I often read about the Pareto principle as a productivity tip: focus on the 20% that matters and leave the rest. Useful advice for a full diary. The same split also applies to revenue and profit. Turned around, it also tells a story about risk. Risks that a buyer, a bank or an investor checks first.
What is the Pareto principle
In 1906 Vilfredo Pareto studied land ownership in Italy and found that about 80% of the land was owned by 20% of the population. It was not until 1941 that the Romanian-American engineer Joseph Juran applied this observation to business, in quality management: a small number of causes explains most of the problems. That ratio turns up surprisingly often. The richest 20% of Dutch households own an estimated 80% or so of total household wealth, excluding pension rights (source: Statistics Netherlands, CBS). It works more or less for the number of rainy days that produce most of the rainfall, the number of 15-minute blocks in which electricity consumption peaks, and so on.
Note: the 80:20 ratio is a rule of thumb, not a law of nature. Some distributions are closer to 90:10, others to 70:30. What matters is the pattern of a skewed distribution. That pattern is exactly why it applies so widely, and why it says more than just where you spend your time.
The flip side
The same skewed distribution has a less comfortable reading. If 80% of your revenue comes from 20% of your customers, your business depends to a large extent on a small number of relationships over which you have only limited control.
Financial advisers, banks and investors use concrete thresholds here. As soon as one customer accounts for more than 20% of total revenue, they speak of significant concentration. Above 30%, this is almost always seen as a structural risk. In the Netherlands, the generally accepted critical threshold for B2B is 15 to 20% per customer.
The problem lies in the dependency that concentration brings. With a concentrated customer base, a customer who retenders its purchasing or extends its payment terms hits the core of your business straight away. Above 30% customer dependency, valuation discounts of 10 to 25% arise. Above 40%, this can rise to 30 to 40% of enterprise value.
The whale curve
In many businesses a small group of customers generates more than 100% of the profit. The long tail of often small customers, slow-moving products and one-off orders quietly eats into part of that profit.
That happens through the cost of serving those customers or products, through operational complexity and through the discounts needed to keep them.
Determine, per customer, all the costs needed to serve that customer. Rank your customers or products from most to least profitable in money terms, and build the cumulative total: the profit of customer 1, then 1+2, then 1+2+3, and so on. Plot those results in a chart and you get a curve that first rises above 100% and then falls again: the so-called whale curve, named after the shape of a hump. The unprofitable part is also called the complexity tax, because it comes from processes that are too complex for that group of customers. Think of:
- Many small orders and rush shipments.
- Many queries, exceptions, complaints or returns.
- Manual invoicing, corrections and credit notes.
- Customer-specific reports or non-standard portals.
- A low price relative to the service actually required.
- Slow payment, credit risk or a lot of receivables work.
An online retailer can also apply this to products. For a manufacturer with hundreds of SKUs or a webshop with a long range, this is relevant. In the end it is about which products or customers structurally depress your margin, without you seeing it at revenue level.
What a buyer sees
When a business is sold, customer concentration is assessed within the first few minutes of a conversation, along with the revenue of the largest customer and that of the three largest customers combined. Customer concentration counts as one of the eight value drivers that determine business value, and as one of the strongest price drivers in a sale.
An example: a business with EBITDA of €2 million and a market multiple of 5.0x is worth €10 million. With 25% of revenue concentrated in one customer, that multiple, and with it the value of the business, falls considerably. Above 30% of revenue from one customer, many buyers simply drop out. A buyer is buying a future cash flow, and that can come under pressure from one failed project or one faulty product. If the relationship also rests entirely on the bond with the owner, that customer does not count as transferable business value.
You do not need plans to sell for this to be useful. A buyer calculates what a bank, an investor or you yourself should also know: how much of your result depends on circumstances outside your own control.
Finally
If you find a concentration above 20 to 25% in one customer, that is no reason to panic. It is a reason to build a second revenue pillar: a new segment, a new channel or a new region. The same exercise at product level shows which part of your range mainly adds cost and complexity rather than profit.
Further reading: Why a fashion webshop with 40 percent returns makes nothing on an extra order and What the ECB rate rise costs a technical wholesaler that lets its customers take 52 days to pay.
Further reading: What the ECB rate rise costs a technical wholesaler that lets its customers take 52 days to pay and Why an importing wholesaler sees a 39 percent margin on an item that yields 25 percent after freight, import duty and currency.
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