Small Businesses and Their Impact on the U.S. Economy

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Small Businesses and Their Impact on the U.S. Economy

Business Essentials · Chapter 4: Business Ownership, Growth, and EntrepreneurshipSection 4.5 · lesson 23 of 10514 min · free with a free account

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In this lesson

How small business is defined, what it contributes, and why it fails.

  • Explain why small business has no single definition
  • Separate firm count from jobs and output
  • Restate the job creation claim accurately
  • Link causes of failure to their warning signs

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Everything said in the video, section by section (2,029 words). Read along, or search it.

Business Ownership, Growth, and Entrepreneurship

Small Businesses and Their Impact on the U.S. Economy

Small business gets a lot of praise, in speeches, in news reports, and in policy debates. This section asks what that praise is actually based on. We'll start with a surprisingly hard question. What counts as a small business? Then we'll look at what small firms contribute, including a claim about jobs that's very often misstated. We'll weigh the advantages and disadvantages of being small, and the recurring reasons small businesses fail. And we'll finish with the support available, and with alternatives to starting from nothing.

The Definition Problem

What Counts as Small?

Start with a problem that sounds trivial. There's no single definition of a small business. That matters, because any statistic about small business depends on the definition behind it. The key tool is called a size standard. It sets the largest size at which a business still counts as small, for a given purpose. In the United States, the Small Business Administration sets these standards, and they vary by industry. They're expressed either as a number of employees, or as average annual revenue. Why vary by industry? A size that's small in manufacturing would be large for a corner shop. The thresholds get revised, so a business should check the current standard for its industry. For general statistics, the SBA's Office of Advocacy often treats firms below a stated employee count as small. But a program offering loan guarantees, or contracting preferences, may apply the industry-specific standard instead. Other agencies, and other countries, use other definitions again. So whenever someone says small businesses do something, first ask how small business was defined.

The Measured Role

Four Established Patterns

So what role do small businesses actually play? We'll describe it in general terms. Two sources matter. The Census Bureau collects data on businesses and their employment. The SBA's Office of Advocacy compiles and publishes small business statistics, from those and other sources. Exact figures change every year, so check the current publications. But four patterns are established. First, by number, small businesses are the great majority of businesses. Nearly all of them, in fact. Second, they account for a large share of private-sector employment. In the Office of Advocacy's general presentation, that's on the order of about half. Third, they contribute a substantial part of new jobs. And fourth, they're concentrated in particular sectors. Construction, professional services, retail, and food service. They're less common in sectors where large fixed investment is needed.

Count Versus Activity

Nearly All Firms, a Smaller Share of Output

Here's a distinction that changes how every small business statistic reads. The number of firms and the share of economic activity are very different things. Many small businesses have no employees at all. A nonemployer firm has no paid employees other than its owner. The Census Bureau's nonemployer statistics show these firms are a majority of all businesses, by count. Yet they account for a very small part of total revenue. So the count is dominated by very small operations. So small businesses are nearly all the firms, but a much smaller share of employment and output. Both statements are true at once. The trap is sliding from one to the other. Saying small businesses are nearly all firms is not saying they provide most jobs, or most output. The rule is simple. Match the measure to the claim.

A Misstated Point

Who Really Creates the Jobs?

It's commonly said that small businesses create most new jobs. The real finding is more careful than that. To see why, we need three terms. Gross job creation is the total number of jobs added by businesses that are expanding, or opening. Gross job destruction is the total lost by businesses that are contracting, or closing. Net job creation is the difference. Jobs created, minus jobs destroyed. Small firms have high gross job creation. But they also have high gross job destruction. That's because small firms open and close, and grow and shrink, at high rates. Research using the Census Bureau's Business Dynamics Statistics looked at the net figure. It found the net contribution concentrated in young firms, not in small firms as a group. Once firm age is accounted for, size alone is a much weaker predictor of net job creation. The better statement is this. New firms, many starting small, account for a disproportionate share of net new jobs. Small firms that have been established for many years do not.

