CHAPTER TWO

SMALL BUSINESS: VITAL COMPONENT OF THE ECONOMY

Objectives of the chapter
At the end of this chapter, students will be able to;
 Define small business.
 Describe the main characteristics of small scale industries.
 Understand the role of small businesses to the economy of a country.
 Indentify the problems of Ethiopian small businesses.
 Indentify the forms of business organizations and the legal issues of entrepreneurs.
Chapter Description
This chapter deals about small businesses and to what extent these small businesses are helpful for
the poor and developing countries economy and economic, social and political aspects.
Furthermore the chapter discusses about small business failure factors, the main problems in
Ethiopian small businesses, forms of business organizations and the legal issues that must be
considered for entrepreneurs.
2.1.Definition of Small Business
Defining small business is not as easy as it looks: we have different definitions depending on the
size of the industry we are talking about, the purpose of the definition, and the country the
definition is applicable to. The variables writers use in defining small businesses include: size of
working capital, number of employees, asset size, annual sales, market share, and operational
domain. For the sake of discussion, we adopt the following definition. Small business is a business
which employs less than 100 employees, is owned by one or few individuals, with the exception
of the marketing function has geographically localized operations, and does not dominate its
industry.
Having the above definition in mind, businesses can be found in different industries but they differ
in their nature and importance from industry to industry which include:
a. Retail industry: Drug stores, clothing stores, auto accessories dealers, appliance dealers,
book stores, music stores…..etc.

b. Service industry: accounting firms, advertising agencies, managerial consultants, barber

and beauty shops, dry cleaners, travel agencies…etc.
 c. Finance insurance and real estate industries: insurance agencies, real estate brokerage
firms, pawn brokers, small banks, loan companies…etc.

d. Transportation and other public utilities: Taxi cab companies, community news paper
publishers, local radio and television stations…etc

e. Manufacturing industries: Bakeries, sawmills, toy factories, job printing shops, shoe
factories, ice cream plants, furniture manufacturing plants…etc.

In terms of entrepreneurship, small business is a very personal approach to creating new

enterprises. And small businesses usually have limited growth opportunities and operate in a
community atmosphere.
2.2.Characteristic of Small Scale Industries
1. Closely held: the unit is generally a one-man show. Even if a unit is run by a partnership
concern/company, the activities are mainly carried out by one of the partners/directors and
the others are merely sleeping partners/directors who generally assist in providing finance.

2. Personal character: there is close personal contract/supervision of all activities, say

purchase, production labor, and sale of products. The owner himself is generally the
manager. Therefore, these firms are generally managed in a personalized manner. The
owner has firsthand knowledge of whatever is going on in the business. He actively
participates in all aspects of business decision making.

3. Limited scale operations: a small scale industrial unit has a lesser gestation period. A
small scale unit has a limited share of a given market. The size of the firm in the industry
is small.

4. Indigenous resources: small-scale industries can be easily located anywhere subject to

availability of raw materials, labor, finance, etc. small scale units use local resources.
Therefore, they have decentralized or dispersed location.

5. Labor intensive: they are generally more labor oriented with comparatively smaller capital
investment then the large units. The capital investment is limited due to the use of simple
technology. They require large amount of working capital to meet their day-to-day
expenses.
 6. Local area of operation: the operations of a small scale unit are generally localized.
However, market for its products need not be local. It may cater to local and regional
demands or its products may even be exported.

7. Simple organization: a small business unit has few or no layers of management. Division
of labor or specialization is low and the resources are limited.

2.3.Why are Small Businesses Important to the Economy?

The purpose is to understand the contribution made by small business as part of our total economic
system. Small firms operate in all industries, but they differ greatly in their nature and importance
from industry to industry. In thinking about their economic contribution, therefore, we first need
to identify the eight major industries (as classified by the U.S. department of commerce) and note
the types of small firms that function in these industries. These eight major industries and examples
of small firms in each are as follows:

I. Wholesale Trade V. Finance, Insurance, and Real Estat

Wholesale drug companies Local insurance agencies
Petroleum bulk stations Real estate brokerage firms

II. Construction
General building contractors VI. Mining
Electrical contractors Sand and gravel companies
Coal mines

III. Retail Trade VII. Transportation and public utilities

Taxi-cab companies
Hard ware stores Local radio stations
Restaurants
IV. Services VIII. Manufacturing
Travel agencies Bakeries
Beauty shops Machine shops
As you can see in the above table, the vast majority of the 3.8 million businesses are small. 98%
have fewer than 100 employees.
Although small businesses pose a number of challenges to the entrepreneur and have certain
limitations, a countries economy cannot superior over large ones in certain aspects of business
activities.
First, let’s try to see why it is advisable for an individual to start when embarking on
entrepreneurial ventures.
1. Providing Job Opportunities: this is one way in which small businesses contribute to the
country’s economy. In fact, in most countries, the number of new jobs created by small
business is significantly higher than created by large businesses. For example, in the US,
50% the employment comes from small businesses and each year small businesses account
for about 80% of the new job created.

