how crucial it is that you inform potential acquirers what percentage of your business is concentrated in your top 10, or even top 25 customers. That kind of report is fairly standard during the acquisition process. Having looked at dozens of LBM businesses, it no longer surprises us to see how many operations have as much as 40% (or more) of their business concentrated in just a dozen high-volume customers.

Is that all bad?

Not always. Some types of large customers can be less-costly to serve, and they deserve discounts. Large customers tend to have access to better technology for delivery scheduling, and they may even pay faster, since big companies have easier access to credit lines and capital. That said, as a rule of thumb, keep this in mind: No one customer should represent more than 10% of your business.

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Company health check
Here’s another “company health check” that a prospective acquirer will run. It focuses on how well you maintain discipline to protect your Gross Profit Margins (GPMs) across your customer base. While your income statement shows your average gross profit margin for the business, it should also include breakouts for the various pricing discount structures, while showing the GPMs you achieve for the various product lines that you sell. The reason is that an aggregate GPM statement won’t reflect how the GPMs vary widely by product category, with lower GPMs achieved for commodity items, and higher GPMs for your value-adds. Obviously, higher margin product categories are a positive and will be viewed as value added services by the acquirer.

When a potential acquirer looks at a GPM report across your entire customer base, in various categories, they are not just expressing idle curiosity. The acquirer wants to see if you are discounting too heavily with your biggest customers. Yes, in reality, everyone discounts for their biggest customers, under the assumption that they’ll “make up any loss on volume.” (That business cliché is so old and so funny, it’s a joke we all hear in the workplace.) But if you are discounting too heavily at the top of your customer list, the lower GPMs will stick out like a sore thumb to anyone looking over your business.

Now, as just mentioned, you can’t possibly maintain the same gross profit margin you get from a “truck and pup” buyer who swings for $100 of lumber, when compared to a large-volume buyer who’s buying truckloads of windows and cabinets. The small guys pay top prices. The big guys get a break.

But it’s a slippery slope when you start giving increasingly steeper discounts to keep the biggest customers happy. So, you should determine a balance between discounts and your costs, so you know the “inflection point” when it stops making sense to discount further. If you’re not watching the store, and not using a dispassionate, data-driven analysis, it’s remarkably easy to lose sight of when you’re selling materials at no profit, or at nearly no profit. You may even find you’re losing money on each sale for those steeply discounted customers, if you have not accounted for all-in costs of carrying that customer. We have seen this blind spot occur in some of the largest and most-sophisticated businesses we have consulted with. It’s remarkably common.

Does lack of gross profit margin discipline affect your value in an acquisition? Yes. Big time.

The value of your entire company will suffer with some rather cruel accounting if an acquirer spots a customer who is either unprofitable or on the bubble/near the bubble of profitability, because clearly that customer is not materially contributing to your EBITDA.

On the other side of the coin, if your gross profit margins are around the same at the highest volume as they are for your down-list customers, that shows you run a tight shop. Indeed, it’s a leading indictor of a well-run business.

As an exercise, before you’re asked to do so by a prospective acquirer, calculate your customer concentration today. Then, assign a gross profit margin for each of the top 25 customers, or even your top 50. You’ll find this instructive. And if you are preparing to sell your company, make adjustments now, as far as you can, so an acquirer doesn’t find anything suspect when they run that same report.

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