Strategic Management - Lesson 3

Analyzing the External
Environment of the Firm

Creating Competitive Advantages
ENHANCING AWARENESS OF
THE EXTERNAL ENVIRONMENT
The Role of Scanning, Monitoring,
Competitive Intelligence, and Forecasting
• Environmental scanning
involves surveillance of a
firm’s external environment to
predict environmental
changes and detect changes
already underway. This alerts
the organization to critical
trends and events before
changes develop a discernible
pattern and before
competitors recognize them.
• Environmental monitoring tracks the evolution of
environmental trends, sequences of events, or streams of
activities. They may be trends that the firm came across by
accident or ones that were brought to its attention from outside
the organization. Monitoring enables firms to evaluate how
dramatically environmental trends are changing the competitive
landscape.
• Competitive intelligence (CI) helps firms define and
understand their industry and identify rivals’ strengths and
weaknesses. This includes the intelligence gathering associated
with collecting data on competitors and interpreting such data.
Done properly, competitive intelligence helps a company avoid
surprises by anticipating competitors’ moves and decreasing
response time.
• Environmental scanning, monitoring, and competitive
intelligence are important inputs for analyzing the external
environment. Environmental forecasting involves the
development of plausible projections about the direction, scope,
speed, and intensity of environmental change. Its purpose is to
predict change.
• It asks: How long will it take a new technology to reach the
marketplace? Will the present social concern about an issue
result in new legislation? Are current lifestyle trends likely to
continue?
• A danger of forecasting is that managers may view uncertainty
as black and white and ignore important gray areas. The
problem is that underestimating uncertainty can lead to
strategies that neither defend against threats nor take advantage
of opportunities.
• Obviously, poor predictions about technology change never go out of
vogue. Consider some other “gems”—predicted by very
knowledgeable people:
• (1981) “Cellular phones will absolutely not replace local wire systems.”
Inventor Marty Cooper
• (1995) “I predict the Internet will soon go spectacularly supernova and in
1996 catastrophically collapse.” Robert Metcalfe, founder of 3Com
• (1997) “Apple is already dead.” Former Microsoft CTO Nathan Myhrvold.
• (2005) “There’s just not that many videos I want to watch.” Steve Chen, CTO
and co-founder of YouTube, expressing concerns about the firm’s long-term
viability.
• (2006) “Everyone’s always asking me when Apple will come out with a cell
phone. My answer is ‘Probably never.’” David Pogue, The New York Times
• (2007) “There’s no chance that the iPhone is going to get significant market
share.” Steve Ballmer, Microsoft
• Scenario analysis is a more in-depth approach to forecasting. It
draws on a range of disciplines and interests, among them
economics, psychology, sociology, and demographics. It usually
begins with a discussion of participants’ thoughts on ways in
which societal trends, economics, politics, and technology may
affect an issue.
• Scenario analysis involves the projection of future possible
events. It does not rely on extrapolation of historical trends.
Rather, it seeks to explore possible developments that may only
be connected to the past. That is, several scenarios are
considered in a scenario analysis in order to envision possible
future outcomes.
SWOT Analysis
• To understand the business environment of a particular firm,
you need to analyze both the general environment and the firm’s
industry and competitive environment. Generally, firms compete
with other firms in the same industry. An industry is composed
of a set of firms that produce similar products or services, sell to
similar customers, and use similar methods of production.
Gathering industry information and understanding competitive
dynamics among the different companies in your industry is key
to successful strategic management.
SWOT Analysis
• SWOT stands for strengths, weaknesses, opportunities, and
threats. It provides “raw material”—a basic listing of conditions
both inside and surrounding your company.
• The Strengths and Weaknesses refer to the internal conditions of
the firm—where your firm excels (strengths) and where it may
be lacking relative to competitors (weaknesses). Opportunities
and Threats are environmental conditions external to the firm.
These could be factors in either the general or the competitive
environment.
