Customer-Base Concentration, Investment, and Profitability: The U.S. Government as a Major Customer

Abstract

We examine whether customer-base concentration has a differential impact on profitability for firms contracting with major government customers versus firms contracting with major corporate customers. We document that firm profitability increases with the concentration of major government customers, but decreases with the concentration of major corporate customers. We attribute the contrasting results to the differential impact of major government and corporate customers on demand uncertainty. Specifically, firms contracting with major government customers face lower demand uncertainty that enables them to realize more efficiency gains from customer-specific investments, whereas firms contracting with major corporate customers are exposed to higher demand uncertainty that reduces the efficiency of customer-specific investments. Overall, our study suggests that major government customers are unique and important in the composition of customer base, and they impact firm outcomes in a significantly different way than major corporate customers. JEL Classifications: M41; L25; G14; H57.

Major government customer and management earnings forecasts

“…1 An emerging literature documents evidence of the influence of the U.S. government as a major customer on suppliers' operating and financial outcomes. U.S. federal government spending constituted about 20% of U.S. gross domestic product (GDP) in the past four decades (Cohen and Li 2020). This is in line with the findings in Mills et al (2013) and Dhaliwal et al (2016) that U.S. federal government spending exceeded USD3.1 trillion between 2000 and 2008 and accounted for 23.2% of GDP in 2011.…”

“…Prior research on the effects of government spending produces mixed findings. While some studies document an adverse impact of government as a major customer on firms' incentive to invest and compete (Cohen and Malloy 2016), others find a positive effect on suppliers' profitability and loan contract terms (Cohen and Li 2020;Dhaliwal et al 2016). Our study adds to this line of research by showing a positive impact of major government customers on the quality of supplier MEFs.…”

“…Hui et al (2012) and Dhaliwal et al (2016) find that firms with major government customers tend to have more conservative accounting and lower cost of capital. Cohen and Li (2020) document that the concentration of major government customers has a positive effect on supplier profitability, whereas the concentration of major corporate customers has a negative effect.…”

“…When uncertainty about future customer demand is low, suppliers are able to plan and undertake customer-specific investments more efficiently (e.g., Chiu et al 2019;Guiso and Parigi 1999). Cohen and Li (2020) find that government suppliers achieve greater efficiency in asset turnover and customer-specific selling, general, and administrative (SG&A) investments, which leads to lower operational uncertainty and higher profitability. Second, government entities have objectives that are different from corporations, thus their decisions are often affected by non-business considerations, such as social welfare, environmental awareness, political lobbying, and campaign donations (Goldman et al 2013).…”

Innovation disclosure in times of uncertainty

“…18 The different number of observations in the table is due to missing values in the variables employed to construct the leader variables. 19 The accounting rule requiring firms to report major customers went into effect in 1977, but few firms started providing such information already on that year (D. Cohen & Li, 2020). Therefore, the sample used in this section starts from 1978.…”