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What is a Small Business?

Objective 3-1 Define small business, discuss its importance to the U.S. economy, and explain popular areas of small business.

The term small business is not easy to define. Locally owned-and-operated restaurants, dry cleaners, and hair salons are obviously small businesses, and giant corporations, such as Nike, Starbucks, Apple, Target, and Netflix, are clearly big businesses. Between these two extremes, though, fall thousands of companies that cannot be easily categorized.

The U.S. Department of Commerce has traditionally considered a business to be small if it has fewer than 500 employees. The U.S. Small Business Administration (SBA), a government agency that assists small businesses, has different standards based on industry. For instance, a manufacturer is considered to be small if it has 1,000 or fewer employees. A wholesaling firm is small if it has between 100 and 500 employees. Other industries, though, such as services, retailing, and construction, are generally classified based on revenue. Because strict numerical terms sometimes lead to contradictory classifications, we will consider a small business to be one that is independent (that is, not owned by or a unit of a larger business) and that has relatively little influence in its market. A small neighborhood grocer would be small, then, assuming it is not part of a chain and that market forces largely set the prices it pays to wholesalers and that it can charge its customers. Dell Computer was a small business when founded by Michael Dell in 1984, but today it’s one of the world’s largest computer companies and is not small in any sense of the term. Hence, it can negotiate from a position of strength with its suppliers and can set its prices with less consideration for what other computer firms are charging.

The Importance of Small Business in the U.S. Economy

As Figure 3.1 shows, most U.S. businesses employ fewer than 100 people, and most U.S. workers are employed by small business. Moreover, this same pattern exists across most free-market economies.

Figure 3.1 Full Alternative Text

Figure 3.1(a) shows that 89.59 percent of all businesses employ 20 or fewer people. Another 8.58 percent employ between 20 and 99 people, and 1.52 percent employ between 100 and 499 people. Only about .16 of 1 percent employ 1,000 or more people. Figure 3.1(b) shows that 17.86 percent of all workers are employed by firms with fewer than 20 people, and 17.14 percent are employed by firms with between 20 and 99 people. Another 14.49 percent are employed by firms with between 100 and 499 people. So, around half of all workers are employed by firms with 500 or fewer employees and the other half work for larger organizations. We can measure the contribution of small business in terms of its impact on key aspects of the U.S. economic system, including job creation, innovation, and its contributions to big business.

Job Creation

Small businesses—especially in certain industries—are an important source of new (and often well-paid) jobs. In recent years, small businesses have accounted for around 40 percent of all new jobs in high-technology sectors of the economy.⁴ Jobs are created by companies of all sizes, all of which hire and lay off workers. Although small firms often hire at a faster rate, they also tend to cut jobs at a higher rate. They are generally the first to hire in times of economic recovery, and big firms are generally the last to lay off workers during downswings.

However, relative job growth among businesses of different sizes is not easy to determine. For one thing, when a successful small business starts adding employees at a rapid clip, it may quickly cease being small. For example, Dell Computer had exactly 1 employee in 1984 (Michael Dell himself). But the payroll grew to around 100 employees in 1986; over 2,000 in 1992; more than 39,000 in 2004; 94,300 in 2010; and over 100,000 in 2016. Although there was no precise point at which Dell turned from “small” into “large,” some of the jobs it created would have been counted in the small business sector and some in the large.

Innovation

History reminds us that major innovations are as likely to come from small businesses (or individuals) as from big ones. Small firms and individuals invented the PC, the stainless-steel razor blade, the photocopier, and the jet engine and launched Facebook, Amazon, Starbucks, Instagram, and eBay. Innovations are not always new products, though. Dell didn’t invent the PC; he developed an innovative way to build it (buying finished components and then assembling them) and an innovative way to sell it (directly to consumers, first by telephone and now online). Similarly, Reed Hastings invented neither the DVD nor the DVD rental business, but he did introduce revolutionary new payment and delivery models. In general, small businesses produce 16 times as many patents per employee as large patenting firms.⁵

Contributions to Big Business

Most of the products made by big businesses are sold to consumers by small ones. For example, most dealerships that sell Chevrolets, Toyotas, and Hondas are independently operated. Even as more shoppers turn to online shopping, smaller businesses still play critical roles. For instance, most larger online retailers actually outsource the creation of their websites and the distribution of their products to other firms, many of them small or regional companies. Smaller businesses also provide data storage services for larger businesses. Moreover, small businesses provide big ones with many of their services and raw materials. Microsoft, for instance, relies on hundreds of small firms for most of its routine code-writing functions.

Popular Areas of Small Business Enterprise

Small businesses play a major role in services, retailing, construction, wholesaling, finance and insurance, manufacturing, and transportation. Generally, the more resources that are required, the harder a business is to start and the less likely it is that small firms dominate an industry. Remember, too, that small is a relative term. The criteria (number of employees and total annual sales) differ among industries and are often meaningful only when compared with truly large businesses. Figure 3.2 shows the distribution of all U.S. businesses employing fewer than 20 people across industry groups.

