Enterprise and Small Business Principles

Strategy and the small business

Colm O'Gorman

21.1 Introduction

This chapter introduces the concepts of strategy and competitive advantage and their relationship to the management of small firms. Within the study of organisations the strategy concept is typically considered in the context of large firms. Do the concepts of strategy discussed in the literature apply in the context of small firms? We might expect them not to as small firms typically have fewer resources and are often organ­ised differently from large firms. Small businesses also differ from large businesses in their perception of opportunities and their commitment of resources to new opportu­nities (Stevenson and Gumpert, 1985). Large organisations are typically characterised by an administrative management style. The resources that the business controls drive the growth and development of the business. Large businesses consider investment pay-off in the medium to long term. In making strategic moves, the large business will typically analyse the opportunity and make a one-off commitment of resources. In contrast, the small business is typically characterised by a lack of resources and man­agement skills and by an entrepreneurial form of management. Small businesses can respond quickly to opportunities but may not be able to commit large amounts of resources to a new opportunity. Therefore, the small business manager tends to commit small amounts of resources, in a number of different stages, as opportunities emerge.

However, small need not be a competitive disadvantage. Small size can increase the flexibility of the business in responding to customer requests and to market changes. Small size can mean that the business can be more flexible in terms of production sys­tems (Fiegenbaum and Karnini, 1991) or in terms of price. Small size may mean that the business is faster to respond to changes in the market. Small businesses may be less risk adverse and more inclined to initiate competitive actions (Chen and Hambrick, 1995).

The differences between small and large firms mean it is often inappropriate to com­pare them in terms of the strategy-making process or in terms of the strategies associ­ated with success. Therefore it is important to consider strategy specifically in the context of the small firm and to consider how the characteristics of the small firm impact on how strategy is made and what strategies are associated with success. So, in reading this chapter bear in mind the following questions: What does strategy mean in the con­text of a small firm? Is it realistic for the small business to define its strategy and its strategic position? Should a small business have a formal strategy? Should a small firm ‘plan’ its strategy? What strategies should a small firm pursue? Can a small business reposition itself strategically?

The first part of this chapter outlines the strategy-making process in small busi­nesses, highlighting the fact that this is a highly informal and ad hoc process in most small businesses. The advantages of a formal strategy-making process are then dis­cussed. The second part of the chapter reviews research on the success strategies of small businesses. This review suggests that successful small businesses pursue ‘focused’ strategies and emphasise competitive advantages such as flexibility, fast response times and closeness to the customer. Innovation can also provide the small business with an important competitive advantage. The chapter concludes by highlighting structural and strategic weaknesses that impact on the choice of strategy and the strategy - making processes of small businesses. These weaknesses make it difficult for the small business manager to develop a clear competitive advantage. One of the most significant structural characteristics of small businesses that influences the strategy-making pro­cess is the centrality of the owner-manager. Strategic weaknesses include the lack of financial and managerial resources, reliance on a small customer base and poor tech­nological competence.

21.2 Learning objectives

1 To appreciate the strategy-making process in small businesses.

2 To recognise the importance of focused and differentiated strategies for small businesses.

3 To understand the strategies that are associated with success in small businesses.

4 To introduce the strategic weaknesses of small businesses.

Key concepts

■ Strategy ■ competitive advantage ■ focus strategy

■ the strategy-making process

21.3 What is strategy?

Strategy is about two questions: ‘What business(es) should we be in?’ and ‘How do we compete in a given business?’ (Hofer, 1975). Drucker (1977) referred to these two challenges in terms of effectiveness and efficiency. Efficiency means doing things right - ensuring that day-to-day operations are managed well; effectiveness refers to ensur­ing that the business is doing the right things - that the focus of the business is correct in the context of customers, competitors and industry trends. Efficiency ensures short­term survival by producing a profit from existing activities, while effectiveness ensures long-term survival by focusing the business on activities that will continue to produce profits in the future. The essence of a good strategy is that it is feasible, that is, it is con­sistent with the resources and skills of the business; that it provides a clear competitive advantage; and that there is a ‘fit’ between the business and its external competitive environment (Rumelt, 1991).

The outcome of a strategy should be a clear competitive advantage. A competitive advantage is an advantage that is valued by customers and which distinguishes the busi­ness from competitors. The source of a competitive advantage can be conceptualised in terms of the strategic positioning of the business or in terms of its resources and skills. The positioning approach emphasises the need for the business to achieve ‘fit’ with the external environment. To develop a strategy the business must have a clear under­standing of its market and of its competitors. The ongoing success of the business is dependent on its ability to maintain the ‘fit’ between itself and a changing environment.

