Why Small Firms Stay Small?

In India across various industrial and trading clusters, small scale manufacturers and traders use manufacturing methods aided by simple tools and technology, basic machines (usually old-reused machines which have outlived their useful life) and low skilled labour to produce and trade goods that get either locally consumed or form a part of the larger OEM[1] value-chain as part manufacturers. These businesses are generally very small, employ less than 6-7 people (low-skilled) and usually offer reasonable income to its owners. While proliferation of a number of smaller businesses opens up employment opportunities, avenues for cheaper “Cost of goods sold”[2], and indicates a thriving and growing economy, empirical research[3] across the world has suggested that the spurring up of tiny units of manufacturing is less likely to promote a stable and resilient economy as compared to a developmental model driven by medium scale manufacturing enterprises.

For a growing and rapidly industrialising economy, the proportion of small to medium scale enterprises is always in flux. A mix more inclined towards medium scale enterprises will ensure absorption of unskilled workers, better capital productivity and technological efficiency[4]. Theory and experience from other developing and industrialised countries have suggested that firms should be encouraged to grow beyond the micro-enterprise level to enable the manufacturing sector to generate employment, to produce efficiently and to trigger technological development. In spite of a strong case for promoting medium scale enterprises and Government of India’s consistent push for the SME sector (in the form of fiscal packages and policy reforms), small and micro enterprises still form a whopping 96% of total registered MSMEs in India[5]. Most businesses start and remain very small.

This post highlights the reasons for the firms staying small based on anecdotal evidence, commonality and trends observed among smaller firms. The methodology used is direct observation, conversations and in-depth interactions with small and micro-business owners (90 firm owners) across 8 states of India in their major industrial and manufacturing clusters. The subsequent sections will highlight major trends exhibited by small enterprises and factors that determine such behaviour and trends.

For the purpose of clarity, this post defines an enterprise as small on the basis of (a) number of workers employed – usually six or less, and (b) annual turnover less than INR 40 Lakh (INR 4 million).

Commonalities observed among small business owners:

Irrespective of nature of product, profitability, business vintage, industry and even geographies the small businesses operate in; they exhibit strikingly common characteristics in terms of their choice of labour-mix, place of production, machine, product offering, supplier selection, bargaining ability, pricing decisions, market discovery ability and risk appetite. While the labour-mix, place of production and low capital intensity offers small firms the power of flexibility to survive uncertain business environments, poor bargaining capability, low risk-appetite, weak market outreach and a non-existent control over pricing decisions, act as constraints for small firms to grow.

Small firms usually have low-paid or unpaid labour and mostly follow a family organisational pattern. The women folk of the households usually double-up as unpaid labourers, offering the flexibility of reduced wage costs to the firm. This pattern is overwhelmingly prominent in firms that use rudimentary production technology and techniques that are transferred across generations. For instance, hand block print textile firms and lac-bangle-making units in Jaipur, rugs and carpet manufacturing units in Panipet rely heavily on low-paid and unpaid labour, usually the women folk of the household.

A majority of small firms usually operate from free or in-expensive workplaces as these are places of business activity and production. Many firms find it convenient to incur and absorb additional cost for transportation of finished goods to buyer locations instead of producing in a costly near-to-buyer location – A case in point being the number of very small firms spread across the outskirts of the Pitampura industrial hub in Indore or in the outskirts of Hosur industrial zone producing exactly the same products as that of the units located within the zone, but with the added cost-advantage. These units dodge the high rental expense and offer the cost-advantage proposition to buyers.

Most of the small firms have exhibited low level of capital investment. They tend to operate with simple tools and equipment for production, which means lower fixed costs and lower maintenance costs. Investments in bigger machines would require significant capital, skill upgradation and a strong visibility of order pipeline to attain the turnover that would economically justify capital-infusion. Firm owners usually track their capital investment vis-à-vis turnover. The decision to invest additional capital is triggered on the basis of visibility of order pipeline to achieve the turnover target. In the absence of any one of the above parameters, firm owners find it risky to invest in technology upgradation and tend to continue remaining small. Many small firm owners have confided that low physical capital helps them change their product mix to meet changing demand or input availability without worrying about the unutilized expensive equipment.

Smaller businesses or firms within an industry segment tend to produce identical or nearly identical products – both in terms of quality and design, without offering significant product differentiation. This has implications over the pricing power of the manufacturers (and subsequently on margins) as well. The buyers always command an upper hand in pricing in the absence of clear product differentiation. The shoe manufacturing cluster in Karampura prominently highlights this commonality of small firms. Taking a close look at the tiny-shoe manufacturing units in Karampura cluster, it will be extremely difficult to identify what differentiates one manufacturer from the other. Surprisingly all of the manufacturers supply to 3-4 buyers (middle-men) in the region. The firm’s ability to choose its own buyer is limited by the quality and quantity of output produced by the manufacturer (bigger buyer will buy from a relatively bigger manufacturer).

