The implementation of the Goods and Services Tax (GST) is expected to alter the business dynamics in favour of micro, small and medium enterprises (MSMEs) based in Tier-2 or smaller cities. Today, MSMEs with manufacturing units based in small cities spend relatively more on materials and less on manpower, compared with their peers in metros and Tier-1 cities, a CRISIL analysis of over 2,200 MSMEs reveals.
The share of material costs in smaller cities is nearly 73 per cent of the cost structure, a good 500 basis points (bps) higher than in larger cities. This is because large-city manufacturers are located closer to economic centres with economies of scale, giving them better negotiation power with suppliers and cheaper logistics.
However, given higher cost of living and better skills among labour, manpower is more expensive in the big cities, making it a cost-leveller. Indeed, employee cost in small cities is nearly 300 bps lower, which allows them to maintain similar operating margins as their large-city peers. The trend is observed in all major sectors, including light engineering, textiles, steel products and electrical equipment, which cover a large chunk of MSMEs.
This could change with the advent of GST, which is expected to be more beneficial for small-city players, looking beyond the short-term implementation challenges. While large cities will continue to have pricing power, their price advantage will narrow. The enhanced systemic efficiency under a simplified indirect tax structure will reduce input prices and logistics costs, making it faster and cheaper for raw materials to reach smaller towns and finished goods to reach larger markets.
Yet, lower employee costs will continue to remain an advantage for small-city players, allowing them to improve their margins or compete better on prices by passing on the benefits to customers. Additionally, given lower land prices in these areas, expanding production capacity, too, will be cheaper. Hence, if supported well by government through improvements in transport and power infrastructure, the potential of small-city manufacturers can be tapped much more effectively.