The resource-based perspective argues that the source of a competitive advantage is the resources and capabilities of the business (Barney, 1991). By developing or acquir­ing resources the business can develop sustainable competitive advantages. Resources confer competitive advantage if they are hard to imitate, if they are heterogeneous (i. e. different from the resources that other businesses have) and if there is uncertainty as to the value of the resource. However, the value of resources can only be understood in the context of the market in which the business is operating and in the context of a particular moment in time. Of particular advantage to firms are having what are referred to as superior core competences and capabilities (Prahalad and Hamel, 1990). Core competences and capabilities refer to areas of activities within the firm that deliver added value to customers or allow the firm to operate more efficiently. In the context of small firms it is necessary to consider both superior competences and areas where the firm might have inferior competences and capabilities relative to competitors (Almor and Hashai, 2004).

The concept of strategy has different meanings in different contexts. Mintzberg pro­posed that strategy can be defined in five different ways, that is as a plan, as a ploy, as a pattern, as a position and as a perspective (Mintzberg and Quinn, 1991). Strategy as a plan refers to the intended actions that management have developed. When these plans refer to a specific decision they can be described as ploys. Mintzberg argues that not all strategies are planned but that in many situations strategy can be inferred from a pattern in a stream of decisions that management have made over time. Strategy can also refer to the position that the business has adopted in the external environment. This position can be defined in terms of the market that the business serves and the position that competitors have adopted. Finally, strategy can be conceptualised in terms of how a business perceives itself and its external environment; that is, in terms of the shared values and beliefs that guide the decisions made by the business.

21.4 Strategy making in the small business

In many cases the owner-manager of a small business may not formally articulate the business strategy or engage in any formal planning. However, there is a strong rela­tionship between the owner-manager and the strategy pursued by the small firm. The strategy chosen by the owner-manager is likely to reflect the personal priorities and goals of the owner-manager (Kisfalvi, 2002). In turn, the owner-manager’s personal priorities are likely to be determined by their own life experiences and prior work experiences. Furthermore, it is widely argued that the entrepreneur places a lasting ‘stamp’ on their company that influences the choice of strategy, organisational culture and managerial behaviours within the firm (Mullins, 1996). However, over-reliance on industry experience can result in a ‘me-too’ or ‘copy-cat’ strategy and no clear com­petitive advantage. In many industries with low barriers to entry, the cycle of ‘me-too’ new start-ups results in low profitability and high failure rates for small businesses.

Others have argued that strategy making in new and small firms is characterised by improvisation (Baker, Miner and Eesley, 2003). Improvisation describes a process whereby design and execution of a strategy occur simultaneously. Bhide (1994) argues that new ventures typically lack a planned strategy. Strategy in the ventures he studied emerged over time, with entrepreneurs responding flexibly to customer requirements. The ventures he studied typically faced significant capital constraints at start-up. There­fore, Bhide (2000) argues that in the context of new firms the key strategic challenge is the acquisition of resources. So rather than focusing on market position and com­petitive advantage Bhide suggests that the entrepreneur engages in creative ways of attracting resources and in generating sales. He argues that this process is unplanned and is typically characterised by ‘guess work’.

One approach to developing a strategy is to engage in a formal planning process. However, there is evidence to suggest that formal and comprehensive planning systems are rare in small businesses. The planning processes observed in most small businesses have been described as ‘informal, unstructured and sporadic’ (Cohn and Lindberg, 1972) and as ‘a passive search for alternatives’ (Bracker, 1982). The structure of the small business and the centrality of the entrepreneur mean that all ‘strategic planning’ is typ­ically concentrated in the owner-manager. The owner-manager may see no advantage in formalising the planning process that they use to develop the strategy of the business. Often the owner-manager will see disadvantages such as the potential loss of control, the loss of secrecy and the loss of flexibility.

The reality of strategy making and planning in the new venture context is that it is opportunistic and informal rather than formal. Founders analyse ideas parsimoniously and they integrate analysis and implementation (Bhide, 1994). However the lack of formal planning does not imply the absence of strategic thinking. Planning can be thought of as any reflective activity that precedes the making of decisions (Foster, 1993). Strategy change in new and small businesses may reflect a process of experimentation (Nicholls-Nixon et al., 2000). As such, the owner-manager seeks to determine the nature of the competitive environment and how best to compete in this environment by engag­ing in a process of trial and error learning.

