Despite More Customers, SMEs Fail to Boost Profits: "Networking ability" is the key

In the face of recession, business sentiment among small and medium-sized enterprises (SMEs) has been increasingly worsening. While high raw material prices continue to squeeze their profit margins, an increasing number of SMEs are also facing financing difficulties as banks tighten their lending standards. SMEs are confronted by a much graver and longer-lasting problem capable of dwarfing the current short-term cyclical business downturn and prolonging for 10-20 years.

First, the number of SMEs continues to decline. According to the Establishment and Enterprise Census reported by the Ministry of Internal Affairs and Communications, the number of SMEs in Japan dropped from 5.09 million in 1996 to 4.2 million in 2006. If the exiting SMEs comprised less competitive, lower quality businesses, this situation would enhance the efficiency of the overall economy because a smaller but stronger group of SMEs would survive. The prevailing tendency, however, is for high-quality SMEs to exit the Japanese market through either voluntary liquidation or transfer of operations overseas.

Second, the labor productivity of overall SMEs has not been improving as much as that of major companies. Indeed, the productivity gap between SMEs and major companies has been widening over the years. Based on data provided by the Ministry of Finance in its report Financial Statements Statistics of Corporations by Industry, gross value added per employee for major companies in 2008 was 2.8 times as large as that of SMEs, compared to 2.2 times in 1985.

Are Japanese SMEs on a long-term declining trend? Is there any way to prevent this trend? In what follows, I would like to address these questions in relationship to the term "tsunagari-ryoku," while referencing both my research findings and a 2007 white paper, which I contributed to, on Japanese SMEs.

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Tsunagari-ryoku, - not a commonly used term in Japanese - is defined as the ability to add value through linkages between independent economic entities. Its rough English translation is "networking ability," and it will be referred to hereinafter as such. Networking ability appears in the government's 2008 economic and fiscal reform policy agenda (Basic Policies 2008) because how and with whom to network are crucial questions for companies and other economic entities.

In the absence of suppliers and customers, companies could neither produce nor sell products. And without banking relationships, it would be difficult to raise the necessary funds for financing capital investments and operations. Networking ability has great significance, particularly for SMEs. Compared to major companies, SMEs are far more dependant on relationships with others due to their relatively limited management resources.

Partly reflecting these circumstances, economists have been paying substantial attention to how a company builds a network with other economic entities. With respect to manufacturing sector components such as the automobile industry, researchers' interest has focused on what relationships assemblers have built with parts suppliers. Likewise, in corporate finance the concept of relationship banking, in which a bank provides a loan to a company by basing its credit decision on data and information obtained through its long-term relationship with the company, has received a considerable amount of academic attention with many theoretical and empirical studies based on the topic.

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SMEs should operate relatively problem-free when their relationships with major companies and banks are functioning properly. However, in reality such is not the case, which suggests that a sufficient level of networking ability may be lacking.

First, take a look at intercompany business relationships. The numbers of customers and suppliers a company deals with have been on the rise in recent years. However, a closer look at the relationship between the numbers of customers/suppliers and sales growth reveals that an increase in the numbers of customers/suppliers does not necessarily lead to improved business performance.

It can be said that business relationships between companies have become more fluid, less stable, and increasingly diversified in recent years. For instance, even in the automobile industry it is no longer rare for an auto-parts maker to supply products to more than one automobile company. According to the 2007 SME white paper that includes, among other things, the results from a survey of some 2,000 different manufacturers, the number of companies that increased their customer/supplier relationships over the past 10 years exceeded by far the number of companies that decreased these same relationships.

Together with Yukiko Saito, a senior associate at Fujitsu Research Institute, I tackled the question of whether or not an increase in customers/suppliers improves a company's business performance. We calculated the numbers of suppliers and customers for each company using data provided by Tokyo Shoko Research, which maintains a database identifying suppliers and customers for about 800,000 Japanese companies. After adjusting the data to take into account company size and certain other factors, we examined whether companies with a greater number of customers achieve higher business performance.

The table shows that an increase in the number of customers generally leads to an increase in sales. However, when the number of customers reaches a certain level sales stop growing, and in some industries an increase in the number of customers beyond that threshold has a negative impact on corporate growth. Specifically, in the manufacturing, transportation, and services industries, the upper threshold number of customers resulting in sales growth is very small at four for transportation and nine for the other two. For these industries, an attempt to increase the number of customers tends to inhibit corporate growth. This suggests that some of the business relationships between companies are not substantive.

