What is a “cash cow”?
In its traditional sense, a cash cow is a product or service with a strong market position in a mature, relatively slow-growing market that generates more cash than it needs to maintain itself.
This situation is fine if you use the surplus cash generated by established parts of the business to invest in new products, markets and opportunities that will provide future growth. The problem is many businesses don’t do this, the comfort the cash cow brings is enough for them for the time being.
The problem gets worse when an SME becomes dependent upon its cash cow.
Here are some examples we have seen:
· One product generates 70% of your gross profit.
· One customer accounts for 40% of your turnover.
· Three customers collectively represent 75% of your sales.
· One particular service is responsible for almost all your recurring income.
None of these situations is in itself a problem. In fact, concentration can be a perfectly rational strategy, particularly for a smaller business. Specialisation can create expertise, efficiency and a strong competitive position.
The danger is failing to recognise the difference between specialisation and dependency.
There are good reasons why a business might deliberately concentrate on a particular product, service or customer group. A successful product can be highly profitable because the business understands its market, has established efficient processes and has built a strong reputation. A major customer can provide a substantial and predictable order book, reducing the cost and effort involved in constantly finding new business.
So, diversification should not be pursued simply for the sake of diversification. The real question is: If something happened to our biggest source of revenue or profit, how quickly could our business adapt? That is where the medium- and long-term risks begin to emerge.
Short-term benefit hiding the long-term risk.
Imagine an SME whose largest customer provides 50% of its annual turnover. For several years, the relationship works extremely well. The customer pays on time, places regular orders and appears highly satisfied.
The business owner quite reasonably invests in additional staff and equipment to service this large account and the company appears to grow. But something else has happened - the business has gradually built its cost base around the assumption that the customer will continue to provide that level of revenue.
Great if that situation continues but if the customer subsequently reduces its orders by 30%, changes supplier, is acquired by another company, experiences financial difficulties or simply decides to negotiate much harder on price, the business can suddenly find itself with substantially reduced revenue and margins but largely unchanged costs.
The business may have been profitable for years but it can still become financially distressed very quickly.
Customer concentration can create potential risks in the following three important areas.
The most obvious danger is losing the customer altogether. Replacing £500,000 of annual sales is very different from replacing £50,000. And finding replacement business takes time.
The larger the proportion of your revenue generated by one customer, the more important that customer becomes to you. The customer can realise their importance and may seek lower prices, longer payment terms, additional services or more favourable contractual arrangements. All adding up to potential problems.
3. Cash-flow pressure
A profitable business can still fail if cash flow deteriorates. If a major customer pays late, disputes an invoice or significantly reduces orders, the impact on working capital can be substantial. The problem can become particularly serious where the business has recently increased staffing, stockholding or borrowing to service the major account.
Management attention can become concentrated around the requirements of one major customer. New opportunities may be rejected because there is insufficient capacity. Marketing to new potential customers may be restricted due to the time constraints of satisfying the major customer. Product development can become focused exclusively on the needs of the dominant customer. So over time, the business becomes increasingly shaped around one relationship.
Perhaps the greatest danger is assuming that today’s successful relationship will continue indefinitely. They can change for a number of reasons. Customers merge and businesses are sold. Procurement policies change and decision-makers leave. New competitors emerge or technology changes. A customer that has been loyal for 15 years may have very different priorities five years from now. All these can create relationship issues.
Product Change Occurs
A business can become equally dependent upon a single product or service. Suppose one product accounts for 65% of turnover and 80% of profit. It may be an excellent product. But what happens if:
· a competitor launches a better alternative?
· technology makes the product obsolete?
· input costs increase significantly?
· regulation changes?
· customer preferences change?
· margins are squeezed by competition?
· demand begins to decline?
The product that has funded the business for years can become its greatest vulnerability. Successful products can create complacency. Why invest time and money developing something new when the existing product continues to sell? A perfectly reasonable approach in the short term that can be a very expensive decision in the long term.
The strategic purpose of a cash cow is not simply to keep milking it indefinitely. The cash it generates should help fund investment in the next generation of products, services and markets. Helping future growth.
Use today’s success to build tomorrow’s business.
What should business owners do when they recognise the cash cow trap?
The answer is not to abandon your most profitable product or your biggest customers. Instead, understand your dependency. Start by asking some uncomfortable questions.
“What percentage of our turnover comes from our largest customer?”
“What percentage of our gross profit comes from our largest product or service?”
“What would happen if that revenue disappeared tomorrow?”
“How long would it take us to replace it?”
“How much of our cost base has been built around this revenue?”
“Are we actively developing alternative sources of revenue?”
“Are we investing enough in new products, services and markets?”
“Do our customers have realistic alternative suppliers to us?”
The answers can reveal risks that are not obvious from a conventional set of annual accounts but can be ticking time bombs that will affect the business in the future.
Diversification does not mean abandoning what you are good at. It means making sure that the success of one part of your business does not determine the survival of the whole business.
This might mean:
· developing additional products or services
· targeting new customer sectors
· reducing dependence on a small number of accounts
· building a stronger sales and marketing pipeline
· developing recurring revenue streams
· investing some of today’s profits in tomorrow’s opportunities
· reviewing supplier concentration as well as customer concentration
· stress-testing cash flow against the loss of a major customer or product
· and regularly reviewing whether today’s competitive advantage is likely to remain relevant.
The objective is not to eliminate risk. That is impossible. The objective is to avoid having one area of risk being capable of overwhelming the entire business.
A successful product, service or customer is something to value. But success can create its own dangers when it leads to dependency. A healthy business should be able to answer two questions:
“What is generating our cash today?”
“What will generate our cash in five or ten years?”
If the answer to both questions is the same product, customer or market, it may be time to look more closely at the business model. Your cash cow should be helping to finance the future of your business — not quietly becoming the single point of failure.
At Kaizen, we believe sustainable business growth comes from understanding not only where your business is making money today, but where its future resilience and opportunities will come from. Sometimes the biggest risk is not a business that is struggling. It is a business that has become dependent upon the one thing that is making it successful and doesn’t acknowledge the risk that can bring.
We can help you discover where you are right now and advise you on what to do to secure the future of your business. And an initial consultation is entirely free! Simply contact Kath on 01482 772261 or email info@kaizengroup.uk. But don’t wait until the cows come home!
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