21.4.1 The arguments in favour of adopting a formal planning system for a small firm

While formal planning systems may be uncommon in small firms there are some reasons for advocating that owner-managers engage in more systematic planning. Planning is generally perceived as a crucial element in the survival of new and small businesses (Kinsella et al., 1993; Hisrich and Peters, 1992; Jones, 1991). The models of planning suggested for small businesses have been adopted from the strategic management literature. However, small businesses differ from large businesses with regard to their planning needs and processes (Curtis, 1983). Small business generally do not have the resources to plan and purchase external advice and support; they are very susceptible to small environmental changes; owner-managers may not have the necessary experi­ence for managing all aspects of a small business; and owner-managers cannot devote a lot of time to consciously working through plans because of day-to-day work pres­sures. A consequence of this is that owner-managers tend to have a shorter and more functional emphasis on planning. The essential components of a successful planning process in a small business are that the owner-manager is central to the planning pro­cess; the owner-manager and, where relevant, managers, must have sufficient time to devote to the planning process; and effective planning will only be possible if sufficient internal information is available. This means that an adequate financial record keep­ing and financial control system should be in place in the business. Financial informa­tion must be timely and accurate.

Business plans are essential if entrepreneurs are to acquire external financial sup­port. By planning, the chances of success are increased as the right battlefield to suit one’s skills is chosen (Hay et al., 1993). Timmons (1994) argues that plans give the new business a results orientation that it would otherwise not have; that they force the new business to work smarter so that goals can be attained in the most effective and efficient manner possible; and that planning results in the consideration of alternatives that may not otherwise have been thought of and this allows planners to choose the optimum way of approaching a problem and, at the same time, it also makes them think ahead.

There are two main roles and uses of plans. Plans are used as communication devices and as aids to controlling the business’s factors of production (Mintzberg, 1994; Baker et al., 1993). The preparation of a business plan by an owner-manager is often seen exclusively as an external communications device. For some owner-managers a plan is written merely to improve legitimacy and satisfy demands from external agencies in order to acquire funding (Frank et al., 1989). A clear description of how the entre­preneur will exploit the business opportunity allows investors to decide whether the project is a worthwhile investment and assess the risk attached to it. The second role of a plan is as a control device. Plans provide benchmarks against which subsequent performance can be evaluated. This is particularly important in small businesses as the owner-manager’s time tends to be consumed by day-to-day management issues. The benefits of formal planning for small businesses are as follows:

■ A Statement of goals and objectives - a formal planning system will require key managers and promoters to state the goals and objectives of the business. Essential to planning is the choice of a future direction, for, ‘if you do not know where you are going, any road will take you there’ (The Koran). By clearly specifying objec­tives, promoters and staff should be more focused in their daily work activities.

■ Efficient use of time - by engaging in a planning process the owner-manager and, where appropriate, the directors of the business should make better use of their own management time. Planning should result in the identification and monitoring of a small number of key success factors.

■ Consideration of alternatives - a formal planning system allows the small business to explicitly consider alternatives for its development. This may include addressing issues such as succession planning in family businesses.

■ Better internal management and staff development - by focusing on the future development of the business a planning system should highlight the need for inter­nal systems and processes and the future staff and managerial requirements of the business. The owner-manager should be able to develop these processes and systems in advance of the actual need. In many cases the development of these internal sys­tems and structures will facilitate the strategic development of the business.

■ Better financial management - planning systems are closely tied to financial systems. In order to plan, the small business will need a basic financial system that provides timely information on current performance. This should improve the financial con­trol of the business and result in better decisions.

21.4.2 Planning and financial performance in small business

Within the literature on small business, research on planning has concentrated on estab­lishing a link between planning and performance. Many researchers make the inference that the ultimate survival of a small business is dependent on the presence of formal planning activity (Bracker and Person, 1986). There is evidence that small business failure is linked to a lack of planning activity (Bracker and Pearson, 1986). However, this research on the significance and impact of planning in small businesses has proved to be inconclusive (Stone and Brush, 1996; Schwenk and Shrader, 1993; Cragg and King,

1988) .

Schwenk and Shrader (1993) reviewed studies on the relationship between planning and financial performance and found conflicting results. In a comparative study between planners and non-planners, Cragg and King (1988) found no correlation between planning activities and financial performance. They also found a negative correlation between planning and size of sales and marketing team. Within this sample, however, younger firms performed better than older ones. Bracker and Pearson (1986) compared small mature firms in terms of age, size and planning history. They concluded that level of sophistication of planning had a positive impact on financial performance; younger firms performed better than older firms, as did firms with a longer planning history.

In many cases, the act of planning cannot necessarily be correlated with the success of a business venture (Robinson and Pearce, 1984). It is possible that the contribution of planning to new and small businesses cannot be measured quantitatively. Rather than compare planning and financial performance a more useful measure of planning might be the amount of vicarious experience that the owner-manager acquires by under­taking the planning process. Planning helps focus owner-managers on their resources, their market and their product; in this way, it could be argued that the main contribu­tion of planning to a business is an increased level of environmental awareness. Similarly, the absence of planning cannot be used as the sole explanation of business failure. In fact, it has been argued that a higher proportion of unsuccessful firms coordinate written plans and performance, set goals and monitor goal achievement (Frank et al.,

1989) .

