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.