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.
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 activities 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 by 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 taxes 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.

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.
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 indian 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 Ethiopia, there is 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. Here, government
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/Supply Chain
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 equipment 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

In the present, although the free market economic policy encourages the development of
entrepreneurship there are also many unfavorable factors. Some of these major problems are:
i) Access to Land: Land is a major source of capital in the Ethiopian economy. The
promulgation that has made the chance of micro, small and medium entrepreneurs and
startups in general to get land on aviation gloomy. It is then a major constraint to new
establishment and expansion of entrepreneurs.
ii) Financial Limitations: The very limited service of the public financial institution has made
it inaccessible to the great majority of the business community. The existing high collateral
requirements and the non-inclusion of machinery as a collateral, and in general the absence
of local financial credit system with a relate relaxed requirements have barred the great
majority of small entrepreneurs form access to credit. On the other side banks currently
 provide only short-term finance. These and others problems of access to credit is more acute
at start-ups and the informal sectors at large with their very limited financial capacity, too
week to meet the requirements of the banks at any standard.
iii) Business Taxes
The present tax policy of the government discourages the entrepreneurs. The private
businesses are required to report and pay sales and excise taxes every thirty days. Under the
prevailing standard of the private sector’s working methods, the frequency seems very
problematic not only to payers but also to the receivers’

The discretionary tax assessment method and the procedures are also problematic. It is also
learnt that business experience such as worker’s training, research and development and
some marketing expenses are not yet routinely allowed to be subtracted from taxable income.
This practice would discourage entrepreneurs from investing in such areas which are crucial
factors in the development of entrepreneurship and the private sectors. A sales tax of 12
percent is also considered too high by the private sector.
iv) Bureaucratic Procedures
A lengthily procedure is a common feature one word the growth of entrepreneurship and the
private sector. In this area, lack of clear coordination within and between departments as well
as intra organizations coupled with lengthy procedures frustrate private entrepreneurs.
Bureaucratic delays and administrative inefficiencies in process of applications for
registration of new business are also part of the problem.
v) Technology
Lack of domestic technology is also one serious problem. The absence of modern indigenous
technologies forces the businessmen in Ethiopia to depend on imported technologies.
vi) Market Problem
The availability of market for the products produced by the local entrepreneurs is low due to
the negative attitude of the society towards domestic products. Moreover, both Ethiopian and
foreigners import variety of products in the name of the frequent exhibitions, free of custom
and other charges. The price of such products is usually less than the price quoted by local
producers producing similar products.
vii) Poor infrastructure
 The lack of or poor communication and transportation facilities, the absence or limited water
and electricity services, lack of information on business opportunities and the lack of or little
business advocacy ad up to the major hurdle the private sector faces,

To sum up, the most common problems of the Ethiopian entrepreneurs are absence of
technology, shortage of working capital, inadequacy and high price of raw materials, non
availability of qualified staff, managerial incapability, bureaucratic red tape, illegal imports,
weak market for domestic products, non-existence of strong institutional support and
inaccessibility to resources. Note also that some of these problems are getting improvements
or solutions.
Even though there are many problems which hindered the development of entrepreneurship there
are also some favorable factors for entrepreneurial activities in Ethiopia.

The private sector had been neglected for a long time and it is now given the opportunity to
manage its own destiny. As part of the economic reform programme necessary to revive the
economy the liberalization policies are considered positive move in the right direction. The
measures are welcomed particularly by the peasant who now have the right to sell their produce
at competitive price.

The package incentives which include exemption of investors /entrepreneurs from paying
import duties and various taxes are expected to attract and promote entrepreneurs.

The availability of untouched natural resources labor resource, and favorable physical
environments are additional opportunities for Ethiopian entrepreneursIt 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.
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.