21.4.3 Reasons for the absence of formal strategic planning in small businesses

Research suggests that most new and small businesses do not plan (Bhide, 1994; Stratos Group, 1990; Robinson and Pearce, 1984; Curtis, 1983). In many cases the structure of the small business is such that the owner-manager is intimately linked to all day-to - day activities. This allows the entrepreneur to control the direction of the business on a day-to-day basis. Where there is a planning process, it is often seen as a separate activity from the day-to-day management of the business rather than as a tool for improving day-to-day management. There are several barriers that inhibit the practice of planning in new and small businesses:

■ Clear sense of strategic direction/position - most owner-mangers have a clear sense of the strategic position and direction of their business. Management activity is typically focused on striving to implement more effectively the strategy chosen at start-up.

■ Centrality of the owner-manager - The close proximity of the entrepreneur to envir­onmental issues often makes objective judgement difficult (West, 1988).

■ Environment context - Many small businesses operate in highly turbulent envir­onments. Formal planning may be counter-productive in such environments as it reduces the strategic flexibility of the business (Chaffee, 1985; Fredrickson and Mitchell, 1984).

■ Rigidity of formal systems - Formal planning systems may be too rigid for a small business (Mintzberg, 1994). The small business often relies on its flexibility and speed of response as a competitive strength and a formal planning system with tight financial controls may restrict the responsiveness of the small business. Once a plan is developed, there are so many links between issues and areas that one change can upset the whole plan. In addition, some goals are planned in ‘lock step immutable order’, which means that the entire plan can be ruined by one unexpected difficulty (Timmons, 1994).

■ Lack of time - the owner-manager is typically involved in the day-to-day manage­ment of the business and may not have the time to invest in formal planning. Many owner-managers have to complete administrative and record-keeping activities out­side work hours.

■ Lack of experience - owner-managers typically have little formal management training and little exposure to budgeting, controlling or planning systems.

■ Lack of openness - owner-managers typically are sensitive about their business plans and performance. They are slow to share this information and key decisions with staff or external advisers.

■ Fear of failure - the explicit statement of goals and objectives, an essential element to a planning process, may result in a failure to achieve these goals and a sense of overall failure by the entrepreneur. By avoiding stating the goals and objectives of the business the entrepreneur can avoid commitment to any one direction or goal.

21.5 Success strategies in small firms

The owner-manager must choose where to compete and then, given a particular envir­onmental or industry context, how to compete (McDougall and Robinson, 1990). These choices have a significant and lasting effect on the organisation and its performance (Mintzberg and Waters, 1982; Quinn and Cameron, 1983). The choice of competitive strategy within a market determines the financial performance of the organisation: if the ‘wrong’ market is chosen performance may be low. However, most owner-managers of small businesses adopt a ‘me-too’ or ‘copy-cat’ strategy - replicating what has been done before.

Small firm performance can also be explained in terms of other factors such as industry structure and the entrepreneurial orientation of the owner-manager. Industry structure impacts on the success of new ventures and has a critical impact on the choice of strategy (Sandberg and Hofer, 1987). Periods of high-demand conditions, such as industry growth and industry maturity, offer better opportunities for the small busi­ness than do periods of low demand such as the emergent stage of the product life­cycle (Carroll and Delacroix, 1982; Romanelli, 1989). However, while market choice is a critical managerial decision, it is not a choice that is, or can be, subject to frequent change. The choice of environment is constrained by the owner-manager’s past experi­ence and by previous choices made, and is therefore not an active decision variable (Eisenhardt and Schoonhoven, 1990).

Recently, research has argued that firms characterised by an ‘entrepreneurial strategic orientation’ have higher levels of performance (Covin and Slevin, 1991). An entrepre­neurial strategic orientation means that the firm is more willing to innovate, is more prepared to take risks and is more proactive than competitors. As such, entrepre­neurial orientation captures aspects of the firm’s decision-making styles, methods and processes (Wiklund and Shepherd, 2005).

More commonly, researchers focus on the strategic attributes of successful small businesses. Success is typically measured in terms of existing competitive position and the change in this position over time. Measuring success in a small business context is inherently difficult, as success should be related to the owner-manager’s objectives rather than measured in terms of competitive, financial or market success. Studies on the strategies pursued by small businesses typically focus on some measure of success in terms of these latter criteria rather than in terms of the owner-manager’s personal definition of success.

21.5.1 Choosing 'where' to compete: a broad or narrow focus?

The small firm might choose to appeal to a narrow market niche, hoping to capture a relatively high market share, or to compete by appealing to a broader range of cus­tomers. That is, the firm can choose to be a specialist or a generalist. The appeal of focusing on a narrow segment is that the small firm’s resources can be targeted or con­centrated and the firm can build a strong reputation and customer loyalty with this tar­geted customer base. The prescriptive advice from the strategy literature is typically that the small business should focus on market niches; that is, it should be a ‘specialist’.

