Chapter 4

The External Assessment

External audit

 focuses on identifying and evaluating trends and events beyond the control of a
single firm

 reveals key opportunities and threats confronting an organization so that

managers can formulate strategies to take advantage of the opportunities and
avoid or reduce the impact of threats.

 An external audit reveals key opportunities and threats confronting an organization

so that managers can formulate strategies to take advantage of the opportunities and
avoid or reduce the impact of threats.

 The Nature of an External Audit

 The external audit is aimed at identifying key variables that offer actionable responses.

Firms should be able to respond either offensively or defensively to the factors by formulating
strategies that take advantage of external opportunities or that minimize the impact of potential
threats. Key External Forces

External forces can be divided into five broad categories:

1-economic forces 2-social, cultural, demographic, and natural environment forces

3-political, governmental, and legal forces 4- Technological forces 5-Competitive forces

 The Process of Performing an External Audit

 First, gather competitive intelligence and information about economic, social, cultural,
demographic, environmental, political, governmental, legal, and technological trends.

 Information should be assimilated and evaluated

 A final list of the most important key external factors should be communicated

Key external factors should be:

1. Important to achieving long-term and annual objectives 2-Measurable

3 Applicable to all competing firms, and

4 Hierarchical in the sense that some will pertain to the overall company and others will be
more narrowly focused on functional or divisional areas

