Why closing the small business productivity gap can create enormous value for economies

Micro, small and medium-size enterprises (MSMEs) play an underappreciated and outsized role in the global economy.

They account for 90% of all businesses, half the value added, and more than two-thirds of business employment. In Indonesia, for example, they account for almost 90% of employment and two-thirds of value added. Small businesses also inject dynamism into economies.

Many large companies of today were MSMEs not long ago. About one in five of today’s very large companies – defined as having a market capitalization of more than $10 billion in the United States and equivalent values in other economies – were MSMEs at some point after 2000 and have since powered their way to large company status.

Yet small businesses struggle with productivity in comparison with large companies. Raising MSME productivity has long been an aim of governments who recognize their central role in economic growth and employment.

McKinsey Global Institute’s recent A microscope on small businesses: Spotting opportunities to boost productivity report analysed MSMEs in 16 economies and found that narrowing the productivity gap could represent value equivalent to 5% of gross domestic product in advanced economies and 10% in emerging ones. The question is how best to capture that value.

Overall MSME productivity is only half that of large companies, and less in emerging economies. In India and Indonesia, for example, small businesses are only one-fourth as productive.

But this is very much an average. In truth, productivity performance varies enormously widely amongst MSMEs depending on the country in which they operate, the sector and even the subsector.

In India, for instance, MSMEs in the manufacturing sector achieve 14% of the productivity of large companies, whereas in administrative services, their productivity is 32%. Conversely, in Indonesia, small businesses in manufacturing are 40% as productive as their large counterparts, but only 10% as productive in administrative services.

How the MSME does business is important, too. Business-to-business MSMEs that interact closely with other companies, often larger ones, have a 40% smaller productivity gap with those larger enterprises than business-to-customer MSMEs that sell primarily to individuals –in five sectors that offer the most potential value.

Indeed, being part of a business network is a major factor in MSMEs’ productivity performance – but also in the performance of the large companies in their networks. Looking around the world, in two-thirds of subsectors, the fortunes of MSMEs and large companies are correlated and go hand-in-hand: a win-win.

Take the trade sector in Japan as illustration. In automotive trade, Japan’s MSMEs are more vertically integrated with large manufacturers than in many other advanced economies, including the US. This enables them to have more efficient logistics that follow just-in-time principles and respond effectively to market fluctuations.

They are top-quartile productivity performers. But in retail and wholesale trade – excluding automotive trade – vertical integration appears to be weaker, and Japan’s MSMEs fall into the bottom two quartiles of relative performance.

These findings have three important implications for how to tackle the MSME productivity problem:

Given evidence that MSMEs and large companies tend to thrive most when they are interconnected, it may well be that stakeholders – including policy-makers, regulatory bodies, associations and large companies – need to foster the right enabling conditions for the growth and prosperity of all enterprises. And that means going beyond conventional policies focused on MSMEs, such as facilitating their access to credit and encouraging training.

It may be preferable to aim for “collective productivity” by taking action to strengthen networks and interactions between large and small businesses where large companies lead on productivity and smaller ones lag behind. Where small businesses outperform while larger ones do not, there would be benefit in enabling those small enterprises to evolve into large ones or merge with them to promote business dynamism.

When both large and small companies lag behind their peers, more fundamental steps to improve the economic fabric as a whole may be needed; for instance, investing in physical and digital infrastructure, establishing transparent and fair regulatory frameworks that boost competition, reducing trade barriers, and ensuring equal access to financial capital.

Stakeholders first need to decide which economic domains to focus on to make MSMEs more productive. It is notable, for instance, that in virtually all the countries studied, eight subsectors out of 24 drive more than 60% of the value potential in manufacturing, but the top ones vary by country.

For example, if we compare Indonesia and Australia, there are important differences. Manufacturing of basic metals, chemicals, rubbers and plastics, and food products are important sources of value in both economies.

But in Indonesia, the apparel manufacturing subsector appears to offer meaningful value, whereas in Australia the textiles subsector is a sizable opportunity. For Indonesia, electrical equipment and automotive manufacturing would be higher priorities, but in Australia the comparable subsectors would be machinery and equipment, and fabricated metal.

It may make sense to prioritize those subsectors in the first instance. Failing to prioritize which opportunities to pursue can lead to a dilution of efforts and place a burden on the often-limited resources at hand. Some countries have selected and supported “national champion” sectors, as has happened with beverage manufacturing in Italy, automotive manufacturing in Japan, and research and development in Israel.

Such prioritization requires meticulous identification of the nation’s competitive advantages and a keen eye for demand trends, as well as allocating resources toward innovation, facilitating access to capital, and cultivating supportive networks.

Measures designed to help MSMEs improve their performance tend to be broad and apply across sectors and businesses. But the detailed lens of McKinsey Global Institute’s research reveals that dynamics and needs differ widely by subsector. Therefore, stakeholders may need to design a tailored menu of measures based on a microscopic approach.

In a world beset by uncertainty amid geopolitical tensions and shifts in manufacturing and services footprints, it is a priority to raise the game of the world’s MSMEs. The potential is large, but it is only likely to be captured with a granular understanding of MSME productivity, and a targeted set of actions that can create a win-win for all companies, small and large.