Augmenting Productivity in SMEs

A Report for the Small Business Service by

Kevin Mole Centre for Small and Medium Sized Enterprises Warwick Business School

October 2002

Aims
Why are some firms more productive than others? This report surveys the recent evidence on total factor productivity, using datasets to track the performance of each firm over time. It examines the resource-based view of the firm and considers the mixed results that total quality management has had on those small firms that have adopted it. The report discusses a survey of engineering companies to explore how they become aware of new technologies, and why they decide to adopt them.

Methodology
The literature review aims to. provide an overview of the main research findings in firm productivity; highlight the gaps in existing knowledge; outline policy implications; make recommendations for future research.

In addition, the report presents results from a survey of 210 engineering firms.

Background
The incomes of UK residents depend on productivity, which varies widely between firms in the same industry. Some firms are three times as productive as their industry counterparts. Smaller firms are usually found lagging behind in terms of productivity, both in the US and UK. However, this does not mean that small and medium enterprises (SMEs) do not contribute to productivity growth. This report sets out to explore some of the issues surrounding productivity within UK SMEs.

Definitions
Firm productivity measures how much input is needed to produce the firms output. Output is measured by the volume of goods and services. There are different measures of productivity depending upon what inputs are measured. Labour productivity measures the output per unit of labour. The unit of labour can be hours worked, or simply per worker.

Different measures trade-off simplicity for analytical power. For example, output per worker is easier to calculate; whereas hours worked shows whether it is the longer hours that add to output, rather than the efficiency of the process. Labour productivity is useful for policy makers because it shows the output per worker and rising incomes depend on this measure. However, this is a partial view of productivity. Total factor productivity (TFP) measures all the inputs to the firm. This provides a better, more rounded picture of firm productivity, but can be difficult to estimate. Using more than one measure can provide insights into what is really going on. For example, UK workers typically work longer hours than workers in France or Germany. The productivity gap implied by output per work hours is greater with France and Germany than it is by output per worker. In a similar fashion, differences between TFP and labour productivity may reflect differences in the amount of capital per worker. The report distinguishes several types of small firms. Existing firms are firms that have been in the industry for more than one year and are not going to exit within that year Start-ups are independent firms that have started trading within the year

Entrants are firms that enter a market within that year. They include startups and existing firms that move into a new market Exiting firms are firms that will exit the industry within that year.

Findings
SME Contribution to Productivity Growth Over time, SMEs contribute to overall UK productivity in three ways. (i) Small firms act as a seedbed for innovations. This seedbed role is most noticeable in small manufacturing firms who employ between 5-9 employees. The growing small firm can disrupt the cosy relationships built up within an industry, and heighten competition. Entrants compete with existing firms and cause those performing badly to exit.

(ii) (iii)

Productivity in Micro-data sets

Total Factor Productivity in some manufacturers is two-and-a-half times that of others in the same market. It is highly likely that those firms with high productivity today will have high productivity tomorrow. High productivity firms are less likely to exit the industry. There are four sources of increased industry productivity. existing plants can increase their productivity; more productive firms can gain market share from less productive firms; new entrants can be more productive than existing firms; exiting firms can be less productive than average.

Most productivity growth comes from the first source - increases in productivity from existing plants. Aggregate productivity is also affected by changes in the market shares of firms within the industry. The productivity of a firm or plant reflects the amount of capital per worker and its technology. But the underlying causes of differences in capital per worker are not obvious. Firms may choose to be high productivity/ high wage / high skill firms whereas others choose to be low productivity/ low wage/ low skill. The question is why would some firms choose low productivity? Firms differ in: the capability of their management how they are organized their use of technology how much capital they can raise.

The productivity of a plant depends on the productivity of its parent. The firms managers influence productivity. Higher minimum wages might be expected to penalise those firms that adopt a low productivity/ low skill/ low wage path.

What can be done to augment productivity in existing firms? Government policy might try to boost competition but; . those firms with the lowest performance are those who know least about their competitive position. many small firms compete in specialised market niches.

If firms are unaware of their competition then it is unlikely to change their investment behaviour. Providing information about the firm type and its relative productivity may improve the decision-making context for smaller firms. On the whole, SMEs are riskier than larger companies, and they may face higher costs of capital, which trims their ability to raise it. Moreover, their managerial capacity may be lower than that of larger firms, again reducing their ability to raise capital. Hence, SMEs may gather fewer capital resources, including technology, than larger firms. In general, SMEs pay lower wages than larger firms; therefore, smaller firms may be last in the queue for highly skilled labour. Firms need skilled workers to embrace new methods and to get the best use from new investment. Consequently, SMEs may find themselves located towards the low end of a productivity/wage/skill scale. Policy implications from this discussion are: most productivity growth comes from existing firms firms increase labour productivity by adding to the ratio of capital per worker firms need information showing where they stand in comparison to others in their industry skill shortages may reduce investment in new technologies by SMEs.

