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Why tomorrow's marketplace may be murder on small companies

It's easy to get carried away with the entrepreneurial revolution of the past decade. More and more start-ups. More and more new jobs -- and new products -- created by young, growing businesses like those on the Inc. 500. Meanwhile, the Fortune 500 continue to thrash about, fending off raiders with one hand and scaling down operations with the other. The marketplace of the future, so it seems, belongs to small companies.

Before you get lost in such a reverie, however, I recommend consideration of Technology and the American Economic Transition, a report issued earlier this year by the U.S. Congress's Office of Technology Assessment (OTA).

Now, I'm not recommending that you actually buy and read this turgid tome. The only people who will get through it are those (like me) who figure the chore is part of their job description. But I do urge that you ponder its analysis of where the American economy is heading. Unlike a lot of government agencies, the OTA has a reputation for solid scholarship. And the trends it has spotted -- particularly the advent of information systems that give their owners dramatic competitive advantages -- have life-or-death implications for small companies.

The report focuses on the networks of companies and markets that produce given "amenities' -- food, housing, and so on -- and scrutinizes the structural changes taking place in each one. An example of structural change? Take the movie business. Years ago, the big Hollywood studios were textbook examples of "standardized industrial mass marketing." They had the stars under contract; they owned the production facilities where the movies were made and the theaters where they were shown. Today the studios have become financiers and facilitators, assembling ad hoc teams to produce products marketed through outlets ranging from theater chains to cable TV operators. "Almost in spite of itself," says the OTA, "the motion picture industry has come to be a model of 'flexible specialization.' "

In general, the changes chronicled by the OTA fall into three categories. Markets -- even whole industries -- are fragmenting faster than ever. Foreign competitors, far from resting on their laurels, are sweeping into sectors of the economy that once seemed safe. Most important, the business world is undergoing a new kind of have and have-not split. The dividing line: whether a company can gain access to complex new information networks that provide up-to-the-minute data on customers, suppliers, and operations.

Fragmentation. Like the movie studios, big manufacturers are giving up on vertical integration; they're farming out everything from parts production to janitorial services. Health-care organizations are delivering fewer services in the hospital and more in the freestanding clinic, the storefront office, even the patient's home. For years, small companies have profited from this fragmentation of markets. But big companies downsized partly to protect themselves from recession; what will happen to all the new suppliers in the next downturn remains to be seen. Even in good times, what's to prevent an industry from reconcentrating after the initial burst of entrepreneurship? The nursing-home business grew rapidly in the 1970s, thanks in part to the trend toward shorter hospital stays. By 1983, the OTA points out, the five largest chains already controlled nearly three-quarters of the beds.

Ever-greater international trade. In the past two decades, imports rose from 5% of gross national product to more than 12%. But plenty of industries, mistakenly thinking themselves protected from foreign competition, have lulled themselves into it-can't-happen-here complacency. Examples include financial services, publishing -- even home building, a business long dominated by small developers and contractors. "Even U.S. residential construction firms must now compete with foreign producers," points out the OTA, "as appliances, building components (ranging from kitchen cabinets to door knobs), hand tools, and even entire housing units are being imported." Worse, such nations as Sweden and Japan are pioneering in the efficient production of high-quality, factory-built homes, a branch of the industry that's practically nonexistent here. Eventually "Americans could find themselves assembling foreign products with foreign tools and adding little value other than site preparation.'

Information networks. Some new information systems link together whole industries; others are the brainchildren of individual companies. Examples of the former: in food retailing, checkout-station scanners can now provide wholesalers and manufacturers with up-to-the-minute information about what's selling and what's not. A system called the Universal Communication Standard, now under development, will allow food marketers to exchange even more data electronically, permitting them to do away with invoices, purchase orders, and so on. In apparel, the so-called Quick Response Program linking retailers, wholesalers, and manufacturers has shortened transportation time, lowered inventory requirements, and generally improved both the speed and efficiency with which garments are moved from factory to sales floor. Such networks, says the OTA, are likely to proliferate. A point-of-sale financial system allowing retailers to debit customers' bank accounts is now being tested in Florida. In France, the 2 million households with Minitel computer terminals can tap out their own travel and lodging reservations anywhere in the country.

