How different are service and manufacturing firms in the informal sector? (Short Note)

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1 World Bank From the SelectedWorks of Mohammad Amin October, 2009 How different are service and manufacturing firms in the informal sector? (Short Note) Mohammad Amin Available at:

2 How different are service and manufacturing firms in the informal sector? A comparison of service and manufacturing firms in the informal sector shows that service firms are larger in terms of total sales and also generate more output per worker. They rely less on physical infrastructure and machines but more on human capital. Service firms also appear to be better integrated with the financial system with access to finance being less of an obstacle to their business. Some of the commonly held reasons for not registering such as taxes that registered businesses have to pay and benefits from registering such as better access to government programs appear to be less important to service than manufacturing firms. Last, there are important country specific differences between service and manufacturing businesses in, for example, female ownership and the motivation for starting the business. There is a growing body of work that suggests that services and manufacturing firms differ fundamentally in the overall structure and growth dynamics. However, this literature is almost entirely based on service and manufacturing firms operating in the formal or registered sector. Anecdotal evidence suggests that in many developing countries, a large proportion of the population works in the informal or the unregistered sector. What are the differences between service and manufacturing firms in the informal sector? This note attempts to shed light on this question using data on informal firms in Ivory Coast, Madagascar and Mauritius (Enterprise Surveys). The exercise is important for a variety of reasons. First, it is not obvious whether the findings for the formal sector can be extended to the informal sector. For example, most informal firms operate on a small scale so that size related differences between manufacturing and service firms in the informal sector may not be as relevant as in the formal sector. Second, informal sector is often criticized for being inefficient and hence a drain on scarce resources. If more efficient utilization of resources is indeed a policy objective for bringing the informal sector into the fold of the formal sector, it would help to know exactly which informal firms (manufacturing vs. services) are more intensive users of resources most scarce in a particular country. Third, effective policy measures aimed at getting the informal firms to register require understanding the reasons why firms choose to go informal and remain informal. These reasons could vary across service and manufacturing firms for a variety of reasons. For example, relative to service firms, manufacturing firms are typically larger and so prime targets for inspections by government officials. This could be an important motivation for manufacturing firms to go informal. Similarly, proposed benefits from registering such as access to finance and electricity may be more important to manufacturing firms than service firms since the former require larger investments in machinery and equipment and are also more intensive users of electricity. Fourth, service and manufacturing activities are easily identifiable so that if we do find differences between these two sectors then policy measures can be tailor made to their respective needs. Fifth, lower entry costs for service firms may be particularly attractive to females who often face difficulty in accessing credit. Also, service firms can be more easily run from within household premises than manufacturing firms which is also attractive for female workers. Issues related to gender parity warrant a closer look at service vs. manufacturing informal firms. 1. Service firms are larger and generate more sales per workers Total sales in a regular month for a service firm equal USD 300 compared with USD 218 for a typical manufacturing firm. That is, the former is about 138 percent of the latter in the full sample. The corresponding figure equals 113 percent for Ivory Coast, 140 (Madagascar) and 150 (Mauritius). In contrast, total employment does not show any systematic difference between a typical service and manufacturing firm. Relative to a manufacturing firm, employment in a service firm is higher by 3.3 percent in the full sample (1.48 vs. 1.57), 22 percent in Ivory Coast and 6 percent in Mauritius. However, it is lower by 20 percent in Madagascar. For sales per workers, a measure of firm efficiency, service firms outperform manufacturing firms except in Ivory Coast (figure 1). The difference is particularly sharp for 1

3 firms where the main decision maker has less than secondary level education (primary or no education) and for firms that were started because the largest owner could not find a satisfactory job (unwilling entrepreneur) rather than to take advantage of a business opportunity. i Figure 1: Service firms generate more sales per workers Total sales per employee (USD, normal month) Output per worker: service vs. manufacturing All firms Ivory Coast Madagascar Mauritius Less than secondary education Unwilling entrepreneur Less than secondary education implies that the main decision maker is has either primary education or no education. Unwilling entrepreneur refers to firms that were started because the largest owner could not find a satisfactory job rather than to take advantage of a business opportunity. Values of output per worker shown are their median values. 2. Service firms rely less on electricity and machines but more on human capital Service firms score over manufacturing firms in terms of the education level of the main decision maker and this holds across all three countries (figure 2). The difference is particularly sharp in the relatively smaller cities and for firms that have all male owners. Education level is also much higher in service relative to manufacturing firms that have unwilling entrepreneurs. A plausible interpretation of this finding is that due to lower entry costs, service sector is more attractive to those unwilling entrepreneurs who are educated and hence expect to find a wage earning job in the near future. ii 2

