Quarterly Journal on Management
From the publishers of THE HINDU BUSINESS LINE
Vol. 2 :: No. 2 :: August 1998
Is small beautiful?
D. Sampathkumar
A recent analysis in Business Line reported that mutual funds with small corpus have outperformed larger and better equipped mutual funds by a handsome margin. The findings, however, run counter to the popular perception that a superior performance on investment management, necessarily require a large infrastructure in equity research besides other facets of back room operations. In other words, there are substantial economies of scale to be had in managing a large investment portfolio with fixed costs being defrayed over a relatively larger corpus of investible funds.
But what of enterprises engaged in manufacturing operations? Is the phenomenon of "small is beautiful" witnessed in investment management applicable here as well? Or, more specifically, do small enterprises have an inherent advantage in being able to generate superior returns on investments? At least, those in the thick of managing such enterprises however do not appear to think so. At a convention of entrepreneurs of Small Scale Industrial units (SSIs) held in Chennai a couple of years ago, speaker after speaker representing such units, complained about poor profitability and blamed it on the complex and the multiple layers of regulatory structure under which these units are forced to operate. In their view, the situation not only rendered them vulnerable to bureaucratic excesses particularly at the lower rungs of the bureaucratic hierarchy but left them with little time to devote to larger aspects of managing a business. As one of them pointed out, the concept of a "single window" of clearances which was supposed to help them, has in reality turned out to be one more "window" of clearance in the administrative structure.
It would, of course, be tempting to dismiss it as a typical case of "breast beating" indulged in by any victim of any regulation who has to contend with some form of regulatory and overseeing mechanism in his operations. But unfortunately, there is considerable substance to this perception. A complex web of controls can not but undermine financial viability of these units. Compliance with a variety of laws and rules and regulations framed thereunder, require of these SSIs, an infrastructure that would not only be expensive but also being technically too complex for any one except those steeped under it. This is because the regulatory framework does not make any distinction between large and small units except those which are really minuscule in size. Presently units employing 10 or more workers (where manufacturing is carried out with the aid of electric power) are brought within the ambit of legislation on factories. In certain aspects of regulation such as in the case of environment protection, even size in terms of number of workers employed is not a relevant criterion.
The combination of Central and State Governments and provincial authorities have created a superstructure of rules and regulations which can not be achieved except at a high cost in terms of human effort. A SSI unit typically, has to go through the process of obtaining a number of statutory clearances, even before the first product rolls out of the factory. As a matter of fact, the entrepreneur gets a taste of this right from the moment a project is conceived and decides upon an SSI structure to carry this out. The decision involves obtaining a certificate of registration from the relevant authorities. If it is to be located in the State capital the registration has to be made with the State Directorate of Industries. If it is to be located in the Districts, then the competent authority is the General Manager of the local District Industries Centre.
Now, registration is a crucial piece of document as it entitles the entrepreneur to seek allotment of an industrial shed in an industrial estate. It would be a prerequisite even to approach a bank for financial assistance. Clearances from Municipal authorities to undertake any manufacturing activity within the municipal limits, sanction of requisite power connection from electricity board etc. require of the entrepreneur to be armed with such a registration. Considering the stakes involved, the authority empowered under law to grant such registration is in a position to wield tremendous influence over the fortunes of the enterprise. The interesting point is, the entrepreneur cannot really claim to put the trauma of registration behind him for good, for the threat of deregistration perpetually hangs over the head of the enterprise. The certificate of registration that may have been granted is only of a provisional nature liable to be withdrawn at any moment. In any case, units require reregistration at the end of every five years.
The entrepreneur must additionally obtain sales tax, excise and pollution control clearances before commencing manufacture of the product identified by him. Sales tax registration requires three different forms to be filed with the sales tax authorities namely a form specifying details of estimated turnover, a form of application nominating an individual as manager who would represent the unit on sales tax matters and finally, details of partners with percentages of their respective shares.
The country's central excise law too imposes an elaborate procedure for registration similar to the one prevailing in the case of sales tax. There is a prescribed format for filing an application for registration and then again a format for declaring quarterly returns which the unit has to submit. The formalities for undertaking job work is no less cumbersome. The environmental protection laws are another dimension of overload on the managerial efforts of an SSI entrepreneur. Depending on the nature of items manufactured, units have been classified as "Red", "Orange" and "Green" in the descending order of possible damage to the ecology. Even the unit that has been classified as "Green" would have to obtain a consent letter from the pollution control authorities which should be renewed once every two years.
