KfW Research: SMEs’ innovation activity has flatlined

• Report shows 40% of small and medium-sized enterprises provide innovative products or processes
• Innovation expenditure remains steady at EUR 34 billion, marking a slight drop after adjusting for inflation
• Skilled labour shortage is a growing obstacle for innovators

SMEs’ innovation activity has stagnated on a low level. According to the current KfW Innovation Report, four in ten small and medium-sized enterprises SMEs brought forth at least one innovation in the three years between 2020 and 2022. That was around 1.5 million SMEs. Thus, the innovator rate of 40% remained unchanged on the previous 2019-2021 period. Innovation expenditure also sits at EUR 34 billion in current prices, as it did in the previous year. This shows a minor drop, adjusted for inflation.

It shows that innovation in the SME sector failed to benefit from the economic recovery after the subsidence of the COVID-19 pandemic, unlike physical investments, which grew both in number of investing enterprises and amounts invested in 2022. The gap between SMEs’ spending on innovation and expenditure on physical investments has widened again lately, with physical investments outpacing innovation expenditure sevenfold.

“The impact of the COVID-pandemic is still being felt strongly, as innovation activity in the SME sector is exhibiting ‘long-COVID’ symptoms”,

explained Dr Fritzi Köhler-Geib, Chief Economist of KfW.

“During the pandemic years, only few innovative ideas were developed, and decisions on innovations were postponed. This is now lacking in terms of output from the innovation process. Furthermore, innovation activity is strongly guided by companies’ business expectations, which decreased again in the spring of 2022.”

A closer look at innovative enterprises reveals that innovation activities are not evenly distributed across individual groups of enterprises but vary greatly. The leading innovators are internationally active businesses, those that conduct own research and development, and SMEs that employ university graduates. The report also shows that the smaller a business is, the less likely it is to innovate. Only around 36% of micro enterprises with fewer than five employees innovate, while that share reaches 71% among larger SMEs with more than 50 employees. Innovation expenditure also grows with the size of the enterprise. The major reason for the “size effect” is the high share of fixed costs involved in innovating. It places a higher burden on small businesses, even if they focus on few and relatively “small” innovation projects. As a consequence, innovation expenditure in the SME sector is heavily concentrated in large businesses.

Among the factors that hamper innovation, barriers around skills and funding occupy the top ranks. The high cost of innovating and the shortage of skilled workers were mentioned by 34% of SMEs as barriers to their innovation activities. In a representative special analysis, KfW Research took a closer look at the recruitment problems faced by innovative enterprises. The skilled labour shortage has already reached a significant stage as a result of the demographic trend underway in Germany, with around one in two innovative SMEs (52%) currently anticipating recruitment problems. Ten years ago, that share was a mere 35%. The supply of young talent, in particular, became inadequate already in the past years, and the problem of baby boomers retiring from the workforce will worsen further in the years ahead.

As employers, however, innovative enterprises and non-innovators are similarly attractive. In fact, the main cause of the significant recruitment problems of innovative enterprises is that they often place higher demands on their applicants than non-innovators. This applies in particular to mathematical/statistical abilities, social skills and digital skills. These specific requirements are due to the fact that innovative enterprises use new technologies more frequently and have a more modern work and business organisation. The requirements of their innovation processes also result in higher demands on the skills required.

Innovative enterprises are aware of the problems and are particularly active in seeking skilled workers. In doing so, they rely on a broad bundle of measures. Investing in the skills of existing employees plays the most important role (39%), for instance in training, continuing education including in-house exchange, support and retention of key personnel. This is followed by general HR policy measures (38%) such as retaining older workers for longer, more support in reconciling family and work commitments, attracting foreign workers and, to a lesser extent, measures aimed at reducing the need for skilled labour (19%) such as rationalisation measures.

“Germany is facing the need to undergo major transformations in a tense geostrategic environment. Succeeding in this will also depend on the contribution which innovation can make. Among other things, it will require the development of new technologies and the establishment of new potentials for value creation in Germany. The existing basis of innovative SMEs will also play a relevant role. They help innovations rapidly diffuse into the broader economy, making an important contribution to overall competitiveness and prosperity. As a result, the years-long trend of stagnating innovation activity on a low level in the SME sector and the increasing concentration in a small group of enterprises is problematic in many ways”,

summarised Dr Fritzi Köhler-Geib.

“The group of innovative enterprises is able to build an innovation capacity that is superior to that of less active enterprises. Latecomers are in danger of falling behind, and they run the risk of losing their competitiveness and ability to successfully innovate in the medium and longer term. The overall economy is at risk of losing its innovative basis."

Economic policymakers are therefore called upon to follow a dual strategy of incentivising innovation both at the cutting edge and across the broad economy.

“Easing the shortage of skilled workers plays a particularly important role for innovation activity. SMEs are experiencing the difficulties in filling vacancies directly and are already responding with a range of measures. Given the scale of the demographic challenge, economic and educational policymakers are also called upon to adopt a variety of approaches and step up their current efforts”,

said Köhler-Geib. Chief among them is the need to mobilise more employable people, such as women and older workers, as well as through immigration, and to train more skilled workers and improve specific skills (both at school and in vocational and academic learning, as well as through ongoing education and lifelong learning).

The current KfW Innovation Report and the special analysis by KfW Research on the recruitment problems among innovative enterprises can be downloaded at:
www.kfw.de/innovationsbericht
www.kfw.de/fokus

The dataset:
The KfW Innovation Report is based on the SME Panel (KfW-Mittelstandspanel), which has been conducted since 2003 as a recurring postal survey of small and medium-sized enterprises in Germany with annual turnover of up to EUR 500 million. The KfW SME Panel provides representative data for all SMEs of all sizes and across all industries in Germany. A total of 11,328 SMEs took part in the most recent survey wave, which was conducted in the spring of 2023.