Entry and Exit Entry and exit contribute more than their (employment) share to productivity growth overall. Net entry punches above its weight. The productivity of entrants varies more widely than that of existing firms. The role of entrants is to promote exit of the least productive firms. Those firms that exit employ fewer workers than the average existing firm and have lower productivity. Increasing entry into an industry serves to (a) galvanise incumbents into productivity increases, or (b) cause some of the smallest, least productive firms to exit. New firms and new organisations offer a vehicle for the testing of innovations, a role that encourages a call for policy to support new innovative small firms. There are two types of entrants: start-ups and market entry from existing firms. The evidence suggests that entrants from existing firms are larger than new firms. Existing firms are more likely to exit the industry if their entry has been unsuccessful. Start-ups may have lower expectations and lack alternative opportunities; they may continue in an industry despite performing poorly. The turnover of firms in the UK is higher than that in the US. Small firms are larger on founding in the UK, but their survival chances are lower. In addition, UK small firms seem to grow much less than either US or European entrants, which is a cause for concern. Growth in firms that employ fewer than ten people is constrained by the managements access to resources, in particular funding. This does not imply, however, that there is a funding gap. This discussion suggests that: overall, the UK does not need to increase the number of small firms research is needed to understand why British entrants grow more slowly

Regulation When regulations are removed, the market shares of existing firms can change radically. The amount of regulations to do with products can affect the number of start-ups. Firms are less likely to adopt existing technologies under stricter product regulation. Employment protection can reduce the average size of firms, if the smallest firms are exempt. Job protection laws do not hamper firms where there are incentives for firms to train staff.

firms may not adopt existing technologies when there are strict product regulations.

Resource-Based View of the Firm The second model that explores the differences between the productivity of the firm is the resource-based view of the firm, which tries to explain why some firms are more competitive in the long run than others. This approach argues that the resources available to the firm are more than the inputs. As well as labour and capital; there are other factors such as teamwork, and tacit knowledge of how to do things, which is built up over time. Firms create a competitive lead by the way they combine their inputs of capital, labour, materials and buildings. For example, in the 1980s, Liverpool Football Club had not only very good players but also an institution known as the boot room, which was a tactical brains trust. Companies create ways of doing things (routines) that are difficult to imitate. The need to establish these routines is a crucial task of the new firm, and may mark out the successful entrants from the unsuccessful. Start-up owners often derive their ideas on how to organise from their previous workplace. Once established, it may be difficult to alter the firms routines. advice to firms on administrative and organisational matters might be better targeted early in the firms life before start-up.

Total Quality Management (TQM) TQM is designed to improve quality and cut costs at the same time. It started in Japan as a tool to improve the performance of Japanese export industries. SMEs have some of the most successful programmes, but TQM has had mixed results in small firms generally. Early adopters of a process such as TQM often reap their rewards. Using their networks to learn about TQM, they implemented it for their own reasons and adapted the programme as they did so. Later adopters often fail to gain any advantage, although in some markets firms believe they need to hold the ISO9000 badge. While late adopters used their networks to find out the right way to implement TQM, every firm will not adopt a method with the same success as early adopters. The failure to achieve with TQM is linked to either the failure to put it into practice fully or the lack of complementary assets needed to make it effective. One reason for the lack of conclusive evidence is the treatment of TQM as discrete; that is you either have or have not adopted it. Some parts of TQM and ISO 9000 are more difficult to put into practice than others and firms are less likely to adopt these. Firms that adopt TQM successfully have an open culture and empowered workers. It is useless to try to adopt a technique without backing from the boss. Researchers suggest that firms should focus on creating a culture within which these procedures thrive. An executive in a successful non-TQM firm said If a firm needs a fancy program to listen to their customers, then I think theyd better get one. Many SMEs are slow to adopt techniques. This could be for rational reasons a wait and see attitude - or due to an information failure (ignorance). Small firms cope with high uncertainty which favours being flexible but can deter investment. In previous research I interviewed a technology adviser in the Dudley Centre for Competitive Manufacturing who claimed that his group could boost productivity by up to one-third through reducing waste. They still had problems in getting work. evidence supports the notion that adopting a bundle of innovative (high performance) work practices benefits productivity where individual techniques have little effect. Investors in People as a programme does attempt to address these issues; yet Investors itself may benefit a subset of firms, who plan and train already. IiP will not work in all firms. new techniques might be targeted at the set of firms that are open, flexible and with empowered workers because new techniques work in these firms.