Beyond Job Counts

Five Roles Small Businesses Play

Small businesses matter for more than the jobs they add. They provide local employment, often to people in areas that larger firms don't serve. They supply larger firms with components, services, and specialized work. In that sense, they're part of the supply chains that large businesses depend on. They serve markets too small for large firms, like a niche product, or a small town. They contribute innovation in particular sectors. There, new firms introduce methods and products that established firms have overlooked. And they generate community economic activity, keeping spending, and ownership, local. None of these roles depends on settling the jobs debate. Each one holds on its own.

The Trade-Offs Of Size

Advantages and Disadvantages of Being Small

Being small brings real advantages, and real disadvantages. Start with four advantages. The first is speed of decision. The person who sees a problem sits close to the person who can decide. Closeness to customers lets an owner know the people served, and adjust quickly. Flexibility lets a small business change its offer, hours, or methods, without the delay of a large organization. And the ability to serve a niche lets it profit, from a market too small to attract larger rivals. The disadvantages are just as real. Limited capital constrains growth, and leaves little cushion against a bad year. Chapter twenty-one covers financing. Thin management means the owner does many jobs. There may be no expert in finance, law, or marketing. Less buying power means paying more for what the business buys, compared with larger competitors. Compliance costs weigh more relative to size, because part of the cost doesn't shrink with the business. Section one point one noted this, though the size of the effect is disputed. And risk is concentrated in one or two people. An owner's illness or departure may threaten the business itself.

Why Small Businesses Fail

Five Recurring Causes

Research on small business failure points to a set of recurring causes. Sources include the SBA Office of Advocacy, and Bureau of Labor Statistics survival studies of new establishments. Undercapitalization means starting or growing with too little money, so early losses or a slow period can't be survived. Insufficient demand means too few customers willing to pay enough. That's often the result of a weak evaluation of the opportunity, the kind described in section four point four. Cash flow problems are the subtle one. Cash flow is the movement of money in and out of a business over time. It isn't profit. A business can be profitable on paper, and still run out of cash. Customers may pay late. Inventory may tie up money. Or growth may require spending before revenue arrives. Management inexperience is a lack of skills in areas like pricing, record-keeping, and hiring. And over-expansion is growing faster than the business can finance, or manage. Cash flow failure in a profitable business is common. Chapter twenty-one covers how to manage cash.

Table 4.5.1

Warning Signs and Preventive Actions

Each of these causes gives a warning before it turns fatal. That's what makes them manageable. Undercapitalization shows up as a reserve smaller than a few months of fixed costs, or an owner adding personal money. Prevention means estimating the full start-up and early-loss cost first, and arranging credit while the business is healthy. Insufficient demand shows up as sales that stay below the plan, and customers who don't return. Test the offer with real customers early, and adjust the product, price, or market before spending more. A cash shortfall in a profitable business shows up as receivables growing faster than sales. The bank balance falls, even while profit is reported. The fix is to forecast cash, not only profit, to shorten collection times, and to negotiate supplier terms. Management inexperience shows up as repeated surprises. Prices that don't cover costs, missed filings, high staff turnover. Advisers, mentors, and training help. So does delegating what the owner doesn't do well. Over-expansion shows up when locations or orders outpace staff, systems, and cash. Expand in stages, each financed and proven first. Every preventive action here costs far less than the failure it prevents. And the most dangerous of the five is the cash shortfall in a business that reports a profit.

Help And Alternatives

Support, and Other Ways In

Support for small businesses comes in several categories. We'll describe them without endorsing any provider. The Small Business Administration is the federal small business agency. Its programs include guarantees on loans made by private lenders, and counseling and training. They also include help obtaining government contracts, and disaster loans. A network of small business development centers offers advice, often at low or no cost. Mentoring organizations offer guidance, some staffed by volunteers who've run businesses themselves. State and local programs, like economic development agencies and incubators, offer training, workspace, and sometimes small loans. Programs are created, changed, and ended, and eligibility differs. So confirm what's currently available, and what it requires. There's also a different route into ownership, without starting from nothing. Buying an established business brings existing customers, an operating history, and immediate revenue. That reduces the risk of untested demand. The costs are the price, which reflects those advantages, possible inherited problems, and the need to investigate thoroughly. Section four point two's due diligence applies on a smaller scale. And always ask why the owner is selling. A franchise offers a tested system and a brand, at the cost of fees and the agreement's constraints. Each alternative trades some of the freedom and upside of a fresh start for reduced uncertainty.

