94 NEW ECONOMY

Small firms,

r (New Economy \-

ALAN HUGHES, DAVID KEEBLE & ERIC WOOD big ideas ~ T z ~ z ~ ~ mspeciiwely, BRC Centm fW Business Reseatrh, Policy must not ignore small

firms' contribution to innovation ,,dvwofMm

ast year a government committee con- techniques for innovation research, relying trasted the strength of the UK's large, on either surveys of firms or the analysis of L international companies and weakness new product launches, can provide better

of small and medium-sized firms with those insights into the innovative performance of in other western European countries. The SMEs. Trade and Industry Committee's report on Even so, methods of surveying new prod- manufacturing industry highlighted the need "to pro- vide conditions in which smaller firms can prosper" (House of Commons, 1994). What we are interested in here is the contribution that these small and medium- sized firms (SMEs) make to the development of new ideas and technologies in

"The CBR databank also suggests SME

innovative activity is far more widespread than is suggested by

surveys that focus on the object of the

innovation itself rather than the innovator. "

~ ~~

Britain. And what are the fac- tors that most influence their performance in innovation?

Looking for the innovators Innovation research has concentrated dispro- portionately on large manufacturing firms. This is partly because of the debate over Schumpeterian dynamics and monopoly power and partly as a result of the reliance on research and development and patent data. The latter are poor indicators of innovative activity in SMEs -here, firms with up to 499 employees - and service firms. Alternative

