A new methodology of enterprise development, especially SMEs: The role of Government - part 1

Lloyd F Yapa

SME SECTOR: Small and Medium Enterprise (SME) development has been advocated as one of the main strategies of poverty alleviation particularly in rural areas by the present government. There is no doubt about the correctness of the decision.

What prompted the writer to contribute this article was the fact it was the subject of discussion at one of the monthly seminars of the Sri Lanka Economic Association (SLEA).

The mainstay of our rural economy is agriculture. However, the incomes derived from such pursuits are quite inadequate to meet the basic needs of most people, because too many of them are dependent on this sector. In fact as many as 34% of the employed work force of about 7 million are crowded into this sector, mainly because of fragmentation of holdings over many years.

Provision of industrial and services employment in rural areas mainly in selected urban centres is the answer to this problem, besides some form of land reform to increase the size of the tiny farm holdings to transform them to viable economic units. Such a strategy needs heavy investment by way of infrastructure development as well as the setting up of factories and service units to absorb those leaving agriculture as productivity improves.

SME development does not need so much of resources and therefore is the ideal way of creating industrial employment in a resource poor setting. The purpose of this set of papers is to indicate how the task should be undertaken in a more comprehensive and effective way to benefit the entire economy.

In the course of this discussion, it will also examine some of the proposals made in the White Paper on the National Strategy for Small and Medium Enterprise Sector Development in Sri Lanka (2002).

2.0. Definitions and contribution to the economy

There is yet no nationally accepted definition to identify SMEs in Sri Lanka; (each Agency concerned has its own definition).

The White Paper on the National Strategy for Small and Medium Enterprise Sector Development in Sri Lanka (2002) defines small enterprises as those with an employment of 5-29 persons and medium enterprises as employing 30-149 persons.

It is reported that the SME category of industries contributes only about 36% of total employment and around 20% of total value added in the industrial sector, although in terms of numbers they are about 96% of all the establishments in the sector. It is not possible to draw any conclusions regarding the contribution of SMEs in the agriculture and the services sectors in the absence of actual data.

3.0. SME market characteristics

Most enterprises, especially Small and Medium Enterprises (SMEs) in Sri Lanka in all sectors, operate in what are described by economists as 'perfectly competitive markets' (PCM). The main characteristics of such markets are: a) the large number of producing firms and buyers each selling a small fraction of the total production; is therefore a price taker b) the homogeneousness (identical nature) of products and services offered with very little value addition or differentiation, c) mortality of firms is quite high there are no barriers to entry into the industry or for exit ; if firms earn above normal profits new firms enter the industry leading to wafer thin profits reducing the price; the.

It is also to be noted that most of the products and services generated by SMEs are more suitable for production on a large scale, except in the case of unique products such as in the case of arts and crafts. All the above comments may not apply to firms producing such products.

It is these attributes of SMEs and even of larger enterprises, that are responsible for the travails and tribulations of businesses in Sri Lanka. Such firms, therefore have to improve productivity/competitiveness on the basis of customer needs i.e. reduce unit costs and sell unique/differentiated products and services valued by customers and become 'price makers', in that they could set prices as the customers would be willing to pay premium prices for them.

So the essence of development of enterprises including SMEs in Sri Lanka lies in the sustained improvement of productivity and competitiveness.

4.0. Other constraints faced by SMEs

The constraints faced, especially by SMEs (as revealed by the firms concerned) are well documented in the above White Paper.

But they suffer from constraints that are not known to many. The main among them are a severe lack of customer/ market orientation and poor entrepreneurship/ management, especially of human resources and finances apart from the lack of access to good infrastructure and to critical inputs (at affordable rates) such as credit, the necessary skills, technologies as well as information on products, their competitors and markets.

5.0. The role of Government

The goal or long term objective of government in assisting enterprises, especially SMEs should therefore be to create an environment for enhancing productivity and competitiveness (on a sustained basis), as stated earlier. Improving productivity would enable it to achieve enhancement and better distribution of incomes through higher yields or release of some of the resources for better use elsewhere and by way of higher prices earned through creating better value for customers.

Productivity improvement also would result in higher satisfaction for a larger circle of customers through reduction of unit costs/prices of goods and services, usually achieved by increasing scales of production. Since SMEs lack resources to for such work, they have to be assisted to graduate into medium and large sized firms, able to cope with globalisation.

Comparative advantage and competitive advantage

Comparative advantages based on abundant raw materials, low cost labour, high levels of protection, devalued currencies and subsidies on a sustained basis may make firms to compete on a strategy of lower costs and prices.

Such firms could become vulnerable to be swamped by rival firms possessing competitive advantage, on the other hand, producing goods and services, which are not only less costly but also are differentiated or possess attributes preferred by customers over those offered by the former category (firms which have created comparative advantage based on cheap resources and protection).

Competitive advantage is based on country differences as well, such as hard working people with integrity. Pushing all enterprise sectors (not one sector only) to innovate and upgrade rapidly to improve productivity also creates competitive advantage for the entire nation and vice versa.

Prioritisation of some industries on the basis of some being better than others or on categorisations e.g. thrust and non- thrust industries would not be effective, especially as it is not possible to pick 'winners'. Productivity/ competitiveness can only be enhanced by applying pressure to innovate by creating competition/ rivalry among firms, though it would not be comfortable for them.

They will compete among themselves to improve profitability either by reducing costs or by differentiating processes and products to capture customer loyalty. Providing opportunities for making more profits through heavy protection granted by imposing high tariffs, extending subsidies and depreciating the currency etc will obviously remove the incentive to satisfy customers here and abroad by reducing costs or by resorting to differentiation.

This would be a great set back for the Sri Lankan economy, as the domestic market is quite small to sustain large scale industries.

The State also will lose revenue by extending unnecessary incentives, which will only lead to mollycoddling a few at the expense of the greater number. A modicum of protection may, however, be required to allow firms to establish themselves in the market and to cope with dumping of goods by competitor countries at below (their domestic) market prices.

In the next two parts of this article the writer will discuss how the Government could influence the determinants of productivity or competitiveness and finally how enterprises themselves including SMEs should formulate strategies to maintain competitiveness, as it is they who are directly responsible to achieve this objective and not the State.

Though well written and presented, these are not elaborated in the above White Paper. 31/08/06.

(Continued next week)