Porter (1985) argues that a focus strategy is most appropriate for smaller businesses. According to Porter, the business pursuing a focus strategy competes by selecting a seg­ment or group of segments in its industry and by tailoring its strategy to serving these segments to the exclusion of others. By optimising its strategy in the target segments the business with a focus strategy achieves a competitive advantage even though it does not possess a competitive advantage for the whole market.

Some research suggests that small firms that focus achieve superior performance. For example, research studies of microbreweries and of local wineries suggest that small firms that compete more narrowly are more successful. Other research suggests that high-growth small businesses pursue market niche strategies. The essence of a market niche strategy in the context of many small businesses appears to be the avoidance of direct competition with both larger and smaller competitors. The evidence from the studies of fast-growth businesses in Ireland and the UK suggests that, despite attempts in the research to control for sector influences on growth by choosing ‘matched pairs’, high-growth companies rarely competed directly with low-growth companies (Storey, 1994; Kinsella and Mulvenna, 1993).

Research on low market share competitors has suggested a number of strategies that the smaller share business can successfully employ. The most common conclusion of these studies is that the smaller business should avoid head-to-head competition by seeking out protected market niches (Cooper et al., 1986; Buzzell and Wiersema, 1981). Combined with this strategy of segmentation, the smaller share competitor should seek to differentiate its product offering and should offer a high-quality product.

Studies of successful medium-sized companies have suggested that a market niche strategy is an important characteristic of these companies. Cavanagh and Clifford (1983: 10) concluded that ‘most winning companies are leaders in market niches, often in markets they have created through innovation’. Research evidence from the UK sug­gests that market position is an important characteristic of fast-growth businesses (Macrae, 1991; Solemn and Stiener, 1989). This research suggests that while the choice of overall sector may influence profitability and growth, the choice of specific market position is more important to the performance of an individual enterprise.

The empirical identification of a market niche strategy in small businesses is fraught with operational and definition difficulties. It is difficult for researchers to define pre­cisely the product market a business is competing in. How does a small food manu­facturer producing speciality frozen deserts for supermarkets define their product market arena? Such a business could define its business very narrowly, ‘a producer of premium frozen deserts for supermarkets’, or broadly, ‘a desert producer’. The classification of its competitive strategy will be a function of the choice of business definition and more importantly this definition may broaden as the business seeks to grow and expand. Neither Kalleberg and Leicht (1991) nor Westhead and Birley (1993) were able to pro­vide conclusive evidence of market niche strategies among fast-growth small businesses in the UK. Biggadike (1976) compared the relative attractiveness of a niche strategy and an aggressive market-share-seeking entry strategy and suggested that the latter is more appropriate for new ventures seeking to establish themselves. He suggested that the poor performance of many new ventures is the direct consequence of limiting mar­ket focus at the time of entry.

The dangers of pursuing a focus strategy are that the business may incorrectly iden­tify a market niche. Unless the business gains a competitive advantage by focusing on the niche then it should pursue a more broadly based strategy. An additional problem of pursuing a focused strategy is that the chosen market niche may be too small for the business to survive or may require that the small business become involved in export markets at a stage when they lack the resources to support these markets.

Rather than focusing on a market niche the entrepreneur might try to gain a large share of the market. Some new businesses must pursue a broad entry strategy because of the large capital investment required at start-up. These businesses are only viable if they achieve high utilisation of their large capital investment. The advantage of a broad market strategy is that if the business is successful it will be on a large scale. Addition­ally a broad strategy might be more attractive to distributors, retailers or consumers. It suggests that there will be continuity in the business and it might include a more com­prehensive service for the customer. Most new businesses do not have the resources to pursue such a strategy and therefore start on a small scale. Despite inconclusive empirical evidence, the prevailing wisdom in the strategy literature is that small busi­nesses should optimise the use of their limited resources by competing in a limited mar­ket niche. In the literature on small businesses the prescriptive advice is that the best way to avoid direct competition with larger competitors is to pursue a niche strategy (Vesper, 1990).

21.5.2 Choosing 'how' to compete: cost or differentiation

Having chosen what market to compete in the small firm must choose how it is going to compete within this market. Porter (1985) identified two types of competitive advantage, which he termed cost leadership and differentiation. Based on these two advantages and on the competitive scope of the business, which he classified as either industry wide or focused, he developed three generic competitive strategies, namely cost leadership, differentiation and focus. According to Porter, businesses must choose one of these generic strategies; failure to do so results in below-average profitability.

