Changing the frame: Making small firms compete like large ones

Although small firms have natural advantages, they face constraints when it comes to reach and scale; this prevents them from competing with larger firms. Pankaj Chandra shares business models from Italy, China, Japan, and various parts of India, where firms have become a part of a network that collectively acts as a large firm. These clusters allow firms to coordinate functions and collaborate in order to grow.

In India, it is often difficult to separate the effect of unemployment on entrepreneurship. On the one hand, entrepreneurship has the lure of driving an idea to the market, of becoming the master of one’s own destiny, and of course, the potential for wealth creation through growth. But on the other hand, given the relatively high unemployment rates over several years in India, starting a small business becomes the only option for the unemployed, and especially educated youth.

Small firms and the advantages of clustering

According to the Confederation of Indian Industry, India has 63.5 million registered small enterprises that provide employment to 120 million people. They contribute 33.4% of manufacturing output, and 45% of exports from India. It is obvious that small firms impact the Indian economy significantly. But it also poses several interesting questions – what strategic advantages do small firms carry that makes them competitive; how should they organise to realise that advantage; and can they provide a growth potential in terms of employment?

We know that small firms are drivers of economic growth in many economies globally. India has experimented with a lassiez-faire clustering approach to organise small firms in order to create agglomeration economies¹. Even though there have been decades of effort to build and strengthen clusters, driven by the United Nations Industrial Development Organization (UNIDO) and the World Bank, the approach remains half-baked – one largely based on geographical agglomeration of firms, while missing out on some key aspects of capabilities, innovation, and network benefits.

There have been traditional clusters, like the Firozabad bangles cluster in Uttar Pradesh on the one hand, and the much talked about Tirupur knitwear and apparel cluster in Tamil Nadu on the other. The former remains a cesspool of old-stone-age technologies and practices that disregard human value and safety. The latter was almost put to waste by price-based competition driven by global firms and low innovation, amongst others. One must ask – why could Tirupur not grow into a world leading high growth cluster after having enjoyed decades of economic growth? There are many other clusters like those in Ludhiana, Rajkot, Jamnagar, Kolhapur, etc. that will fall somewhere between the two. It appears that something was structurally missing in the design and the operation of clusters in India that may have prevented small firms from becoming generators of large-scale employment.

Obstacles to growth for small firms

Most small firms remain small all their life. In emerging markets, they face three key challenges: capital, relationships, and reach. Small firms compete on variety and small volumes, while a large firm competes on volumes and cost. The former has to innovate at a lower cost, while the latter owns channels of distribution and hence has a better reach in the market. The big question of our times is then: how should small firms compete and especially against large ones? Is there a model of technological development that would allow a small firm to have all its natural advantages as well as those of a large firm (that is, produce variety in small volumes and still be competitive on costs)?

I argue that the challenge in India has been our inability to organise small firms as part of a network (Chandra 2014). This thereby deprives them of the ability to invest scarce capital in building distinctive capabilities; find a mechanism to form ties with competitors on shared services; and of course, be able to become part of large and distributed supply chains. Those that have managed to do so have grown out of their ‘tininess’, provided valuable products and services to their customers and have grown their endowment.

Principles for building ‘network firms’

There are several interesting models from India, China, Japan and elsewhere as well where small firms have managed to build strong ties with other small organisations. Their association, then, acts like a large firm (that is, a ‘network firm’ comprising largely of small and medium enterprises (SMEs)). Firms in the network cooperate with others on all activities where small firms face market failures and compete with each other on orders. In some cases, it has also led to the building of a unique brand of the network. This helps in building distinctive capabilities and the ability to win orders. Interestingly, it presents an opportunity to build global brands based on diverse capabilities. This network model of capability-driven growth is strengthened by developments in technology and platforms. Such thinking is not only useful to small firms competing with large ones, but also to diverse mid-size or large manufacturers that can develop long term capacity by building unique relationships with small (be it their vendors or contract producers or even their smaller competitors).

Several questions come to mind: what is the premise under which such networks are likely to succeed; what are the incentives that make it work; what happens to risk and uncertainty; what is the relationship value built on; and most important, how are such networks coordinated for success?

Running a large volume plant (with lower variety) requires very different capabilities as compared to running a mid-sized one (with higher variety). Our field research has shown that, on an average, India does not have strong systems and the individual discipline required to run large volume plants productively; however, it manages its small and mid-size production units quite well (Chandra 2009). So, any strategy towards building scale in manufacturing must take such abilities into account. Hence, a ‘network firm’ becomes an attractive proposition.

Unfortunately, the planned cluster policies of the Government of India have failed to build such ‘network firms’. These policies do not think of a cluster as an agglomeration of diverse capabilities that bring together the entire ecosystem for a product category and help them scale. The technology supply chain in many sectors – among which the electronics industry is particularly telling – is highly fragmented in India. Having firms of the same kind in a cluster does not complete a supply chain for a product category. The cluster as an organisational form works well when it can remain diverse in its capabilities, can leverage capital, can share resources, and can create a reach for its capabilities and products. That way a cluster of mostly small firms acts like a large firm and it is able to grow its employment.

International experience and learnings

There are several examples that embody the spirit of a ‘network firm’. When the integrated textile mills in Prato, Italy started to lose their competitive advantage, they “gracefully disintegrated” into a cluster of small firms, each specialising in certain product categories or specific process capabilities (Jaikumar 1986). They cooperated on common services like logistics, banking, housekeeping, maintenance support etc. while competing with firms within the cluster to win orders. Interestingly, the old owners of the integrated mills became “impannatores” or market makers – getting orders globally, and booking capacity with the small plants in Prato for production.