2. Introducing Innovations: new products which originate in the research laboratories of big
businesses make a valuable contribution to our standard of living. There is a question,
however, as to the relative importance of big businesses in achieving the truly significant
innovations. Usually, the research departments of big businesses tend to emphasize the
improvement of existing products. Records show that many scientific breakthroughs
originate with independent inventors and small organizations.

3. Stimulating Economic Competition: small business by definition is one that does not
dominate its industry, and competition will be closer to perfection when the market price
and supply when operating individually.

4. Aiding Big Businesses: the fact that some functions are more expertly performed by small
businesses enables small businesses to contribute to the success for larger ones. Especially,
there are two types of business activates that are performed by small businesses
inexpensive consumer products find it desirable to own resale and retail out lets. Second,
supply functions. Most small businesses act as suppliers and sub contractors for large firms.

5. Producing Goods and Services: we depend highly on small businesses for the provision
of most goods and services we need in our lives. In fact, if it was not for small businesses,
 we would have not been able to find the goods and services we need at the time we need
them, in a convenient place, and at the quantity we prefer.

In addition to the above general advantages small businesses offer a country’s economy, they have
certain benefits to the individual entrepreneur. These include:
 Small businesses require less time, energy and financial resources to establish

 They also provide the entrepreneur with greater autonomy, and independence-because the
money needed to start small businesses is relatively small, the entrepreneur can raise most
of it by him/herself without relinquishing significant onrushing interest and control.

 In addition to these, small businesses help the entrepreneur develop his skill in running
organizations as he is expected to perform different kinds of activities concerning the
business. These include; business planning, investment and finance, customer relations,
personnel and human resources, cash control and book keeping, inventory control,
purchasing, marketing and sales, and leadership.