SWOT Analysis
• In the general environment, one might experience developments
that are beneficial for most companies, such as improving
economic conditions that lower borrowing costs, or trends that
benefit some companies and harm others. An example is the
heightened concern with fitness, which is a threat to some
companies (e.g., tobacco) and an opportunity to others (e.g.,
health clubs). Opportunities and threats are also present in the
competitive environment among firms competing for the same
customers.
SWOT Analysis
• The general idea of SWOT analysis is that a firm’s strategy
must:
• Build on its strengths.
• Remedy the weaknesses or work around them.
• Take advantage of the opportunities presented by the environment.
• Protect the firm from the threats.
SWOT Analysis
• First, it forces managers to consider both internal and external
factors simultaneously.
• Second, its emphasis on identifying opportunities and threats
makes firms act proactively rather than reactively.
• Third, it raises awareness about the role of strategy in creating a
match between the environmental conditions and the firm’s
internal strengths and weaknesses.
• Finally, its conceptual simplicity is achieved without sacrificing
analytical rigor.
THE GENERAL ENVIRONMENT
The General Environment
• The general environment is composed of factors that can have
dramatic effects on firm strategy.
• We divide the general environment into six segments:
• Demographic
• Sociocultural
• Political/Legal
• Technological
• Economic
• Global
The Demographic Segment
• Demographics are the most easily understood and quantifiable
elements of the general environment. They are at the root of
many changes in society. Demographics include elements such
as the aging population, rising or declining affluence, changes in
ethnic composition, geographic distribution of the population,
and disparities in income level.
The Sociocultural Segment
• Sociocultural forces influence the values, beliefs, and lifestyles
of a society.
• Examples include a higher percentage of women in the workforce, dual-
income families, increases in the number of temporary workers, greater
concern for healthy diets and physical fitness, greater interest in the
environment, and postponement of having children.
The Political/Legal Segment
• Political processes and legislation influence environmental
regulations with which industries must comply.
The Technological Segment
• Developments in technology lead to new products and services
and improve how they are produced and delivered to the end
user. Innovations can create entirely new industries and alter the
boundaries of existing industries. Technological developments
and trends include genetic engineering, Internet technology,
computer-aided design/computer-aided manufacturing
(CAD/CAM), research in artificial and exotic materials, and, on
the downside, pollution and global warming.
The Economic Segment
• The economy affects all industries, from suppliers of raw
materials to manufacturers of finished goods and services, as
well as all organizations in the service, wholesale, retail,
government, and nonprofit sectors. Key economic indicators
include interest rates, unemployment rates, the consumer price
index, the gross domestic product, and net disposable income.
The Global Segment
• More firms are expanding their operations and market reach
beyond the borders of their “home” country. Globalization
provides both opportunities to access larger potential markets
and a broad base of production factors such as raw materials,
labor, skilled managers, and technical professionals. However,
such endeavors also carry many political, social, and economic
risks.
Data Analytics: A Technology That Affects
Multiple Segments of the General Environment
• Data analytics has been a leading and highly visible component
of a broader technological phenomenon—the emergence of
digital technology. Such technologies are altering the way
business is being conducted in a broad variety of sectors—
government, industry, academia, and commerce.
• Corporations are increasingly collecting and analyzing data on
their customers, including data on customer characteristics,
purchasing patterns, employee productivity, and physical asset
utilization.
The Impact of General Environmental
Trends on Various Industries
THE COMPETITIVE ENVIRONMENT
The Competitive Environment
• The competitive environment consists of many factors that are
particularly relevant to a firm’s strategy. These include
competitors (existing or potential), customers, and suppliers.
Porter’s Five Forces Model of Industry
Competition
• The “five forces” model developed by Michael E. Porter has
been the most commonly used analytical tool for examining the
competitive environment. It describes the competitive
environment in terms of five basic competitive forces:
1. The threat of new entrants.
2. The bargaining power of buyers.
3. The bargaining power of suppliers.
4. The threat of substitute products and services.
5. The intensity of rivalry among competitors in an industry.
Competition
• A manager should be familiar with the five forces model for
several reasons. It helps you decide whether your firm should
remain in or exit an industry. It provides the rationale for
increasing or decreasing resource commitments. The model
helps you assess how to improve your firm’s competitive position
with regard to each of the five forces.