Figure 3.2 Full Alternative Text

Services

About 56.2 percent of businesses with fewer than 20 employees are involved in the service industry, which ranges from marriage counseling to computer software, from management consulting to professional dog walking. Partly because they require few resources (and hence don’t cost as much to start), service providers are the fastest growing segment of small business.

Retailing

Retailers, which sell products made by other firms directly to consumers, account for about 11.9 percent of small businesses. Usually, people who start small retail businesses favor specialty shops, such as big men’s clothing or gourmet coffees that let the owners focus limited resources on narrow or small market segments.

Construction

About 11.9 percent of all U.S. businesses are involved in construction. Because many construction jobs are small local projects, such as a homeowner adding a garage or remodeling a room, local contractors are often best suited to handle them.

Wholesaling

Small business owners often do well in wholesaling, which accounts for about 5.0 percent of businesses with fewer than 20 employees. Wholesalers buy products in bulk from manufacturers or other producers and store them in quantities and locations convenient for selling them to retailers.

Finance and Insurance

Financial and insurance firms account for about 4.1 percent of small businesses. Most of these businesses, such as local State Farm Insurance offices, are affiliates of or agents for larger national firms. Small locally owned banks are also common in smaller communities and rural areas.

Finding a Better Way

The Rise of Services

Manufacturing is a form of business that combines and transforms resources into tangible outcomes that are then sold to others. Goodyear is a manufacturer because it combines rubber and chemical compounds and uses blending equipment and molding machines to create tires. Broyhill is a manufacturer because it buys wood and metal components, pads, and fabric and then combines them into furniture. And Apple is a manufacturer because it uses electronic, metal, plastic, and composite components to build smartphones, computers, and other digital products.

Manufacturing was once the dominant technology in the United States. During the 1970s, though, manufacturing entered a long period of decline, primarily because of foreign competition. U.S. firms had grown lax and sluggish, and new foreign competitors came onto the scene with better equipment, much higher levels of efficiency, and employees willing to work for lower wages. For example, steel companies in Asia were able to produce high-quality steel for much lower prices than large U.S. steel companies such as Bethlehem Steel and U.S. Steel. Faced with a battle for survival, some companies disappeared, but many others underwent a long and difficult period of change by eliminating waste and transforming themselves into leaner, more efficient, and responsive entities. They reduced their workforces dramatically, closed antiquated or unnecessary plants, and modernized their remaining plants. Over the last decade or so, however, their efforts have started to pay dividends because U.S. manufacturing has regained a competitive position in many different industries. Although low wages continue to center a great deal of global manufacturing in Asia, once-strong manufacturers are once again thriving in the United States.

During the decline of the manufacturing sector, a tremendous growth in the service sector, often fueled by visionary entrepreneurs, kept the overall U.S. economy from declining at the same rate. A service organization is one that transforms resources into an intangible output and creates time or place utility for its customers. For example, Netflix provides video rentals through mail order and online streaming. Facebook offers its members a venue for networking and interacting with others. And your local hairdresser cuts your hair. In 1947, the service sector was responsible for less than half of the U.S. gross national product (GNP). By 1975, however, this figure was nearly 65 percent, and by 2016, it had reached approximately 80 percent. The service sector has been responsible for almost 90 percent of all new jobs created in the United States since 1990.

Moreover, employment in service occupations is expected to continue to represent a larger share of employment in the U.S. economy. In 2002, 76.3 percent of U.S. workers were employed in the service sector, and this grew to 79.9 percent in 2012. By 2022, it is expected that 80.9 percent of workers in this country will be employed in service jobs. Among all service jobs, it is expected that professional and business services and health care and social assistance will represent an increased share. Looking at the Bureau of Labor Statistics list of the fastest-growing occupations between 2012 and 2022, we see that almost all of these occupations are in the service sector, largely in the areas of professional and business services and health care and social assistance.

Managers have come to see that many of the tools, techniques, and methods that are used in a factory are also useful to a service firm. For example, managers of automobile plants and hair salons each have to decide how to design their facility, identify the best location for it, determine optimal capacity, make decisions about inventory storage, set procedures for purchasing raw materials, and set standards for productivity and quality. At the same time, though, service-based firms must hire and train employees based on a different skill set than is required by most manufacturers. For instance, consumers seldom come into contact with the Toyota employee who installs the seats in their car, so that person can be hired based on technical skills. But Toyota must also recruit people for sales and customer service jobs who not only know how to do a job but who can also effectively interface with a variety of consumers. In addition, most services are simultaneously produced and consumed, so traditional models of quality control need to be revisited. As the service economy grows, managers will need to learn more about how to effectively recruit, train, and reward employees in service jobs.⁶

Manufacturing

More than any other industry, manufacturing lends itself to big business, but it still accounts for about 3.9 percent of firms with fewer than 20 employees. Indeed, small manufacturers sometimes outperform big ones in such innovation-driven industries as electronics, equipment and machine parts, and computer software.

Transportation

About 2.8 percent of small companies are in transportation and related businesses, including many taxi and limousine companies, charter airplane services, and tour operators.

Other

The remaining 4.2 percent or so of small businesses are in other industries, such as small research-and-development laboratories and independent media companies—start-up web channels, small-town newspapers, and radio broadcasters.

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Table of Contents for What is a Small Business?

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What is a Small Business?