2.4.Economic, Social and Political Aspects of small business enterprise

Small businesses (enterprises) have to play a vital role in Ethiopian economy. They need a strong
support on socio-economic and political grounds.
2.4.1. Socialistic Idea (The Equality Argument)
Our goal is being the establishment of a socialist pattern of society. Our objectives are equitable
distribution of wealth and decentralization of economic power. The benefits of industrial growth
should be shared by as many people as possible and should improve the general standard of living.
Proliferation of small enterprises will go a long way in achieving these objectives.
According to this argument unregulated growth of large scale industries results in concentration
of economic power in a few hands and consequently grosses inequalities in the distribution of
income and wealth in the country. On the other hand, income generated in large number of small
enterprises is dispersed more widely and its benefit is derived b a large population. This is due to
wide spread ownership and decentralized location of small scale units. In this way small scale
enterprises bring about greater equality of income distribution. It is also argued that most of the
small scale units are either proprietary or partnership concerns. As a result relations between
workers and employers are more harmonious in small enterprises than in large enterprises. Critics
of small business argue that due to absence of strong trade unions in small units, the employer can
more easily exploit workers. Wages and other benefits in the small firm are lower than in large
firms. By paying low wages, small business enterprises generate less savings and less axes and
there by result in low growth potential.
However, in underdeveloped countries workers prefer a low paid job to no job at all. In the absence
of small enterprises workers may have to lose even the small wage which they hope to get.
Moreover, wage rates in small firms can be improved through labor laws and trade unions. Small
enterprises also encourage competitive spirit and generate the impulse of self development.
The state of Ethiopia where there is a large network of small scale enterprises, with comparatively
less investments in the large scale sector, the general standard of living is much higher than in the
states where heavy investments have been made in large scale industries.
2.4.2. Less Capital and More Labor (The Employment Argument)
The main problem is that we have vast manpower but inadequate capital, which has resulted in
increasing unemployment. This is unlike in situation in western countries where manpower is
limited but capital resources are enormous. Planners have realized the necessity of encouraging
small industries because they require less capital but generate more employment. It is estimated
that through the net-out per worker n large and medium industries is more than twice as compared
to that in small scale industries, the investment of capital per worker is about seven times.
The small-scale sector has the capacity to generate a much higher degree of employment than the
large-scale sector. For example according to the data collected by the in dial development
commissioner of small industries states that-the fixed investment in plant and machinery per
worker in the small-scale sector is about Rs. 3000 and Rs. 20,000 in the large scale sector. The
present inflationary trend is largely due to shortage of goods. More production needs more capital
in such a situation. These small industries will stand in good position because they are less capital
intensive and more employment oriented.
The argument is based on the assumption that small scale industries are labor intensive and thus
create more employment per unit of capital. It is said that employment generation capacity of small
sector is eight times that of the large scale sector. According to prof. P.C. Mahalanobis, household
or cottage industries require very little capital. With any given investment employment
possibilities would be ten or fifteen or even twenty times greater in comparison with corresponding
factory industries.
2.4.3. Removing Regional Imbalance (The Decentralization Argument)
Another problem is the continuous shifting of people from rural to urban areas which causes over-
crowding in cities with slum conditions due to lack of social and medical amenities which require
heavy investment. This problem can be solved inducing people to set up small industries in rural
areas.
The prolific setting up of agro-based industries will go a long way in creating a balance in our
country’s economy. In order that industrialization may benefit the economy of the country as a
whole, it is important that disparities in the matter of development between different regions should
be progressively reduced.
Large scale industries have the tendency to concentrate in big cities. As a result semi urban and
rural areas remain deprived of the benefits of industrialization. Moreover, undue concentration of
large industries in urban areas creates several problems. E.g., pollution, slums, shortage of civic
facilities, etc. due to employment opportunities in the countryside, people migrate in large number
to big cities. Small scale units can be located in rural and semi urban areas to reduce regional
disparities.
Creating Self Employment Opportunities
In India, since independence it has had a steady rise in the number of qualified engineers seeking
suitable jobs. But having in adequate adventures, they can have self-employment by setting up
small industries with the help and expertise proved by the government and other agencies. Main
bank and have several industrial corporations, here, have arranged special training programs for
young entrepreneurs, who can easily set up their own units with package assistance from the
governments.
Ancillary Function
Many small-scale industries units supply and accessories bigger industries. This ancillary function
involves specialization in specific areas and results in greater profitability. The government has,
therefore, relaxed the ceiling of investment in plant and machinery for ancillary unit.
Export Promotion
Small-scale industries are now a day opening up fresh avenues in the export market in our world.
Realizing the importance of the small-scale sector in the economy the Ethiopian government has
adopted several measures to speed up the growth for small industries.
Supply of Critical Raw Materials
The government has also liberalized the importer to ensure regular supply of raw materials to small
industrial units, and devised a more efficient and consistent system of distribution of critical raw
materials.
2.5.Risks and Causes of Failure Associated with Small Business
Although a lot of new small businesses are established in most countries, the success rate is very
minimal. This can be attributed to a lot of factors, which can be generally classified in to two
categories:
Internal Factors of Failure and Personal Factors of Failure
Economic business cycles, fluctuating interest rates, interrupted suppliers, labor market trends,
inflation, government regulations and unstable financial markets are some of the external factors
that might bring about small business failure. Although all businesses /small or big/ are subject to
these risks, their effect on small businesses is far more serious than any other business. This is
because the resources a small business owner controls are very limited which makes it very
difficult to deal with these situations.
On the other hand there certain problems that can be attributed to personal weaknesses and
limitations of the entrepreneur. These include:
 Inexperience: too often, entrepreneurs launch their enterprises without having sufficient
experience to succeed. Inexperience can be translated to mean a lack of technical skills of
management acumen.

 Arrogance: many small business persons-particularly inventors and innovative

entrepreneurs with new products become consumed with their own brilliance, convinced
beyond reason (often without market research) that…

 Their bright idea will change the world: it is got to see! Their arrogance will not allow
them to take advice from others.

 Mismanagement: humble entrepreneurs steeped in experience can still go under simply

mismanagement of resources; they simply make bad decisions in critical situations. These
may include:
  Over investment on fixed assets: when starting or expanding a business, it is tempting to
buy facilities and equipments rather than lease or subcontract. Everyone likes to own assets,
but greater investment on fixed assets means less flexibility to adjust to adverse conditions.

 Poor inventory control: purchasing too much inventory increases the risk of low turnover
and obsolescence. Having too little inventory undermines customer satisfaction and sales.
Buying the wrong inventory, or buying at the wrong time, evaporates cash. In each
scenario, the business tries up high powered cash in non-earning assets, and the inventory
items can rarely by disposed of for more than a fraction of their costs in an emergency. The
result is that a business “purchases” itself in to insolvency.

