In a recent post, we examined some proposed new size standards for manufacturing and other industries that utilize employee-based size standards. This probably got many of you wondering: How does the SBA determine what the size standards should be? It’s a good question, and today, we’re going to look at just that. Hopefully, this will provide some insight as to the SBA’s approach to setting size standards.
The SBA revised its size standards methodology most recently back in April 2019. This methodology is compiled in a 59-page document located here. We thought it’d be useful to break down and summarize this document for your convenience.
While calculations are used, there really isn’t a “one-size-fits-all” calculation that the SBA uses to determine proper size standards. There are five primary factors that SBA uses for determining if an industry’s size standard should be modified. They are: 1) Average firm size, 2) Start-up costs and entry barriers, 3) Industry competition, 4) Size distribution of Firms and Gini Coefficient, and 5) Federal contracting factor. The SBA generally takes the figures it gets for each of these factors and averages them out to get an appropriate size standard, to greatly simplify things.
Average Firm Size
The first thing the SBA looks at is probably the simplest factor: What’s the average size of a firm in the industry in question? A simple averaging of the industry’s total receipts or employees divided amongst the total number of firms is the first step here. However, that alone is generally not enough. Often, industries have a few very large firms and then many small firms. Just using the average alone weighs in favor of the larger firms. As such, the SBA conducts a weighted average calculation that takes this fact into account. The specific calculation the SBA uses is in the document if you are curious.
The SBA uses average firm size because they find it is a close approximation of what they call the “minimal efficient firm size” or MES. The MES is “the level of output where firms in an industry are able to minimize their average cost of production and become competitive.” In other words, how big must a firm be for it to have the lowest possible average cost of production? At that level, the firm becomes most competitive. SBA explains that it also compares average firm sizes of industries: If the average firm size for a given industry is larger than the average firm size for most other industries, that naturally supports a higher size standard.
Start-up Costs and Entry Barriers
The SBA also considers start-up costs and entry barriers for new firms in an industry when making size determinations. Naturally, it costs more to start up a firm for some industries than for others. For example, a janitorial services company might require some cleaning equipment and transportation to start, whereas a nuclear power provider obviously would need a nuclear reactor (which we imagine is quite costly). Greater start-up costs and entry barriers suggest a higher size standard is appropriate. Unfortunately, there isn’t really data on actual start-up costs and entry barriers, so the SBA often looks at the average assets sizes for industries to get a sense on how much capital is needed for firms in that industry at a minimum. This, too, isn’t perfect, so SBA is always looking for other suggested means of calculation for this factor.
Another primary factor the SBA considers is industry competition. What this means is that SBA looks at how market share is distributed across the firms of an industry. If the market share is more concentrated in a few industries as opposed to being more evenly distributed, this suggests to SBA that a higher size standard is appropriate. Of course, the more evenly distributed market share is, the more this tells SBA that a lower size standard is appropriate. The SBA currently utilizes what it calls the “4-firm concentration ratio,” which, to simplify things, basically is just figuring out how much market share the four largest firms in an industry control. Interestingly, it did not always consider this an important factor in the past if the four biggest firms controlled less than 40% of the industry market share combined, but this is changing to be applied more universally.
Size Distribution of Firms and Gini Coefficient
This factor is actually pretty similar to the factor of industry competition. It looks more, however, at how the industry’s economic activity is distributed. As the SBA explains, if most “of an industry’s economic activity is attributable to several small firms, this generally indicates that small businesses are competitive in that industry and would support adopting a smaller size standard.” What SBA is looking at is the inequality of distribution, that is, how are the industry’s total receipts or employees distributed among the firms in that industry? This is represented by what is called the Gini coefficient. The Gini coefficient is a number between zero and one produced after some calculations that shows how evenly or unevenly distributed the receipts are. A Gini coefficient of zero means that the receipts or employees are perfectly equally distributed among the firms. A Gini coefficient of one means one firm alone has all the receipts or employees. Generally, industries with higher Gini coefficients should have larger size standards and those with lower Gini coefficients should have smaller size standards.
Federal Contracting Factor
Finally, the SBA looks at small business participation in federal contracting in terms of share of total federal contract dollars awarded to small businesses relative to the small business share of an industry’s total receipts. As the SBA explains, “[i]n general, if the share of Federal contract dollars awarded to small businesses in an industry is significantly smaller than the small business share of total industry’s receipts, all else remaining the same, a justification would exist for considering a size standard higher than the current size standard.” In other words, the less that small businesses in the industry generally rely on federal contract money, the higher the size standard.
The above five factors are only the primary factors the SBA considers when determining size standards. It also considers recent technological changes, competition between industries, growth trends, the industry’s history, and of course how a change in the size standard would impact the federal government.
As you can see, the SBA uses a methodical system for determining size standards. Of course, what we presented here is only a summary, each industry’s size standard is arrived at via the SBA’s discretion and own calculations. But hopefully, this sheds some light on how the SBA does just that.
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