Research suggests that a differentiation strategy is the most appropriate strategy for small businesses. The limited resources of small businesses suggest that the owner - manager should focus resources and pursue a differentiation strategy. A large number of firms pursuing different differentiation strategies may be successful in the same envir­onment (Eisenhardt and Schoonhoven, 1990; McDougall and Robinson, 1990; Porter, 1980).

Product quality was the most important competitive advantage identified by SMEs across a number of European countries (Bamberger, 1989); in addition, factors such as ‘reliability of delivery’, ‘reputation of firm’ and ‘competence of the workforce’ were ranked as important competitive advantages. Interestingly, pricing factors were only rated 16th out of the 26 factors important to the development of competitive advant­age. New ventures pursuing undifferentiated strategies performed less well than new ventures pursuing differentiated strategies (Sandberg and Hofer, 1987).

There are many ways in which a business may have a better product/service. These include superior product/service performance, faster delivery service, better location, wider product range, personal advice and after-sales service, longer credit terms, more flexible service, personalised attention, etc. It is important that the entrepreneur tries to maximise the number and the extent of advantages that the product/service has. This strategy is often not successful because the ‘better’ service/product that the busi­ness is offering is not of value to customers. Another reason why this strategy is unsuc­cessful is because the small business fails to communicate its better service/product to their customers. This may be because of the financial investment and time required for promotion, advertising and sales support, activities and areas of expenditure that most small businesses consider a luxury.

Porter (1985) proposes that a business differentiates itself from competitors by being unique at something which is of value to buyers. To be sustainable a business’s differentiation must perform unique activities that impact on the customers’ purchas­ing criteria. Porter (1985: 152) identifies several methods that a business can employ to enhance its differentiation. These are:

■ to enhance its sources of uniqueness;

■ to make the cost of differentiation an advantage;

■ to change the rules of competition to create uniqueness; and

■ to reconfigure the value chain to be unique in entirely new ways.

Intuitively most owner-managers believe that a low-cost strategy will be successful - customers should be willing to pay less for the same product/service. However, this strategy is not so easy to pursue and many owner-managers fail to pursue it suc­cessfully with the result that their business performs poorly. To pursue a low-priced strategy the new business should have a lower cost base than competitors. Many small businesses pursue this strategy of lower costs by ensuring that they have lower overheads, by operating outside the tax system, or by using low-cost labour and not costing their own time at the market rate. The danger with this approach is that the entrepreneur may not have identified all the overheads that the business will incur and that as the business develops overheads will increase. The advantage of a low - price strategy is that the new business should be able to attract customers. Lower prices should encourage customers to try the new business and may encourage new customers.

However, this strategy does not always work for small businesses. Often the net effect of lower prices is lower profits for the entrepreneur rather than increased sales. There are a number of reasons why this strategy may not work for the small business. The first is that for many products the price charged is assumed by customers to be a reflection of the quality of the product. Customers may interpret low prices as a sign of lower quality service rather than as a more efficient supplier. To overcome this prob­lem it might be necessary for the entrepreneur to inform customers why they are cheaper, for example ‘cheaper because we buy direct from the factory’.

The second reason why this strategy may not work is that the owner-manager fails to invest in promotion and advertising. The owner-manager may incorrectly assume that a low-cost strategy means not investing in marketing and selling costs. The net effect of this is that the customer is unaware of the lower-cost alternative and the new business remains small. Many small businesses fail to generate revenues to invest in advertising and promotion because of their low prices and turnover.

21.5.3 Innovation as a source of advantage

Within the literature on innovation, researchers have sought to establish a relationship between business size and the level of innovation. An alternative perspective is to com­pare the level of innovation with business profitability, growth and survival. To the extent that this has been done, mostly indirectly by studies examining the characteristics of better-performing companies in a particular size/industry sector, it appears that there is a relationship between better performance and higher levels of innovation. Scherer (1980: 422) concluded that ‘what we find... is a kind of threshold effect. A little bit of bigness - up to sales levels of $250m to $400m at 1978 price levels - is good for invention and innovation. But beyond the threshold further bigness adds little or nothing and it carries with it the danger of diminishing the effectiveness of inventive and innovative performance’.

Innovation may manifest itself in terms of the introduction of new products. Research suggests that the ability to introduce new products is positively related to performance in small businesses (Murray and O’Gorman, 1994; Kinsella et al., 1993; Wynarczyki et al., 1993; Cambridge Small Business Research Centre, 1992; Woo et al., 1989). Other evidence suggests that those businesses that are technically more sophisticated or technologically more innovative are likely to grow faster (Boeker, 1989; Philips and Kirchhoff, 1989). However, it may be that these technically more sophisticated sectors are experiencing faster growth.

Buzzell and Wiersema (1981) used the PIMS database to test which strategies were characteristic of businesses that were increasing their market share position. They found that the strategic factors generally involved in market share gains included increases in new product activity, increases in relative product quality and increases in sales pro­motion, relative to the growth rate of the served market.