uct launches still appear bi- ased toward identlfying in- novative activity in manufac- turing. The Science Policy Research Unit (SPRU) sur- vey of 'significant technical innovations' in the UK, for example, suggested that fewer than 9 per cent of inno- vations between 1945 and 1983 originated from service

~~~

firms. Yet the Economic and Social Research Council's Centre for Business Research (CBR) databank on more than 2000 SMEs in the UK, using instead the fm survey approach, suggests no systematic differences in the innovative performances of manufac- turing and service SMEs (SBRC, 1992).

The CBR databank also suggests SME in- novative activity is far more widespread, both in manufacturing and services, than is sug- gested by surveys that focus on the object of the innovation itself rather than the subject doing the innovating. These disparities may reflect the fact that object-oriented surveys fo-

.c'. 1995 THE DRYDEN PRESS

SMALL FIRMS, BIG IDEAS 95

cus on technical innovations in new products, thereby excluding a large number of service innovations and SME incremental innovation. Even within technical innovations, the sample definition of what is techno- logically 'significant' is arbitrary.

What we know The most significant findings based on the SPRU innovation da- tabase regarding UK SMEs in the manufacturing sector can be sum- marised as follows.

SME share of total innovations doubled, from 19 to 38 per cent between 1956 and 1983, whereas their share of total employment fell from 36 to 35 per cent. In all firm categories with 500 or more

Small firm innovation varies by sector Share ofinnovotion and employment for firms with up to 199 employees in the UK

sector Innovations Share of Share of per100000 sectoral sectoral employees innovations employment (all firms) (%I (%I

Food 14.1 Chemicals 99.0 Metals 32.3 Fabricated metal products 91.5 Mechanical machinery 104.9

Electrical & electronic eng. 100.2 Shipbuilding 36.7

Instruments 187.6

Vehicles 26.4 Textiles, leather & clothing 12.5 Bricks, pottery, glass, cement 53.0 Paper & printing 13.7

4.6 4.8 0.3

14.0 26.2 31.6 11.1 13.4 9.4

20.1 14.0 13.3

Source: Employment data ffepflon ihe Cemus of iroduction 1970 (GCS), innovation data calculated fim Pawt et al. 1987, Table VI, pg 306.

14 12 11 34 18 23 10 12 6

29 22 30

employees, the share of innovations grew less than the share of employment. In me- dium enterprises - those with between 100 and 499 employees - the ratio of innova- tion share to employment share increased consistently throughout the period (Pavitt et al, 1987). For small and micro firms - those with up to 99 employees - the ratio of innovation share to employment share rose sharply in the period 1956-65, after which it stagnated. How much innovating smaller firms do differs substantially across manufacturing sectors. The data in Pavitt et a1 (1987) do not allow sectoral comparison of SMEs with up to 500 employees, but the per- formance of firms with up to 199 employ- ees can be used as a guide. The Table above shows the innovation performance of smaller firms has been particularly strong in mechanical machinery, instru- ments, electrical and electronic engineer- ing, shipbuilding and vehicles. In all these sectors, firms with up to 199 employees had a bigger share of sectoral innovation than of sectoral employment. But their performance was poor in food, chemicals,

metals, fabricated metal products, and pa- per and printing - in all of which their innovation share was less than half their employment share. The results for the small firms in chemicals and metals should be treated with caution; they con- trast starkly with US research which showed good SME innovation perfom- ance in those sectors. Small firms' innova- tiveness does not appear to correlate with the innovation-intensity (measured by the number of innovations per 100 000 em- ployees) of the industry, at least at the level of aggregation in the Table.

0 The third significant conclusion based on the SPRU databank is that innovation per- formance of small and micro firms in the UK may be well below that of their coun- terparts in other industrial countries. In- adequate coverage of the UK in the recent European innovation initiative, the Com- munity Innovations Survey (CIS), has hampered comparisons with the rest of Europe, and the SPRU methodology may lead to under-reporting for SMEs. Never- theless, a comparison of the SPRU data with comparable data for the USA

96 NEW ECONOMY

(Audretsch and Acs, 1991), revealed that in the early 1980s the SME share of UK innovations (38 per cent) was only sightly below that in the USA (44 per cent). How- ever, small and micro firms’ share of UK innovations (13 per cent) was roughly half that in the USA (25 per cent). If this result is reliable, then UK smaller SMEs are un- der-performing in innovative activity.

The disparity between the contribution to national innovation made by small and mi- cro firms in the UK and USA occurs despite the fact that this type of company accounted for a larger proportion of the total number of manufacturing outfits and a larger share of total manufacturing employment in the UK than in the USA. Manufacturing estab- lishments in the category ’small and micro’ in 1990 represented 93.9 per cent of the total in the UK and 90 per cent in the USA. These ’small and micro‘ firms represented 34.1 per cent of total manufacturing employment, compared with 28.9 per cent in the US. Pre- liminary evidence on cross-country differ- ences in sectoral innovation performance suggests that even in those sectors where British SMEs were most innovative, SMEs in the USA were generally doing far more - their share of sectoral innovation was often more than double their share of sectoral em- ployment.

What determines SME innovation? A number of explanations have been put for- ward for innovation performance patterns across firms. These include factors external to the firm, such as location, market structure, technological characteristics of the industry and availability of finance; and internal fac- tors, such as managerial experience and style, employee skills and organisational structure.

L oca tion There are sigruficant geographical variations in British SME innovativeness, both between dif- ferent regons and between large cities and

smaller towns and rural areas. These vari- ations reflect differences in the spatial char- acteristics of the firms. They also reflect the degree to which environments encourage or inhibit innovative behaviour - for example, through skills and expertise, local subcon- tracting and customer relations, or access to university research resources. The SPRU dat- abank indicates that manufacturing SMEs developing radical technological innova- tions have historically been concentrated in south east England, East Anglia and the South West, and s iwcant ly under-repre- sented in Scotland, Wales and north west England. Post-war innovation rates are nearly three times higher in southern than in northern Britain. According to the CBR dat- abank, two-thirds of all new high-tech SMES in Britain during 1980-90 were established in the three southern regions.

This north-south divide in the innovative activity of SMEs cannot be explained by dif- ferences in industrial structure. It reflects the impact on locally-founded small firms of south east England’s concentration of re- search and development establishments (in- cluding universities), highly-qualified scien- tists, engineers and professionals, and infor- mation-intensive business services and con- sultancies. Indeed, recent research for the European Commission has identified the South East as Britain’s sole representative among the 10 urban regions or ’European in- novation islands’ dominating innovative business activity in Europe.