The same principles were used by small producers of Wenzhou, in the south-eastern Zhejiang province of China, to become global market leaders in a large number of commodity consumer goods (like lighters, locks, ties, spectacle frames, razors, mechanical pencils and ball pens, packaging machines etc.) and low to medium voltage electrical appliances. Starting in the 1970s with a ‘one village, one product’ production system, a group of market makers would commission the production of components and their assembly to different households and then sell them, initially, to stores across China and then around the world. Households were supported by locally available ‘small funds’. By the year 2000, large agency firms had emerged that helped transform tiny and small firms serving local markets into mid-size and large firms serving globally. They developed many national brands and became suppliers to global brands, with a large number of producers forming the network economy, and providing scale in their collective output and, consequently, employment (Chandra 2014).

Another global example is the Technology Advanced Metropolitan Area (or TAMA) cluster in the Ota Ward of Tokyo, where people working in pre-World War II armament and textile factories set up small enterprises after the war to produce non-military goods (such as instrumentation, electronics, machine control, metal processing, and machinery of all types). By the late 1990s, TAMA had emerged as one of the most innovative clusters of Japan (See Table 1). It comprised a large number of specialised tiny/small “product processing” firms (about 16,262) that focussed on proprietary process technology; a limited number of ‘product developing’ SMEs (about 300) that produced end-products; a few large factories with research and development (R&D) units (about 15); and 34 universities and colleges with science, engineering and management departments. However, all were being coordinated by an organisation (the TAMA Association) that helped SMEs with superior processing technologies get linked to product developing SMEs, and provided global market exposure to the cluster. The goal was to increase product variety and efficiency by agglomeration and innovation.

Table 1. Characteristics of the TAMA Cluster in 1998

TAMA Characteristics	Outcomes
Number of people working in TAMA	4 million (largely in small enterprises)
Value of goods shipped from TAMA	$214 billion in 1998 (grew to $390 billion in 2018)
Total value add per worker of TAMA firms	$116,447 (as opposed to $110,184 for all of Japan and $94,970 for US)
Number of new products in the market in the past 3 years:	22 (as against 4 by non-member SMEs within TAMA region)
Percentage of firms cooperating with research universities	65%
Patents	62.9% of TAMA firms held patents (as opposed to 29.6% of all SMEs in Japan)
R&D expenditure/sales	5% (by product developing SMEs) and 2% (by product processing SMEs)

Source: Author’s field work in TAMA

Closer to home, AMUL is the largest milk dairy network in the world. The AMUL network in India is a strong example of a cluster firm where today 3.6 million small and mid-size farmers contribute their milk produce at 18,565 village societies. Six production companies (including AMUL and the Surat Milk Union Limited (SUMUL)) process milk to produce products from their 87 plants, and a marketing entity (the Gujarat Milk Marketing Federation (GCMMF)) coordinates the entire supply chain of one million retailers and creates markets for the products of the network. The network brand, AMUL, is worked by GCMMF, which ensures uniform quality of products across various independent cooperatives or plants and their village societies. GCMMF also coordinates various services for all producers in the network like the animal feed, veterinary services, animal husbandry, support to farmers for capital expenses etc. Its cluster revenue stands at Rs. 530 billion in 2021, making it the largest dairy network in the world comprising largely small producers, and the goal is to grow it to Rs. 1 trillion by 2025.

Akin to the AMUL network, cooperation and competition between SMEs can also be seen in the engineering cluster in Rajkot that has developed innovative processing capabilities across a wide variety of products. Small firms in Rajkot are found to collaborate on orders, on processing capacity, on sharing of workforce, and even on the development of new products.

Concluding thoughts

Such a cluster is akin to a large firm which is diverse in its products and processes but where each small firm is a focussed firm – most of them around a process (for example, bending or precision machining, or die making in an engineering context). It is neither a hierarchy nor a market. Small firms built around innovative processes have the possibility of producing a large variety of products, which reflects the strategic advantage of small firms.

The cluster becomes a brand in some cases, with a formal brand symbol representing the cluster and signalling its quality. When a cluster is organised in this manner, where a number of small firms carry distinctive capabilities (often complementary in nature), and others are product producers or assemblers, or perform complementary services, then the ecosystem for bringing a product to the market gets completed within the cluster itself.

Small firms seek each other’s technical skills and often become suppliers to each other. This co-dependence decreases risk and helps in bringing a product into the market at a much lower cost (and hence, bringing products to market more often). All firms are simultaneously working on ‘related’ products. All firms do R&D, and all upgrade the capabilities of talent continuously. The operational principle is simple: identify what you are good at and depend on others who are good at the products/services that you need.

Carefully designing clusters allows small firms to leverage the capabilities of other small firms, overcome the disadvantage of reach, and take full advantage of geographical agglomeration. Managerially, the cluster requires a coordinator in the form of a firm or an organisation that can help coordinate functions across firms and integrate their capabilities to win orders and grow. Such coordinators are facilitators and problem solvers. They transfer information from market to producers and vice-versa; they advise SMEs to build certain market-driven capabilities; they help in trimming costs and finalising pricing; and they act as a default guarantors. This is the face of a modern-day agency firm that supports SMEs to compete in end-product market while collaborating on infrastructure (for example, credit, technology, housekeeping, transport, R&D, etc.). Such a congregation of SMEs as a ‘large firm’ provides scalable, value adding partnerships, as it ensures effective management of innovation and the flow of goods and services along the entire value chain.

This post is the second in a six-part series on 'The good jobs challenge in India'.

Note:

Firms in agglomeration economies benefit from being in close proximity (in cities or industrial clusters) to other firms in the same industry or closely related industries.