Small firms find it difficult to identify or discover markets beyond localised markets. This can be attributed to lack of information, both on part of consumers and manufacturers, to discover each other. It is difficult for consumers to learn about the existence and quality of different firms’ outputs. As a result, consumers often buy exclusively from a local producer, and producers sell mostly to local customers. The limited size of their potential customer base limits firms’ ability to grow[6]. A comparison of firm size and profitability of manufacturers in the Kolhapur and Karampura shoe clusters will prominently highlight the fact that market discovery beyond local markets has contributed significantly to the overall profitability and prosperity of Kolhapur shoe unit manufacturers.

Understanding the factors driving the commonalities:

Specifically addressing the question of “why do small firms stay small” and the reasons for demonstrating the common behaviour- a significant number of factors like lack of capital, lack of skill – technical and managerial, limited market availability, weak policy and infrastructure frameworks and low risk-appetites contribute to constricted growth. However, it was observed that it is primarily the risk management strategies of small firm owners (given all other factors kept unchanged or nearly stable) that prevents or augments the growth of small firm owners into medium scale enterprises.

On the basis of discussions with small firm owners who have been profitable for more than 2 years and have still remained small, it was found that they have invariably adopted risk-averse strategies of opting for a product line which promises lower certain returns as compared to a variable one with higher expected value from a new product line. Many firm owners clearly mentioned that their choice of business line or product mix is determined by the ability of the product to offer a minimum income to them. While a few expressed an intention to take their business to the next level, they were constricted by a lack of capital and skill. For instance, a first generation entrepreneur, whose business was in making automotive spark plugs, illustrated this point aptly. He wanted to purchase a new machine that would enable him to introduce a new product line for his 8 year old business. He had collected about INR 10 Lakhs from personal savings to purchase the machine. He required additional INR 8 Lakhs to set up the machine. However, he could not raise the additional capital and was forced to stay small.

Many small-firm owners have managed risk through flexibility – flexibility which is achieved through employing low-paid or unpaid labourers (in lean seasons, firm owners and labourers take up alternate income generating activities), working in inexpensive workplaces (reduces the overhead expenses during lean periods), flexibility in level of capital deployed. On the basis of discussions with collection executives for various financing companies who deal with recovery from stressed firms, it was found that small firms invariably fall into financial stress when they compromise on capital-flexibility – if a significant chunk of capital is blocked at the firm level and it is unable to generate the expected return, firm profitability plunges. However, businesses with higher vintage are better placed to invest capital in business, mainly because of strong networks built over a period which would ensure better order visibility.

The risk appetite of small firm owners has also engendered an inertia against moving to new product lines and venturing into new markets or unknown geographies. Many businesses clearly stated that growing to a medium scale enterprise will force them to be compliant with various regulatory requirements and hence, they find little incentive to expand beyond the “small-firm”. Instead they find it more lucrative to open/invest in a second small business or purchase an asset which would offer economic security in the event of failure of the first business. For instance, a classic example of this behaviour was observed in Mr. Durgalal (name changed), a stone carving firm owner in Jaipur, who insisted that he would prefer to remain an owner of a 4-member labour team and buy agricultural land instead of investing capital in buying new machines for stone cutting or securing labour advance. Small firm owners resort to livelihood diversification instead of investing in the same business.

While intuitively the risk management strategies adopted by small-firm owners, safeguards them from uncertainties of the business environment, at a broader macro-economic level, the larger goals of employment generation and efficient production remain unachieved. The true benefits of a growing economy will be realised when the proportion of medium scale enterprises increases and this shift would require targeted and specific strategies that would address the risk-concerns and risk-response of small firm owners.

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[1] Original Equipment manufacturers

[2] Cost of goods sold (COGS) is the direct costs attributable to the production of the goods sold.

[3] The Growth and Decline of Small firms in Developing Countries by Alex Coad, Jagannadha Pawan Tamvada; An Analysis of Small Business and Jobs by Brian Headd, Success in Small and medium scale enterprise: the evidence from Columbia by Cortes, Mariluz; Berry, Albert; Ishaq, Ashfaq, Risk and growth in Nairobi’s small scale manufacturing by McCormick, Dorothy

[4] Risk and growth in Nairobi’s small scale manufacturing by McCormick, Dorothy

[5] Annual Report by Ministry of MSME 2015-16, 2017

[6] Information, demand and the growth of firms: Evidence from a natural experiment in India by Robert Jensen, Nolan Miller