 Poor business philosophy: an unfortunate aspect of many business failures is that too
often individual owner’s priorities get in the way of sound business practices. In the least
obtrusive way, entrepreneurs may not be fully committed to the long hours required to
make a venture success full.

 Lack of Planning: most entrepreneurs frequently underestimate the importance of

planning in business success. However,, not planning means not anticipating future
problems and challenges and not being prepared for them in advance. This surely leads the
entrepreneur in to making mistakes and facing problems which could have been easily
avoided though sound planning.

2.6.Problems in Ethiopia Small Business

Small scale industries have not been able to contribute substantially as needed to the economic
development particularly because of financial, production, and marketing problems. These
problems are still major handicaps to their development lack of adequate finance and credit has
always been a major problem of Ethiopian small business. Small-scale units do not have easy
access to the capital market because they mostly organized on proprietary partnership basis and
are of very small size. They do not have access to industrial sources of finance partly because of
their size and partly because of the fact that their surpluses which can be utilized to repay loans
are negligible. Because of their size and partly because of the fat limited profit, they search for
funds for investment purposes. Consequently, the approach moneylenders who charge high rate of
interest hence small enterprises continue to be financially weak.
Small-scale enterprises find it difficult to get raw materials of good quality and at cheaper rates in
the field of production. Very often they do not get raw materials in time. As a result, these
enterprises very often fail to produce goods in requisite quantities and of good quality of a low
cost. Furthermore, the techniques of production, which these enterprises have adopted, are usually
outdated. Because of their poor financial position they are not able to buy new equipment
consequently their productivity suffers. Besides, many small business enterprises are suffering
with the problem of marketing their products.
It is only by overcoming all these constraints that small enterprises can hope to make their
enterprises successful.
Management Practice in Ethiopian Small Business
Small-scale industries sector occupies a strategic position of unique importance in the Ethiopian
economy. Today, the village and small-scale industries sector roughly account for roughly about
one-half of the total industrial production. Industrial relations is not a major problem in Ethiopian
small business and job specialization is not strictly adhered to by them, life time employment may
not be possible in Ethiopian small business because of limited scope they offer for career growth
of employees.
What is more important in the Ethiopian business environment is to change the attitude of work
force, make them disciplined and duty conscious, and inculcate in them a sense of commitment
towards their organization.
The Small Business Survival Rate
As a final note in this section, we must acknowledge the surprising rate of survival by small firms.
Debunking many myths about the failure rates if small firms, recent studies are demonstrating a
much higher level of survival for these enterprises than ever envisioned. The most recent statistics
show an overall 75.5 percent survival rate over a four-year period. Firms without employees
survived at a 72.4 percent rate, and firms with employees experienced at a 90.5 percent survival
rate. These are encouraging figures as we begin the new century.
Certainly numerous factors affect this survival rate. One factor enhancing survival may be the
technological development experienced over the last few years.
Table 1. Survival Rates of Small Businesses

Firms closing each year Firms Surviving

 All firms 1992 1993 1994 1995 Until 1996
without 7.3 6.7 5.8 4.7 75.5
employees
8.3 7.7 6.5 5.1 72.4
Firms with 2.7 1.5 2.3 3.0 90.5
employees

Source: Haile GebretinsaeBeyene, 2007. Page102

2.7 Setting small businesses
2.7.1 Basic Business Idea
All business begins with a business idea. There are many ideas around, but they are not all are
business idea. A business idea has two defining characteristics, it meets an unmet need and it
drives transaction.
In the first, the product or service that we offer must satisfy a customer’s unmet need. This may
mean a brand-new product or service or it may mean finding a way to provide a product or service
at a lower price than currently available.
Second a good business idea drive transaction. Whatever the product we offer to customers they
must be willing to exchange their money for our product or service. A key point keep in mind is
that people do not buy products or services they buy the benefits they get from the product or
service. So what benefits are we providing that meet their needs and solve their problem.
The test of a good business atmosphere guides the choice of basic business idea. A basic business
idea results from the identification of business opportunities in market.
To be success in business consistently watches the opportunities to spot where the entrepreneur
has to be sensitive to the market changes. Watch demand and supply study consumer behavior and
grasp the business ideas.