4 Figure 2: Main decision maker in service firms is more likely to be educated than in manufacturing firms Percentage of firms Percentage of firms with main decision maker having secondary or higher education Full sample Ivory Coast Madagascar Mauritius All male owners Small city (Population less than 250,000) Unwilling entrepreneur Unwilling entrepreneur refers to firms that were started because the largest owner could not find a satisfactory job rather than to take advantage of a business opportunity. Values of output per worker shown are their median values. As expected, relative to manufacturing, service firms are less likely to use electricity (53 vs. 69 percent) and machinery (26 vs. 62 percent). They are also less likely to operate outside the household premises (24 vs. 41 percent). However, use of vehicles or other means of transport is roughly same in the two sectors (14 vs. 12 percent) and the same holds for cell phones (76 vs. 79 percent) and to communicate with clients and suppliers (92 vs. 96 percent). 3. Service firms are better integrated into the financial system Over 46 percent of the service firms have a bank account to run the business and 30 percent have a business account that is separate from the household account. Corresponding figures for manufacturing firms are much lower at 33 and 20 percent, respectively. Similarly, financial accounts of the business are run separately from the accounts of the household for over 50 percent of the service firms but only 34 percent of the manufacturing firms. These findings suggest better banking habits among service firms. Service firms also score over manufacturing firms in the percentage of firms that use bank finance for their day to day operation (6 vs. 2 percent) and the same holds for microfinance (5 vs. 1 percent). Note that the percentage of firms using bank finance or microfinance in both the sectors is low so that it is difficult to make any definitive conclusions from the reported differences. At best these findings are indicative of better access to external financial institutions for service relative to manufacturing firms. This is further corroborated by the fact that fewer service relative to manufacturing firms report access to finance as major or very severe obstacle for running their business (44 vs. 53 percent). 3

5 Consistent with the findings reported above, less than 10 percent of all firms applied for a loan during the year prior to the survey. The percentage is lower among manufacturing compared with service firms (8 vs. 12 percent). Lack of collateral as the main reason for not applying for a loan is significantly more common among manufacturing relative to service firms (figure 3), a somewhat surprising result since machines and equipments used by manufacturing firms could be expected to useful collaterals. Figure 3: Lack of collateral required for a loan is a more common problem among manufacturing than service firms Main reason for not applying for a loan (% of firms) No need for a loan Application procedures are complex Did not have required guarantee Did not think it would be approved because the firm is unregistered Interest rates are too high Other Percentage of firms that did not apply for a loan All figures are expressed as percentage of firms that did not apply for a loan during the year prior to the survey. 4. Production structure and basic firm characteristics are similar between service and manufacturing firms With a few exceptions, service and manufacturing firms show very little difference in the production structure or firm characteristics such as age, probability of having one or more female owner, total number of owners, hours of operation in a typical week, proportion of output that the main product/service represents, ratio of paid to unpaid workers and the level of seasonality measured by the ratio of sales in the busiest to the slowest month. Also, we find virtually no difference in the gender composition of the workforce between services and manufacturing firms, a finding that is sharply different from existing studies on the formal economy that suggest greater concentration of women in services vs. manufacturing sectors. Differences that do exist in some of firm characteristics discussed above are largely confined to a single country (discussed below). Three exceptions are that relative to service firms, manufacturing firms are much more likely to produce under contract for another business or person than service firms (14.2 vs. 4.5 percent), more likely to operate outside than within household premises (41 vs. 24 percent) and have managers with more experience working in the industry (12.7 vs. 9.4 years). 4