Competition
Competition
• The Threat of New Entrants The threat of new entrants refers to
the possibility that the profits of established firms in the industry may
be eroded by new competitors. The extent of the threat depends on
existing barriers to entry and the combined reactions from existing
competitors. If entry barriers are high and/or the newcomer can
anticipate a sharp retaliation from established competitors, the threat
of entry is low. These circumstances discourage new competitors.
There are six major sources of entry barriers.
• Economies of scale refers to spreading the costs of production over the
number of units produced. The cost of a product per unit declines as the
absolute volume per period increases. This deters entry by forcing the entrant
to come in at a large scale and risk strong reaction from existing firms or come
in at a small scale and accept a cost disadvantage.
Competition
• When existing competitors have strong brand identification and customer loyalty,
product differentiation creates a barrier to entry by forcing entrants to spend heavily
to overcome existing customer loyalties.
• The need to invest large financial resources to compete creates a barrier to entry,
especially if the capital is required for risky or unrecoverable up-front advertising or
research and development (R&D).
• A barrier to entry is created by the existence of one-time costs that the buyer faces
when switching from one supplier’s product or service to another.
• The new entrant’s need to secure distribution for its product can create a barrier to
entry.
• Some existing competitors may have advantages that are independent of size or
economies of scale. These derive from:
• Proprietary products
• Favorable access to raw materials
• Government subsidies
• Favorable government policies
Competition
• The Bargaining Power of Buyers Buyers threaten an
industry by forcing down prices, bargaining for higher quality or
more services, and playing competitors against each other. These
actions erode industry profitability. The power of each large
buyer group depends on attributes of the market situation and
the importance of purchases from that group compared with the
industry’s overall business. A buyer group is powerful when:
• It is concentrated or purchases large volumes relative to seller sales. If a
large percentage of a supplier’s sales are purchased by a single buyer,
the importance of the buyer’s business to the supplier increases.
Competition
• The products it purchases from the industry are standard or
undifferentiated. Confident they can always find alternative suppliers,
buyers play one company against the other
• It earns low profits. Low profits create incentives to lower purchasing
costs.
• The buyers pose a credible threat of backward integration. If buyers either
are partially integrated or pose a credible threat of backward
integration, they are typically able to secure bargaining concessions.
Competition
• The Bargaining Power of Suppliers Suppliers can exert
bargaining power by threatening to raise prices or reduce the
quality of purchased goods and services. Powerful suppliers can
squeeze the profitability of firms so far that they can’t recover
the costs of raw material inputs. The factors that make suppliers
powerful tend to mirror those that make buyers powerful. A
supplier group will be powerful when:
• The supplier group is dominated by a few companies and is more
concentrated (few firms dominate the industry) than the industry it sells
to. Suppliers selling to fragmented industries influence prices, quality,
and terms.
Competition
• The supplier group is not obliged to contend with substitute products for
sale to the industry.
• The industry is not an important customer of the supplier group. When
suppliers sell to several industries and a particular industry does not
represent a significant fraction of its sales, suppliers are more prone to
exert power.
• The supplier’s product is an important input to the buyer’s business. When
such inputs are important to the success of the buyer’s manufacturing
process or product quality, the bargaining power of suppliers is high.
• The supplier group poses a credible threat of forward integration. This
provides a check against the industry’s ability to improve the terms by
which it purchases.
Competition
• The Threat of Substitute Products and Services All firms within an
industry compete with industries producing substitute products and
services. Substitutes limit the potential returns of an industry by
placing a ceiling on the prices that firms in that industry can
profitably charge. The more attractive the price/performance ratio of
substitute products, the tighter the lid on an industry’s profits.
• Identifying substitute products involves searching for other products
or services that can perform the same function as the industry’s
offerings. This may lead a manager into businesses seemingly far
removed from the industry.