In theory, tying into a marketwide information network can put small companies on a par with larger competitors. But who owns the systems? Most of the small airlines that started up in the wake of the 1978 Airline Deregulation Act proved unable to compete, thanks partly to major airlines' domination of computerized reservation systems. Even today, according to a recent Wall Street Journal article, travel agents book 75% of all flights on systems owned by United Airlines or American Airlines. The two giants (and three smaller systems) take in about $1.80 per passenger for the flights they book -- some $530 million a year, all told, paid by their competitors.

In other industries, information networks are still in their formative stages. But there's no law requiring supermarkets, for example, to cut small specialty suppliers in on the same electronic information they supply to Kraft Inc. In the future, trying to compete without such access may be like trying to do business without a phone or a computer.

Proprietary information systems within companies can also erect barriers to competition. A fast-growing segment of the trucking industry is the highly specialized less-than-truckload market -- in which, the OTA points out, the top 10 companies now control 60% of shipments and 90% of profits. The big companies' edge lies in the fact that they can "operate sophisticated, computer-based communication and dispatch systems," which make the difference between profit and loss. The Limited Inc., the giant clothing chain founded by Leslie Wexner, has developed a network that feeds sales data from in-store computers to the company's headquarters, which then places orders with suppliers and gets hot-selling merchandise back into stores within 60 days. Such systems can't be bought off the shelf; they require years to develop and fine-tune. Think back to the experience of John McCormack, whom Inc. named the "hottest entrepreneur in America" last January. The market information provided by McCormack's elaborate computer system helped his company weather -- and even prosper in -- the brutal recession that hit Texas a few years ago. McCormack had been developing the system since 1979.

If there's a common thread to the trends chronicled by the OTA, it's this: the stiffening of competition that we've seen in recent years is only a foretaste of what's to come. That foretaste shook things up, opening up niches for companies that were sufficiently fast on their feet. In the next round, bigger players will wise up -- and begin to capitalize on advantages such as the power to shape new information networks.

Unless entrepreneurs wise up too, the revolution they are conducting will be yesterday's news rather than tomorrow's.


Does Japan's strength lie in its big companies -- or in its small ones?

If the U.S. is to win the economic competition with Japan, how should our economy be organized? Japan's strength, say such pundits as MIT's Charles H. Ferguson and former U.S. trade negotiator Clyde V. Prestowitz, lies in its giant industrial combines, which can manufacture and market on a global scale. The implication: we too should encourage the growth of large and powerful companies.

But the Japanese economy we've been hearing about may not be the one most responsible for that country's rise as an economic power. According to David Friedman's The Misunderstood Miracle (Cornell University Press, 1988), Japan's success in world markets stems not from its big conglomerates but from the proliferation of small, flexible manufacturing companies.

Friedman, a lawyer specializing in Pacific Basin business matters, begins with some striking statistics. Between 1954 and 1977, a period when Japan's economy was rising to a preeminent position, the number of manufacturing establishments exploded, from 429,000 to 720,000. By 1977 Japanese industrial firms with fewer than 300 employees accounted for roughly 70% of the industrial work force (as compared with 40% in the United States).

The reason for this tilt toward small companies, says Friedman, is that the giants were forced into becoming assemblers and marketers rather than vertically integrated manufacturers as in the United States. Nissan, for example, originally set out to "mimic the factory practices of General Motors as closely as possible," emphasizing long production runs and low costs. But its cars were shoddily made and didn't sell. As the company tinkered with production techniques, it came to rely more on subcontractors, who themselves learned to turn out high-quality, sophisticated parts. Nissan also began pursuing a strategy of constant product innovation, including annual design changes "much more thorough" than Detroit's. Its production network therefore had to be kept as flexible as possible.

Nor was Nissan alone, observes Friedman. "The large assembly firms -- Nissan or Toyota in autos, for instance, or Matsushita in electronics, Mitsubishi in machinery -- increasingly relied on small specialist producers... "Overall, the portion of value added by large companies declined from 51% in 1954 to nearly 40% in 1977.

Tersely written in academic style, The Misunderstood Miracle is unlikely to make the best-seller charts. But it underscores the significance of the fact that small U.S. companies have been increasing their share of employment in nearly every industrial category. This revival of small-scale manufacturing may be the best hope for restoring our own beleaguered industrial base.

Contributor: Joel Kotkin