Worked Application

Reading One Sentence Carefully

Let's apply all of this to one sentence from speeches and news reports. Small businesses create most of the new jobs in the economy. To assess it, ask three questions in turn. First, how is small business defined? A general employee cut-off counts every firm below that size, including the huge number of nonemployer firms. That's a very mixed group. An industry-specific standard gives a different group again. Without knowing which definition is meant, the sentence can't be tested. Second, what's being counted, gross or net job creation? The sentence says create, and small firms do have high gross job creation. On that reading, it can be defended. But one small business opens and hires ten people, while another closes and dismisses ten. If the claim is about net new jobs, the difference counts. And that comes from young firms. So as a claim about net jobs, and about size, the sentence isn't supported. Third, what's the claim being used for? Helping small firms, and helping new firms, are different proposals. A thirty-year-old firm with twelve employees is small, but not young. A new technology firm hiring fifty people in its second year is young, but may already exceed some definitions of small. Asking how each term is defined is the most useful habit this section can teach.

Case Vignette (Composite)

Profitable and Out of Cash

We'll end with a case. It's a composite, constructed for instruction, and its figures are illustrative. Wen owns a commercial cleaning company with a dozen employees. After winning contracts with two large office managers, the company doubles its work within a year. The accounts show a profit every quarter, and Wen plans to hire twenty more employees. But Wen pays staff weekly, and buys supplies at once. The new clients pay invoices sixty days after receipt. In the fourth quarter, Wen can't make the payroll. Yet the income statement shows a profit for the year. The profit is real. It's just tied up in unpaid invoices, money earned but not yet held. Profit records what's been earned. Cash flow records when money actually moves. Rapid growth widens the gap. Each new contract adds costs immediately, and revenue only after a delay. So the trade-off is growing at the pace the contracts allow, or at the pace the cash allows. Wen has little borrowing capacity, and no reserve. The options include slowing the hiring, or asking new clients for faster payment, or a deposit. Wen could also arrange financing against the unpaid invoices. Each option has a cost. The real question isn't whether the business is profitable. It's whether it can finance the growth that profit implies.

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FAQ

Questions students ask us

About Small Businesses and Their Impact on the U.S. Economy

How is a small business defined in the United States?
There is no single definition; it depends on a size standard. The U.S. Small Business Administration sets size standards that vary by industry and are expressed either as a number of employees or as average annual revenue. For general statistics, the SBA's Office of Advocacy commonly counts firms with fewer than 500 employees as small, while loan and contracting programs typically apply industry-specific standards. Always check which definition a statistic uses.
Do small businesses really create most new jobs?
Not in the simple sense; the careful finding is that young firms, many of them small, account for a disproportionate share of net new jobs. Small firms have high gross job creation but also high gross job destruction, because they open, close, grow, and shrink at high rates. Research using the Census Bureau's Business Dynamics Statistics found that once firm age is accounted for, size alone is a weak predictor of net job creation.
How much of the U.S. economy do small businesses account for?
Small businesses are nearly all U.S. firms by count and employ roughly half of private-sector workers, according to the SBA Office of Advocacy's general figures. Their share of output is far smaller than their share of firms, because many are nonemployer firms with no paid staff besides the owner. Nonemployer firms are a majority of businesses by count but earn a very small part of total revenue, so always match the measure to the claim.
Why do small businesses fail even when they are profitable?
A profitable small business can fail because it runs out of cash. Cash flow, the movement of money in and out over time, is not the same as profit: customers may pay late, inventory can tie up money, and growth often requires spending before revenue arrives. Warning signs include receivables growing faster than sales and a falling bank balance while profit is reported. The other recurring causes are undercapitalization, insufficient demand, management inexperience, and over-expansion.

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Business Essentials (Business 100) carries a NCCRS credit recommendation for 3 semester credits. ACE and NCCRS have over 2,100 cooperating colleges that will consider accepting credits; the final decision is with the universities.
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