Adoption of Technology

Small firms are slow to adopt technology for a number of reasons. Small firms are very diverse; they need to believe that the technologies work in firms like their own the chances of survival for the smallest firms are lower. Smaller firms uncertain future reduces their incentive to invest. with fewer people to survey the external scene, smaller firms are less able to assess new methods new process technologies are often based upon large firm experience.

Our survey found that firms adopted new methods to improve their productivity, reduce costs and improve quality. The role of consultants and advisers in this respect was minimal, and this was not because the firm did not accept advice from outside. To increase the take-up of technologies, public policy might have to look at the ways small and medium sized firms find out about technological developments. Technologies are more likely to be adopted when their benefit for the individual firm is clear they fit with the firms processes they are simple they can be piloted within the firm they are easily observed.

Adopting technologies requires the firm to have an awareness of new technologies. Firms find out about technology from trade journals, at trade fairs and through customer research. Studies of innovation have stressed the important role of customer research. There is support for technology reviews and technology studies tailored for each small firm there is an important role for trade journals as providers of information that may be used to improve SMEs benchmarking might provide a way to increase smaller firms knowledge of techniques.

Policy Implications and Recommendations

Firms with high productivity;

use more capital per worker; adopt new techniques including high performance work practices; have the knowledge to integrate these techniques into their existing processes.

The real question then is what constrains SMEs from increasing their productivity? Most productivity growth comes from existing firms who add to the ratio of capital per worker and adopt new technology. Firms may not adopt existing technologies when there are strict product and employment regulations. However, when there is support for training within the firm, for example where business associations split training costs; this removes the cost of regulation. This report supports technology reviews and technology studies tailored for each small firm. Overall, the UK does not need to increase the number of small firms. Advice to firms on administrative and organisational matters should be provided before start-up. Some SMEs operate as lifestyle firms. These are unlikely to want to increase their funding or borrowing to invest in more technology. Over their early years, UK firms typically reduce their level of debt. Yet, this may not be as low risk a strategy as firms think it is, i.e. firms that grow, albeit slowly, have better survival chances. There is an information problem. The reason why a small firms competitors are out-competing them is not always apparent. Given that the smallest firms with low productivity are most at risk of exit, firms might welcome a simple marker that reveals their relative performance within the industry. Trade journals are the most heavily used sources to keep abreast of new technology, arguably their raison dtre is to plug such information gaps.

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This leads to a contingent view of enhancing productivity. For an SME to increase productivity, a certain number of things must be present, from the basic awareness of the problem to the means to do something about it. 1. Management must perceive that productivity is a problem. Most of the surveys that ask SMEs about their problems find that lack of demand and red tape are mentioned but little or nothing is said about productivity. (a) Managers may not be aware of the strong links between low productivity, small size and business failure. (b) Management may not be aware of productivity differences within its markets and industry (c) Productivity may be the root cause of a firms lack of custom. 2. There needs to be an answer. Managers need to be persuaded that tried and tested methods to improve productivity in their firm exist. Highly productive large firms may have little interest for the SME manager. The key conduits for this sort of information are trade journals, word of mouth networks and trade shows. (a) When there are features of the firm that complement programmes, it is difficult to identify correctly causes and effects. For example, total quality can work well in one firm but not in another. This may be due to employment practices and the atmosphere within the firm. (b) The firms methods, its history, reputation and contacts matter. New plans must fit into the firms existing operations. Radical changes that destroy the processes that the firm has built up over years are likely to be rejected. Consequently, asking firms that do not plan to adopt a programme that requires a great deal of planning can harm their ability to grow. 3. Firms must have the resources to put into practice tools that increase their productivity. Resources in the widest sense (financial, managerial and technical) are required. When firms adopt a practice they have to make it fit in with the existing routines, both informal and formal. 4. Policy may act upon all three of these contingent aspects. defining the problem has been neglected those making policy have tried to provide answers. more recently, policy has focussed on ensuring firms have the resources to adopt new practices.

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5. While it might be assumed that competition would force firms to be more productive; the evidence of wide variations in productivity casts some doubt upon this. Benchmarking could be used as a way to increase smaller firms knowledge of their performance. Managers must believe that their firms survival depends upon its productivity. More research is needed on the way in which firms locate along a productivity/wage/skill continuum from high to low, and in particular, how firms' and their managers learn about management and organisation. Research to understand why British entrants grow more slowly is also required.

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