6 5. Benefits/costs of registering The survey reports on the severity of various obstacles to registering as experienced by the firms. These obstacles include getting information on registration procedures, time to complete registration and the required fees, taxes on registered businesses, inspection and meetings with government officials that registered business must have and bribes that registered businesses need to pay. On average, service firms report the severity of these obstacles at par with the manufacturing firms and in some cases, lower. Obstacles less severe for service firms include getting information on how to register, registration fees and bribes that registered businesses pay. iii Looking at which of the above obstacles is most important to service vs. manufacturing firms, there are important differences at the country level (figure 4). For example, in Madagascar, taxes on registered businesses are the important obstacle for 51 percent of service firms compared with 42 percent of manufacturing firms. Corresponding figures for registration fees are 23 and 32 percent, respectively. Figure 4: Most important reason for not registering in services vs. manufacturing varies by country Percentage of firms Getting information for registering Most important reason for not registering (% of firms) Ivory Coast Fees for registering Madagascar Fees for registering Taxes on registered businesses Mauritius Getting information for registering Time to complete registration Taxes on registered businesses For the perceived benefits from registering, firms were asked about better access to finance, raw materials, markets, services, workers, government programs, less bribes to pay, better legal foundation on property rights and better opportunities of negotiation with formal firms. Much like the obstacles discussed above, percentage of firms reporting the benefits as important was lower for services firms in some cases and roughly same as the manufacturing firms in the remaining cases. The former cases include access to government programs (57 vs. 67 percent) and access to workers (39 vs. 50 percent). 5

7 to markets and better access was also more common for manufacturing relative to service firms in Madagascar, and to some extent, Ivory Coast. How do service vs. manufacturing firms rank the benefits listed above? The answer to the question varies by country (figure 5). For example, in Ivory Coast, better access to markets is the most important benefit for 15 percent of manufacturing firms but only 3 percent of service firms. Corresponding figures for better access to finance are 69 and 78 percent, respectively. Figure 5: Most important benefit from registering in services vs. manufacturing varies by country Most important benefit from registering (% of firms) Ivory Coast Madagascar Mauritius Percentage of firms to financing to markets to financing More access to government programs or services to markets More access to government programs or services to markets 6. There are important country specific differences across sectors Female ownership in Ivory Coast: Ivory Coast stands out from the other countries in the percentage of service vs. manufacturing firms with one or more female owners. About 48 percent of service firms but only 25 percent of manufacturing firms in Ivory Coast have a female owner. There is virtually no difference in female ownership of service vs. manufacturing firms in Mauritius (31 vs. 30 percent) and Madagascar (50 percent each). Unwilling entrepreneurs in Madagascar: Many informal businesses are started because the owner(s) cannot find a satisfactory job (henceforth, unwilling entrepreneurs) rather than to take advantage of business opportunities. The distinction between these two motivations for starting a business is important, both for policy measures and understanding how informal businesses function. For example, an unwilling 6

8 entrepreneur may not have the skills or the inclination to run a business implying a distortion in the economy. Bringing the informal firms into the fold of the formal sector does not necessarily eliminate this distortion. Hence what may be needed are more wage jobs and not just getting informal firms to register. How do service and manufacturing sectors compare in the proportion of firms established because the largest owner could not find a satisfactory job? Madagascar stands out for the high proportion of such firms in the manufacturing relative to service sector (48 vs. 29 percent). The corresponding figures equal 42 vs. 48 percent in Ivory Coast and 35 vs. 27 percent in Mauritius, respectively. Selling goods and services on credit in Mauritius: Service and manufacturing firms in Mauritius show a number of differences that are unique to the country. For example, less than 14 percent of the service firms but over 38 percent of manufacturing firms in Mauritius report selling their goods/services on credit. Corresponding figures for Ivory Coast are 63 and 58 percent and 38 and 45 percent for Madagascar, respectively. The effectiveness of policy measures aimed at improving the functioning of firms in the informal sector and the proposed benefits from such policy measures depend crucially on the sorts of firms that operate in the sector, how they do business and the main obstacles they face in doing so. That these dimensions may vary across service and manufacturing informal firms is neither obvious nor implausible. It is an empirical question that this note attempts to explore. In addition to size, output per worker, infrastructure usage, human capital and benefits/costs of registering related differences, there are important country specific features that distinguish service from manufacturing firms. Depending on the objective, policies towards the informal sector may need to be tailored to the country in question. i Values of total sales and output per workers are the median values for the various samples discussed. The qualitative analysis does not change much if arithmetic means are used instead although in some of the cases these are unduly affected by extreme values. ii Note that the education level refers to the main decision maker while the motivation for starting the business refers to the largest owner. However, for on overwhelming percentage of firms (over 95 percent), the main decision maker is also the largest owner. iii One exception is Ivory Coast where service firms report bribes that registered business must pay to be a bigger obstacle for registering than manufacturing firms. 7