Small businesses face a number of disadvantages in trying to be innovative. Most small businesses lack the financial, technical and human resources needed to innovate. The lack of time by the owner-manager for long-term thinking prevents the develop­ment of both technical and market-led innovations. The absence of a marketing func­tion and marketing expertise restricts the development of customer-driven innovations. Even those small businesses that are technologically competent, for example small engineering or software firms, face problems in the management of technology. The competitive strength of these small businesses, their specialist technical knowledge, exposes them to the possibility of being exposed to technical developments outside their area of expertise. This problem is particularly apparent in sectors where devel­opments have been driven by the fusion of two or more existing technologies. The small business typically does not have the expertise or the financial resources to cope with external developments. The solution to this problem often necessitates coopera­tion with other businesses or with universities or technical institutes. However, small businesses are reluctant to cooperate with other businesses. While universities may provide technical assistance they seldom provide access to investment and therefore can only partially solve the problems facing the small business.

21.5.4 Exporting and internationalisation strategies

Exporting or internationalisation can provide the small business with access to larger and more attractive markets (see Chapter 24). However, most small businesses do not engage in any exporting or international activities; in particular, small businesses in the service sector have very low levels of direct international activity. Small firms face significant barriers in trying to internationalise their activities. Of particular signific­ance are a lack of knowledge and resources (Johanson and Vahlne, 1984). However, it is important to note that many small businesses are involved indirectly in interna­tional markets through their sub-supply activities with larger indigenous and multi­national companies. The globalisation of some new high-technology sectors facilitates small companies internationalising at an earlier stage of development than is typical among small businesses (see Chapters 13 and 24).

21.6 The strategic problems of small businesses

Developing a sustainable competitive strategy entails not only developing superior competences and capabilities in some aspects of the business but also in minimising the impact of areas of the small firm where there are inferior competences and capabilities (Almor and Hashai, 2004). The strategic weaknesses that characterise most small busi­nesses are the consequence of the managerial deficiencies of the owner-manager and the resource deficiencies of the small business.

21.6.1 Lack of financial resources

Most small businesses are undercapitalised and are inappropriately capitalised, in terms of both a high debt-equity ratio and an over-reliance on short-term debt (Davidson and Dutia, 1991). Inadequate and inappropriate capitalisation is a significant contri­butory factor to the high levels of failure among new businesses. Poor capitalisation may be the result of the difficulties that new businesses face in raising capital (Hall, 1989) and the low levels of profitability in small businesses (Davidson and Dutia, 1991). When capital is available entrepreneurs may choose debt capital in preference to equity capital due to its perceived lower cost (Brigham and Smith, 1967).

However, the capital structure decision is not purely a financial decision. Strategic factors also determine debt-equity ratios (Chaganti et al., 1995). The desire to main­tain control of the business may increase the use of personal equity investment. The level of personal equity investment by the entrepreneur may reflect the entrepreneur’s ‘insider’ knowledge of the business and his evaluation of the likelihood of success, with low levels of investment resulting in non-value maximising behaviours such as higher chief executive salaries. Entrepreneurs may substitute financial capital with cheaper ‘sweat equity’.

21.6.2 Marketing problems and customer concentration

Small businesses engage in little marketing activity. Most small businesses have few resources to devote to marketing and many owner-managers have no experience of marketing, preferring to devote their time to activities that are more familiar (e. g. production), with the result that little time is spent on either marketing or selling activities. Some of the marketing problems of small businesses relate to their lack of product differentiation. This makes it difficult for the owner-manager to position the product or service as a distinctive offering. A distinguishing characteristic of small businesses is their high dependency on a small number of customers. Research evidence suggests that as many as one-third of all small businesses are dependent on one cus­tomer for 25% or greater of their sales (Cambridge Small Business Research Centre, 1992). This is a high-risk strategy for the small business as the loss of one customer may result in business failure. Finally, owner-managers tend to have very little know­ledge of export markets.

21.6.3 Management resources and human resources

By their nature most small businesses are owner-managed. The owner-manager is required to manage all functions of the business, including operations, finance, staff and marketing. However, the narrow expertise of the owner-manager and the lack of management skills mean that the small business is deficient in a number of these func­tional areas. Most small businesses do not have the resources to hire outside managers to strengthen functional areas of the business. Where resources are available the per­vasive involvement of the entrepreneur in the business may make it difficult for outside managers to function in the business.

Small firms have difficulty in attracting good staff. For many potential employees, a small business will not offer the scope for training and development. Additionally, potential employees perceive working in a small business as a risky career move owing to possible business failure. Due to a lack of resources and low levels of profitability, small businesses often pay lower salaries than competing larger ones.