3.2 Source of Business Ideas

Some of the more frequently used sources are:
1) Market characteristics / observing the market /
Careful observation of markets can reveal a business idea. Market can reveal the demand
and supply position for various products unfulfilled demand will open the door for new
product or service
 2) Government organization: several government organizations nowadays assist
entrepreneurs in discovering and evaluating business ideas. Development bank, state
industrial development corporation, technical consultancy organization, etc. provide
assistance in technical, financial, marketing and other areas business. Government rule,
regulation and policy on import and export, research and training service etc encourage
entrepreneurs to think about the new option.
3) Development in other nation: people in under developed countries generally follow the
fashion trend of developed countries. Therefore an entrepreneur can discover good
business idea by keeping in touch with development in advanced nations. Sometimes,
entrepreneurs visit foreign countries in search of ideas for new product or service.
4) Social and economic trends
Social and economic status of people is always dynamic in nature and offer wide
opportunities. An entrepreneur should observe such change.
5) Emerging new technology.
Commercial exploitation of indigenous or imported technologies and know how is another
source of project idea.
6) Trade fairs and exhibitions: national and international trade fairs are very good sources
of business idea. At these fairs, producers and dealers in the concerned industry put up their
products for display and / for sale.
Magazines, journals, industries, trade fairs offer wide scope for business opportunities
Methods for Generating Business Idea

The entrepreneur can use several methods including focus groups, brainstorming, and problem
inventory analysis to come up with and test new ideas.
A. Conducting research: an entrepreneur can primarily generate new business idea by
conducting a target research. It is necessary to estimate future demand and take in to
account anticipated change in fashion income levels, technology, etc.
B. Focus groups: is a group of individuals providing information in a structured format,a
moderator, often called a focal person leads a group of people through an open in depth
discussion rather than simply asking questions to solicit/seek participants’ response. For a
new product area, the moderator focuses the discussion of the group in either a directive or
 a non-directive manner. The group of participants is stimulated by comments from other
group members in creativity conceptualizing and developing a new product idea.
C. Brainstorming: is a group method of obtaining new idea and solution. Brainstorming is
probably the most well known and widely used techniques for both creative problem
solving and idea generation. It is an unstructured process for generating all possible ideas
about a problem within a limited frame though the spontaneous contributions of
participants. It serves to generate as many ideas as possible to screen out for further
development. A good brainstorming session starts with a problem statement that is neither
too broad nor too narrow.
Once the problem statement is prepared, a group of individuals is to forward a wide range
of knowledge. The following rules should be followed while using this method.
 No criticism is allowed by anyone in the group –no negative comments.
 Freewheeling is encouraged –the wider the idea the better.
 Quality of ideas is desired- the greater the number of ideas, the greater the
likelihood of useful ideas emerging.
 Combinations and improvements of ideas are encouraged-ideas of others can be
used to produce –still another new idea.
 The brainstorming session is fun, not to be spoiled with seriousness.
D. Problem inventory Analysis: is a method for obtaining new ideas and solution by
focusing on problem.Problem inventory analysis uses individuals a manner analogous to
focus groups to generate new product ideas. However, instead of generating new ideas
themselves, consumers are provided a laundry list of problems in a general product
category. They are then asked to identify and discuss products in this category that have
particular problem. This method is often effective since it is easier to relate, known
products to suggested problems and arrive at a new product idea than to generate an entirely
new product idea by itself. Problem inventory analysis can also be used to test a new
product idea.

2.7.2.What Project an Entrepreneur should have?

A project can be defined in different ways. A project is a complex of economic activity in which
the players commit scarce resources in the expectation that the benefits gained will exceed these
resources.
The project should have to consider the SWOT and should be designed accordingly.
SWOT is a series of steps one has to consider in evaluating a business opportunity and arriving at
a decision on starting a business or not.
The SWOT approach compels individuals to think or reason out systematically and analytically
the important factors strengths, weakness, opportunities, and threats.
a. Opportunity ;refers to any factor that offer promise or potential for moving closer or more
quickly towards the firms goal
b. Threat; is any factor that may limit or impede the business in the pursuit of its goals
c. Strength; is an inherent capacity, which an organization can use to gain strategic
advantage over its competitors.
d. Weakness; is an inherent limitation or constraint, which creates a strategic disadvantage.

To be a successful an entrepreneur, one major determinant factor is the choice of a good

business idea. To select the best business idea, the following steps needs to be pursued.
a. Identifying your problem
b. Define your objectives
c. Identifying ,develop and analyze the possible alternative
d. Select the best alternative in light of the specific criteria set to the better fulfillment of the
objective.