Second, what about the relationship between companies and banks? While the number of banks an SME borrows from or deals with otherwise has increased over the years, the additional relationships are often superficial. In recent years, there has been a tendency among SMEs to deal with multiple banks to ensure stable funding. According to the 2007 SME white paper, a survey of some 1,500 SMEs found that the number of banks an SME dealt with in 2006 increased by 1.5 banks from 2001. The increase came despite a decline in the total number of banks as a result of a series of bank mergers, particularly between shinkin cooperative banks.

However, even though SMEs have thus formed relationships with many banks, the banks' lending behavior does not necessarily reflect such relationships. For instance, according to research conducted by Hirofumi Uchida, an associate professor at Wakayama University, in many cases a long-term banking relationship does not benefit SMEs in terms of greater availability of loans or lower interest rates.

The ongoing credit crunch, which has been attracting much media attention recently, can be described as a phenomenon resulting from the malfunctioning of relationship banking. Meanwhile, according to my analysis, governmental credit guarantees provided through prefectural Credit Guarantee Corporations (CGCs) have been somewhat effective in helping SMEs weather financial difficulties amid the serious credit crunch. The very fact that such government involvement has had an observable impact stands as a testimonial that there lacks a sufficient bond between companies and their lending banks, i.e., each side lacks sufficient networking ability. (Both studies are published in Tsutomu Watanabe and Iichiro Uesugi, ed., "Kensho: Chusho-kigyo Kinyu (Review: Small Business Financing)," Sept. 2008)

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Networking ability determines the future course of SMEs with limited management resources. It is thus all the more critical for companies to improve the quality of their networks. In this regard, Japanese SMEs have a lot to learn from initiatives undertaken by their German counterparts in the export-oriented manufacturing sector. German SME manufacturers may maintain a low profile with their aggregate sales amounting to less than 100 billion yen, but many of them command the leading global market share in their respective fields. These successful companies characteristically have built networks giving them direct access - not via agencies - to their customers. Therefore, they can quickly enhance their products to reflect the potential needs and demands of their customers.

SMEs, even mediocre ones, have a lot of room to build high-quality networks. For instance, companies that are in the same trade and operate in the same geographical area can create a local network to jointly receive and process customer orders, thereby dividing various functions among themselves. There have been cases where such attempts successfully led to the formation of business relationships with companies in a leading-edge industry led to the successful formation of new business relationships.

In order for SMEs to explore new sales channels with promising prospects, they need to to take a long-term approach to recruiting and developing human resources with marketing expertise, a particular skill set that has historically been in short supply. SME company executives and senior managers are often mid-career recruits. Severe business conditions such as what we are now experiencing can provide a golden opportunity for SMEs to recruit promising human resources.

As government policy, it would be effective to implement measures designed to reduce information asymmetry and transaction costs so as to facilitate the formation of new relationships and quickly terminate ineffective relationships. The credit risk database, which was created in 2001 and provides banks with credit risk information on SMEs based on the financial data of millions of companies, has helped lower transaction costs for both banks and SMEs. In addition to providing credit risk information, efforts are currently underway, primarily at the Ministry of Economy, Trade and Industry, to establish a system for evaluating SMEs' technical growth potential based on observable data and information. Various hurdles need to be overcome, but if realized, such an evaluation system could become a driving force for generating new relationships between SMEs and banks.

It is also necessary to get a precise picture of how various economic entities, including companies, relate with each other, and to closely examine such relationships in terms of strength and characteristics. The use of such data would help resolve many unanswered questions - i.e., what problems exist in current inter-company relationships compared to those in the past; and how networking ability is altered when drastic changes occur in the overall business environment, for instance, when major companies transfer operations overseas or declare bankruptcy.

In October 2008, a new research project led by Professor Watanabe of Hitotsubashi University was launched to empirically verify industrial and financial network structures that enable sustainable growth. The project, under which extensive data on the diverse relationships between economic entities will be collected and examined, is being counted on to generate new findings and increase knowledge concerning networking ability and related economic activity.

>> Original text in Japanese

Translated by RIETI from the original Japanese Keizai kyoshitsu column published in the Dec. 9, 2008, issue of the Nihon Keizai Shimbun.