• For example, the airline industry might not consider video cameras much of a
threat. But as digital technology has improved and wireless and other forms of
telecommunication have become more efficient, teleconferencing has become
a viable substitute for business travel.
Competition
• The Intensity of Rivalry among Competitors in an Industry Firms
use tactics like price competition, advertising battles, product
introductions, and increased customer service or warranties. Rivalry
occurs when competitors sense the pressure or act on an opportunity
to improve their position.
• Intense rivalry is the result of several interacting factors, including the
following:
• Numerous or equally balanced competitors. When there are many firms in an
industry, the likelihood of mavericks is great. Some firms believe they can
make moves without being noticed. Even when there are relatively few firms,
and they are nearly equal in size and resources, instability results from fighting
among companies having the resources for sustained and vigorous retaliation.
Competition
• Slow industry growth. Slow industry growth turns competition into a fight for market
share, since firms seek to expand their sales.
• High fixed or storage costs. High fixed costs create strong pressures for all firms to
increase capacity. Excess capacity often leads to escalating price cutting.
• Lack of differentiation or switching costs. Where the product or service is perceived as a
commodity or near commodity, the buyer’s choice is typically based on price and
service, resulting in pressures for intense price and service competition. Lack of
switching costs, described earlier, has the same effect.
• Capacity augmented in large increments. Where economies of scale require that capacity
must be added in large increments, capacity additions can be very disruptive to the
industry supply/demand balance.
• High exit barriers. Exit barriers are economic, strategic, and emotional factors that
keep firms competing even though they may be earning low or negative returns on
their investments. Some exit barriers are specialized assets, fixed costs of exit, strategic
interrelationships (e.g., relationships between the business units and others within a
company in terms of image, marketing, shared facilities, and so on), emotional
barriers, and government and social pressures (e.g., governmental discouragement of
exit out of concern for job loss).
Competition
Competition
Using Industry Analysis: A Few Caveats
• For industry analysis to be valuable, a company must collect and
evaluate a wide variety of information. Industry analysis helps a firm
not only to evaluate the profit potential of an industry but also to
consider various ways to strengthen its position vis-à-vis the five
forces. However, there are a few caveats.
• First, managers must not always avoid low-profit industries (or low-profit
segments in profitable industries). Such industries can still yield high returns for
some players who pursue sound strategies.
• Second, five-forces analysis implicitly assumes a zero-sum game, determining
how a firm can enhance its position relative to the forces. Yet such an approach
can often be shortsighted; that is, it can overlook the many potential benefits
of developing constructive win–win relationships with suppliers and
customers.
• Zero-sum game a situation in which multiple players interact, and winners win only
by taking from other players.
• Third, the five-forces analysis also has been criticized for being
essentially a static analysis. External forces as well as strategies of
individual firms are continually changing the structure of all industries.
• Complements typically are products or services that have a potential impact on the
value of a firm’s own products or services. Those who produce complements are
usually referred to as complementors.
• Michael Porter addresses two critical issues in conducting a good
industry analysis, which will yield an improved understanding of the
root causes of profitability: (1) choosing the appropriate time frame
and (2) a rigorous quantification of the five forces.
• Good industry analysis looks rigorously at the structural underpinnings of
profitability. A first step is to understand the time horizon. One of the essential
tasks in industry analysis is to distinguish short-term fluctuations from
structural changes. A good guideline for the appropriate time horizon is the
full business cycle for the particular industry. For most industries, a three- to
five-year horizon is appropriate. However, for some industries with long lead
times, such as mining, the appropriate horizon may be a decade or more. It is
average profitability over this period, not profitability in any particular year,
which should be the focus of analysis.
• The point of industry analysis is not to declare the industry attractive or
unattractive but to understand the underpinnings of competition and the
root causes of profitability. As much as possible, analysts should look at
industry structure quantitatively, rather than be satisfied with lists of
qualitative factors.

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Analyzing the External

Environment of the Firm

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