21.6.4 Over-reliance on the entrepreneur

Most small businesses are characterised by what Mintzberg refers to as a ‘simple’ structure (1979). This structure reflects the personality traits of the owner-manager (Miller and Droge, 1986). Typically the owner-manager is actively involved in the day-to-day management of the business and is often involved in the direct production of the product or the provision of the service. The customer base of the business is typically limited and is known directly to the entrepreneur. The entrepreneur relies on informal communication channels to communicate internally and externally. Due to a lack of time many entrepreneurs keep incomplete and out-of-date financial records and/or spend ‘out of work’ hours updating financial accounts. The benefits of this ‘simple’ structure are that the entrepreneur is in close contact with the key issues of the business and is ‘on the spot’ to deal with problems; quality standards are maintained through direct supervision by the entrepreneur; and staff are involved in the business and engage in frequent informal communication with the entrepreneur. These advant­ages allow the business to respond to the needs of customers in a quick, innovative and flexible manner. It is these latter qualities that many larger bureaucratic organisations are now trying to emulate through de-layering, down-sizing and team work (Kanter, 1984). Others argue that small firms exhibit diversity in how they are organised; that is, in how jobs are divided, grouped and coordinated (Barth, 2003).

However, in many cases it appears that the management style of the owner-manager is the antithesis of good management practices. The skills, competencies and behavi­ours necessary for successful new venture creation become barriers to the growth and development of a business (Kazanjian 1988; Churchill and Lewis, 1983). Traits such as a strong need for control and a high sense of distrust can result in owner-managers engaging in behaviours that prevent the organisation growing (Baumback and Mancuso, 1993; Kets de Vries, 1985; Churchill and Lewis, 1983). Such behaviours might include the centralisation of control and ‘scape-goating’ when activities are not successful (Kets de Vries, 1985). The pervasive involvement of the entrepreneur in the business means that it is difficult for them to attend to important, though non-urgent, issues. Finally, the high need for achievement that drives the entrepreneur may result in the central­isation of decision making (Miller and Droge, 1986).

21.6.5 Lack of systems and controls

Small businesses are characterised by informality and poor information systems. Specifically, small businesses are characterised by poor formal control systems (Huff and Reger, 1987). During the start-up period informality dominates in many aspects of the new business, including its control system (Walsh and Dewar, 1987; Quinn and Cameron, 1983). The lack of information results in poor decision making.

21.6.6 Technological skills

The majority of small businesses can be classified as technology contingent - having no influence on the technological trends and innovations that impact on the business. Most small businesses lack the capacity to investigate and assess new technical developments that might impact on their competitive position. In many cases, a small business oper­ates in sectors that have a stable technological trajectory, allowing it to pursue a reactive strategy, that is, to respond to external changes as they happen. However, with tech­nological developments the technical demands on many small businesses have increased significantly and technological competence has become a prerequisite to survival in many sectors.

21.7 Chapter summary

This chapter outlined research that explores how strategy is formed in a small firm, success strategies in small firms and the strategic weaknesses that characterise small firms. Most small businesses face significant strategic and structural weaknesses. In par­ticular, small businesses lack the managerial skills necessary to develop and implement a strategy. The strategy-making process is typically ad hoc and informal, and frequently the entrepreneur’s personality prevents the sharing of information about the business’s strategic position. There is some evidence to suggest that some strategies, such as a focused market position and a differentiated competitive advantage, are positively associated with success in small businesses. In addition, the importance and signific­ance of innovation as a means of developing competitive advantage was discussed. Strategic weaknesses also prevent the implementation of a strategy. Small businesses are typically characterised by insufficient financial and managerial resources. The lack of financial resources prevents investment in activities such as product development and marketing. The owner-manager’s lack of financial skills means that the information necessary for managerial decisions is not available.

The implications of the research presented in this chapter for the owner-manager are that the development of a clear competitive advantage is essential to both short - and long-term survival. The owner-manager must understand that choices in relation to ‘where’ they compete and ‘how’ they compete impact on the viability and performance of the business. In addition, the owner-manager needs to understand that the structural characteristics of the business and their own managerial style may restrict the devel­opment of both an effective strategy-making process and an effective strategy.

Implications for the policy maker are that most small businesses are characterised by significant strategic and structural weaknesses. For individual small businesses to develop and prosper these deficiencies must be reduced. Clearly, the role of the policy maker is to help the owner-manager in the development of a strategy and competitive advantage. It is important that policy makers appreciate that the problem is not with the strategy formulation process but rather with the development of a clear competi­tive advantage. Pressurising owner-managers to produce formal plans does not assist them in addressing the strategic and structural deficiencies of the small business. Policy makers need to address systematically the strategic and structural deficiencies of small businesses by providing the owner-manager with the opportunity to develop the skills and acquire the resources that are needed for the development and implementation of an effective strategy.