Innovative performance in Britain‘s pe- ripheral regions may, however, be improv- ing. Keeble (1993) reveals that in 1985-90 inno- vation frequencies for both manufacturing and service firms were not significantly differ- ent in the South East and peripheral Britain. Indeed, innovation among technology-based SMEs was actually more frequent in the pe- ripheries. And peripheral firms’ success rates in obtaining Department of Trade and Indus- try Small Firm Merit Awards for Research and Technology for technologically-innova-

SMALL FIRMS, BIG IDEAS

tive products have been signhcantly higher since 1990 than for south eastern firms.

Traditional ideas about urban-rural vari- ations in SME innovation rates have por- trayed large cities as the dominant focus of innovative activity. This view has been chal- lenged by recent research by the CBR (Keeble, 1993) and PA Cambridge Economic Consult- ants (PACEC), revealing significantly higher innovation frequencies among smaller enter- prises in rural areas and small towns than in conurbations such as London. This coincides with a recent urban-rural shift of high-tech activity and employment involving large and small firms (see Chart). It also coin- cides with above-av- erage 1980s creation rates of innovative technology-based firms in small towns and rural areas (56 per cent, compared with only 44 per cent in conurbations and towns with 150 000 population or more).

However, the PACEC analysis of SMEs in urban, and accessible and remote rural areas reveals

ity workforce, and better opportunities for ex- panding premises.

Source: Keeb!e (1993)

that the high rural innovation rates are en- tirely attributable to firms located in accessi- ble rural settlements, within 100 km of a con- urbation. Remote rural firms record low inno- vation frequencies, in line with traditional views.

The exceptional innovative behaviour of accessible rural firms is explained by the ori- gin and nature of the SMEs involved. They tend to be founded by professional entrepre- neurs moving from cities, and they tend to target new and often technologically dynamic market niches. Their rural environment places fewer constraints on ’enterprising be- haviour’ because of lower costs, a higher qual-

Market structure Market structure has long been considered a key to innovation performance, with highly concentrated industries being more innova- tion intensive and the dominant firms being the most innovative. Evidence for these propositions must now be considered mixed; several of the most innovation-intensive in- dustries in the UK (see Table page 95) and the USA have substantial SME innovation con- tributions. Also, although large firms’ share

of innovations may be greater in a concen- trated industry with larger entry barriers, their share of innova- tion may not necessar- ily outstrip their share of employment. In US industries with high entry barriers, such as chemicals and metals, SME share of innova- tions is substantially greater than their share of sectoral em- ployment. The oppo- site is true in the UK. So innovation in the

most capital intensive industries in the UK still appears to be the domain of the large firm.

Technological characteristics An industry’s technological characteristics, including technological opportunity and the conditions for owning or gaining ownership of innovations, may be more important than location or market structure in determining innovation performance. Technological op- portunity is strongly affected by the level and pace of related basic scientific knowledge, which may vary widely across industries.

Patenting is dominant in a minority of in-

98 NEW ECONOMY

dustries - such as chemicals and pharmaceu- ticals - and, in any case, may be too costly for the SME to procure, let alone defend. In many , industries, firms have to rely on other means to appropriate benefits from innovation, such as secrecy or complementary investment in marketing and services. The Advisory Coun- cil on Science and Technology identified a British SME that in its early stages registered its patents in the name of a large firm with extensive experience of patents, which pro- vided a credible threat to would-be pirates.

So the cost of managing innovation, from development through commercialisation to reaping the benefits, may be extremely high in some industries, possibly putting innovation beyond the means of the SME. Indeed, the industries in which SME innovation perform- ance has been best are probably those where the financial cost barriers are relatively low and some appropriability exists.

These conditions wdl enable SMEs to bear the cost of entering the innovation race, bene- fit to some extent from other firms’ innova- tion efforts and secure some benefit from their own. This would seem to be the case for in- dustries such as mechanical machinery, elec- trical and electronic engineering and instru- ments, in which SMEs contribute a significant proportion of sectoral innovation.

Money trouble To what extent is the innovative performance of SMEs constrained by a lack of finance? Difficulties between banks and small firms in the UK suggest there are problems not only over the quantity of finance for small firms but also the terms of financial lending. Too many small firms are dependent on short- term debt, although UK banks now claim they are pursuing a significant shift away from short-term overdraft facihties toward a programme of longer-term loans to smaller firms .

It has been argued that the flow of internal funds is the principal determinant of the inno- vative performance of small US high-tech

firms. Given that profits are the most impor- tant source of investment finance, SME inno- vative performance in the UK may have been hampered in the 1980s by declining profit margins relative to larger firms (Cosh & Hughes 1994).

Managers Managerial competence is also crucial. An ACOST survey emphasised the importance to medium-sized firms of a balanced mana- gerial team combining marketing, financial and technical skills, and the need for an or- ganisational structure that insulates senior management from day-to-day pressures suf- ficiently for it to be able to take a strategic view. In the smallest firms, effective manag- ers require a range of skills. ACOST sug- gested that managers with a combination of technical qualifications and business aware- ness were in particularly short supply, and this was a constraint on rapidly growing small firms pursuing a sequence of innova- tions.

Information defecit Despite the problems of measurement, SMEs’ contribution to British innovation ap- pears to have grown in a variety of sectors. Yet signs of lagging innpvativeness do exist among the smallest SMEs, and possibly among those in certain industries and certain parts of the country.

The ability of SMEs to finance their innova- tion efforts depends on stable and reasonable profits, which in turn will be promoted by macroeconomic stability. Continued public sector initiatives to raise the quality and sup- ply of management skills and long-term fi- nance, particularly for manufacturing SMEs, wdl help sustain growth in the contribution SMEs make to developing new technologies and ideas. Such assistance will be better in- formed when the true extent of their innova- tive behavioux can be gauged by a proper national audit of innovation by small and me- dium-sized firms 0