The regulatory system thus has in built provisions for entrepreneurial overload with its emphasis prior registration and on periodic renewal. This may not pose such a serious problem but for the fact that there is an utter lack of accountability on the bureaucratic structure. The political authority, too, is either a willing accomplice to bureaucratic subversion of the regulatory structure, for its own self-serving ends or is incapable of reining it in.
Record keeping is another aspect. The country's labour laws, for instance, require of the entrepreneur to maintain registers of workmen on his rolls, of wages paid, deductions effected, overtimes paid, fines extracted, advances paid, engagement of sub-contractors etc. The law on sales tax typically require the registered unit to maintain 11 registers, eight books of account and files of 10 different types of documents. Taken together with registers and records under other statutes, the SSI unit's obligations under law in this regard could easily run into a hundred if not more, types of documents and other records. They complement of the plethora of legislative Dos and Dont's under labour law each of which is a potential minefield for the entrepreneur.
The entrepreneur managing a small scale unit then has basically one of two options. He could expend all the energy in ensuring compliance with the multitude of state regulations applicable to industrial establishments, in which case there is very little time to pay attention to aspects of quality, business promotion, technical innovation etc relating to the business. Alternatively, he enters into some sort of secret conspiracy with the regulatory establishment so that it winks at any possible violation, deliberate or inadvertent as the case may be, of the state's regulatory structure. But such a secret arrangement comes with a price tag that nullifies whatever advantage that these units enjoy vis-a-vis larger establishments in the organised sector.
Not surprisingly, this is also reflected in their operational performance. Statistics published by the Centre for Monitoring Indian Economy show that operating surplus of unorganised sector in manufacturing, of which SSI units are a part, has grown at a lesser rate than those in the organised sector. Operating Surplus and Mixed Incomes of unorganised units in private sector grew from Rs. 21,964 crores to Rs. 43,402 crores, thus registering a compounded annual growth rate of 14.6 per cent during the period 1989-90 and 1994-95 (National Income Statistics, CMIE February 1998). For the organised private sector units engaged in manufacturing in contrast, such surplus grew by a compounded annual rate of 18.1 per cent. The units in the organised sector posted a surplus of Rs. 43,564 crores in 1994-95, up from Rs. 18,994 during the same period (Table I). Statistics for the later years are not available. But no evidence has surfaced in recent years to suggest that things have changed for the better since then.
Further confirmation of the fact that all is not right with the Small Scale industry is available from figures of growth in output, number of units and workers employed over the years. While output and number of workers employed have grown in absolute terms, the output per unit in real terms has more or less stagnated and output per worker has actually declined. The output per unit has recorded only a marginal increase in constant prices between 1990-91 and 1996-97. It has grown from Rs.7.97 lakhs per unit in 1990-91 to Rs.8.79 lakhs in 1996-97 when reckoned on the basis of prices prevailing in 1990-91. Similarly, a total of 19.48 lakh units accounted for a workforce of 125.30 lakhs in 1990-91 giving an average staff strength of 6.43 per unit. But this has declined to 5.60 in 1996-97, with 28.57 lakh SSI units accounting for a workforce of only 160 lakhs at the end of that year (See Table II).
That the value of output per unit has more or less stagnated seems to suggest that SSI units either operate in a low technology environment employing possibly primitive manufacturing processes. This is hardly conducive for these units to secure for themselves, business opportunities in the high-end spectrum of manufactured goods. Taken together with a phenomenon of declining per unit employment presages creeping sickness among such units.
The findings of the committee appointed by the RBI under the chairmanship of S. L. Kapur on sickness in SSI units clearly confirms this. The percentage of SSI advances of the banking sector in which the assisted SSI unit is either sick or manifestly unviable or otherwise subject to some uncertainty on recovery stands at 24 per cent of the total advances to this sector, as of March 31, 1997 (See Table III). Not only is this much higher than the level of non-performing assets within the banks portfolio, the percentage has also gone up marginally in 1996-97 over that of the previous year.
Whether it is a case of entrepreneurial energies being frittered away in regulatory compliance, or it is a case of institutional structure makes them inherently unviable is a matter of detail. But what can not be denied is that these units suffer from an image of poor profitability. It is no surprise then that banks haven't been particularly forthcoming with financial support to their entrepreneurial aspirations. The number of assisted SSI units has practically remained constant over the years. According to the RBI there were 36.92 lakh SSI accounts availing bank finance as of March 1993. By March 31, 1996 the number of assisted units remained at Rs. 36.94 lakhs. During this period the number of registered units has however gone up by 4.78 lakhs (RBI Report on Currency and Finance 1996-97). Clearly, what this means is that the number of additional units accessing bank finance hasn't been going up in proportion to the number of units getting registered in the country. True, the quantum of bank finance has gone up from Rs. 23,698 crores as of March 93 to Rs. 37,680 crores by March 96. But what is significant is that the output has gone up by a much greater percentage signalling a reduced dependence on bank finance (See Table IV).
Improving profitability of SSI units would involve moving into higher end of the value chain in manufacturing operations. But this calls for additional investments in fixed and working capital to sustain operating capability. Banking sector as a major source of institutional finance thus clearly has a crucial role to play in this. But the banks are clearly not equipped to play a proactive role in credit appraisal, and certainly not in the face of doubts about financial viability of SSI structure. The onus clearly has to be with units in the organised sector who largely consume the output of this sector. For the organised sector to play the role of mediating credit from the banking sector to the SSI units, an incentive structure should be evolved. The bank may extend a concession by way of ready refinance to the large borrower on the quantum of monies advanced to specific SSI units. As a further incentive, such refinance may be granted at a concessional rate of interest. The large unit in the organised sector procuring goods from an SSI could then be expected to factor the above arrangement into the price. The system thus has the advantage of involving a customer in the organised sector with the process of credit appraisal who is also better equipped to assess credit risk than the banker himself. For the banker too, the fact that the loan transaction is now only with a large borrower in the organised sector and the asset backing of such a unit should help in overcoming his diffidence in extending credit to an SSI unit.
A similar approach could be adopted in which a large mother unit assumes the responsibility for regulatory compliance on sales tax, excise, labour welfare legislation so that the entrepreneur is free to concentrate on the basic task of organising the factors of production and ensure that these are deployed in the production process. Making the mother unit responsible is not an outlandish proposition as it may seem at first sight. Even now, a large unit is responsible for ensuring compliance with a variety of welfare measures statutorily imposed, by the sub-contractor employed in his own premises. Extension of this concept to off-site execution of jobs is only a marginal extension of a principle which has now become well accepted.
SSI units suffer from economies of scale not just in terms of manufacturing capability but also in terms of institutional infrastructure. The infrastructure is needed to support compliance with regulatory requirements. It is also required to sustain increasing access to bank and institutional finance. Only an innovative approach would lead to the SSI units taking their rightful place in the task of economic growth. But the reality today is that even the mere act of keeping the production infrastructure in readiness saps all energies of an SSI entrepreneur, leaving little for managing core business activities of the enterprise.
Regulatory framework under factories legislation
The Factories Act is an imposing piece of legislation. There are just too many parameters of functioning of the unit that the entrepreneur has to monitor and ensure compliance. Many of them are loosely specified, and if they are not they are so stringent that it would be beyond the scope of most small enterprises.
In the event, a unit's record of performance is a matter that is dependent solely on the subjective satisfaction of the Inspector appointed under the Act. Just what kind of pitfalls that an entrepreneur faces in ensuring that the inspector gives a clean chit on compliance with provisions of the Factories Act.
For a start, he should be satisfied that the unit has provided proper information, training and supervision necessary for the health and safety of workers employed in the factory.
The unit has to make adequate provision for monitoring the work environment, keep the work place clean and make arrangements for proper disposal of waste and effluents.
He should also be convinced that there is no overcrowding in the factory; that there are adequate number of urinals, washing points drinking points etc. (God help the entrepreneurs should one of the taps run dry when the inspector is on a visit!)
The there is the requirement of provision of facilities for sitting for workers who are required to perform their duties standing. (Chairs, of course, have a notorious habit disappearing and if Peter's Principle is to be believed, especially during times of visits by the Factory Inspector).
Motivate the workers to bring to the notice of the management any situation where there is a likelihood of imminent danger to human life. (Posters hanging from factory walls cautioning workers on different types of mishaps on the shop floor and precautions that must be taken, should do the trick. But there could be a problem if the inspector thought that one of the posters on the wall looked faded).