Sources of External Information

Firms use several sources to analyze the general environment, including a wide variety of printed
materials (such as trade publications, newspapers, business publications, and the results of
academic research and public polls), trade shows and suppliers, customers, and employees of
public-sector organizations. People in boundary-spanning positions can obtain a great deal of this
type of information. Salespersons, purchasing managers, public relations directors, and customer
service representatives, each of whom interacts with external constituents, are examples of
boundary-spanning positions.
Scanning
Scanning entails the study of all segments in the general environment. Through scanning, firms
identify early signals of potential changes in the general environment and detect changes that are
already under way. Scanning often reveals ambiguous, incomplete, or unconnected data and
information. Thus, environmental scanning is challenging but critically important for firms,
especially those competing in highly volatile environments. In addition, scanning activities must
be aligned with the organizational context.
Monitoring
When monitoring, analysts observe environmental changes to see if an important trend is
emerging from among those spotted through scanning. Critical to successful monitoring is the
firm’s ability to detect meaning in different environmental events and trends. Effective
monitoring requires the firm to identify important stakeholders as the foundation for serving their
unique needs. Scanning and monitoring are particularly important when a firm competes in an
industry with high technological uncertainty. Scanning and monitoring can provide the firm with
information; they also serve as a means of importing knowledge about markets and about how to
successfully commercialize new technologies the firm has developed.
Forecasting
Scanning and monitoring are concerned with events and trends in the general environment at a
point in time. When forecasting, analysts develop feasible projections of what might happen, and
how quickly, as a result of the changes and trends detected through scanning and monitoring.
For example, analysts might forecast the time that will be required for a new technology to reach
the marketplace, the length of time before different corporate training procedures are required to
deal with anticipated changes in the composition of the workforce, or how much time will elapse
before changes in governmental taxation policies affect consumers’ purchasing patterns.
Forecasting events and outcomes accurately is challenging.
Forecasting Tools and Techniques
Forecasts are educated assumptions about future trends and events. Forecasting is a complex
activity because of factors such as technological innovation, cultural changes, new products,
improved services, stronger competitors, and shifts in government priorities, changing social
values, unstable economic conditions, and unforeseen events. Managers often must rely on
published forecasts to effectively identify key external opportunities and threats.
A sense of the future permeates all action and underlies every decision a person makes. People
eat expecting to be satisfied and sustained in the future. People sleep assuming that in the future
they will feel rested. They invest energy, money, and time because they believe their efforts will
be rewarded in the future. They build highways assuming that automobiles and trucks will need
them in the future. Parents educate children on the basis of forecasts that they will need certain
skills, attitudes, and knowledge when they grow up. The truth is we all make implicit forecasts
throughout our daily lives.
The question, therefore, is not whether we should forecast but rather how we can best forecast to
enable us to move beyond our ordinarily unarticulated assumptions about the future. Can we
obtain information and then make educated assumptions (forecasts) to better guide our current
decisions to achieve a more desirable future state of affairs. We should go into the future with
our eyes and our minds open, rather than stumble into the future with our eyes closed.
Forecasting tools can be broadly categorized into two groups: quantitative techniques and
qualitative techniques. Quantitative forecasts are most appropriate when historical data are
available and when the relationships among key variables are expected to remain the same in the
future. Linear regression, for example, is based on the assumption that the future will be just like
the past, which, of course, it never is.
No forecast is perfect, and some forecasts are even wildly inaccurate. This fact accents the need
for strategists to devote sufficient time and effort to study the underlying bases for published
forecasts and to develop internal forecasts of their own. Key external opportunities and threats
can be effectively identified only through good forecasts. Accurate forecasts can provide major
competitive advantages for organizations.
Qualitative Techniques in Forecasting
Grass Roots: Grass roots forecasting builds the forecast by adding successively from the bottom.
The assumption here is that the person closest to the customer or end use of the product knows
its future needs best. Though this is not always true, in many instances it is a valid assumption,
and it is the basis for this method.
Market Research: Firms often hire outside companies that specialize in market research to
conduct this type of forecasting. You may have been involved in market surveys through a
marketing class. Certainly you have not escaped telephone calls asking you about product
preferences, your income, habits, and so on. Market research is used mostly for product research
in the sense of looking for new product ideas, likes and dislikes about existing products, which
competitive products within a particular class are preferred, and so on. Again, the data collection
methods are primarily surveys and interviews.
Panel Consensus: In a panel consensus, the idea that two heads are better than one is
extrapolated to the idea that a panel of people from a variety of positions can develop a more
reliable forecast than a narrower group. Panel forecasts are developed through open meetings
with free exchange of ideas form all levels of management and individuals.
The difficulty with this open style is that lower employee levels are intimidated by higher levels
of management. For example, a salesperson in a particular product line may have a good
estimate of future product demand but may not speak up to refute a much different estimate
given by the vice president of marketing. When decisions in forecasting are at a broader, higher
level (as when introducing a new product line or concerning strategic product decisions such as
new marketing areas) the term executive judgment is generally used.
Historical Analogy: The historical analogy method is used for forecasting the demand for a
product or service under the circumstances that no past demand data are available. This may
specially be true if the product happens to be new for the organization. However, the
organization may have marketed product(s) earlier which may be similar in some features to the
new product. In such circumstances, the marketing personnel use the historical analogy between
the two products and derive the demand for the new product using the historical data of the
earlier product.
Delphi Method: As we mentioned/stated under panel consensus, a statement or opinion of a
higher-level person will likely be weighted more than that of a lower-level person. The worst
case is where lower level people feel threatened and do not contribute their true beliefs. To
prevent this problem, the Delphi method conceals the identity of the individuals participating in
the study. Everyone has the same weight. A moderator creates a questionnaire and distributes it
to participants. Their responses are summed and given back to the entire group along with a new
set of questions. The step-by-step procedure is:
1. Choose the experts to participate. There should be a variety of knowledgeable people in
different areas.
2. Through a questionnaire (or e-mail), obtain forecasts (and any premises or qualification
captions for the forecasts) from all participants.
3. Summarize the results and redistribute them to the participants along with appropriate new
questions.
4. Summarize again, refining forecasts and conditions, and again develop new questions.
5. Repeat Step 4 if necessary. Distribute the final results to all participants. The Delphi
technique can usually achieve satisfactory results in three rounds. The time required is a
function of the number of participants, how much work is involved for them to develop their
forecasts, and their speed in responding.
Quantitative Technique
Time-Series Methods: Simply attempt to project past experience into the future. These
techniques use historical data with the assumption that the future will be like the past. Some
models merely attempt to smooth out random variations in historical data; others attempt to
identify specific patterns in the data and project or extrapolate those patterns into the future,
without trying to identify causes of the patterns. In many forecasting situations enough historical
consumption data are available. The data may relate to the past periodic sales of products,
demands placed on services like transportation, electricity and telephones. There are available to
the forecaster a large number of methods, popularly known as the time series methods, which
carry out a statistical analysis of past data to develop forecasts for the future. The underlying
assumption here is that past relationships will continue to hold in the future. The different
methods differ primarily in the manner in which the past values are related to the forecasted
ones.
Trends: These relate to the long-term persistent movements/tendencies/changes in data like price
increases, population growth, and decline in market shares. It is a long-term upward or
downward movement in the data.
Seasonal variations: There could be periodic, repetitive variations in time-series which occur
because of buying or consuming patterns and social habits, during different times of a year. It
refers to short-term, fairly regular variations generally related to factors such as the calendar or
time of day. Restaurants, supermarkets, and theaters experience weekly and even daily
“seasonal” variations.
Cyclical variations: These refer to the variations in time series which arise out of the
phenomenon of business cycles. The business cycle refers to the periods of expansion followed
by periods of contraction. The period of a business cycle may vary from one year to thirty years.
The duration and the level of resulting demand variation due to business cycles are quite difficult
to predict.
Random or irregular variations: These refer to the erratic fluctuations in the data which cannot
be attributed to the trend, seasonal or cyclical factors. In many cases, the root cause of these
variations can be isolated only after a detailed analysis of the data and the accompanying
explanations, if any. Such variations can be due to a wide variety of factors like sudden weather
changes, strike or a communal clash.
The Naive Methods: A simple but widely used approach to forecasting is the naive approach. A
naive forecast uses a single previous value of a time series as the basis of a forecast. The naive
approach can be used with a stable series (variations around an average), with seasonal
variations, or with trend.
With a stable series, the last data point becomes the forecast for the next period. Thus, if demand
for a product last week was 20 cases, the forecast for this week is 20 cases. With seasonal
variations, the forecast for this “season” is equal to the value of the series last “season.” For
example, the forecast of the number of checks cashed at a bank on the first day of the month next
month is equal to the number of checks cashed on the first day of this month; and the forecast for
highway traffic volume this Friday is equal to the highway traffic volume last Friday. For data
with trend, the forecast is equal to the last value of the series plus or minus the difference
between the last two values of the series. For example, suppose the last two values were 60 and
62. The next forecast would be 64:
Period Actual Change from previous value Forecast
1 60
2 62 +2
3 62+2=64

Simple Moving Average Method: One weakness of the naive method is that the forecast just
traces the actual data, with a lag of one period; it does not smooth at all. But by expanding the
amount of historical data a forecast is based on, this difficulty can be overcome. A moving
average forecast uses a number of the most recent actual data values in generating a forecast. The
moving average forecast can be computed using the following equation:
F t = Forecast for time period t
MA n = n period moving average
A t - i = Actual value in period t - i
n = Number of periods (data points) in the moving average
For example, MA 3 would refer to a three-period moving average forecast, and MA 5 would
refer to a five-period moving average forecast. Compute a three-period moving average forecast
given demand for shopping carts for the last five periods.
Period Demand
1 42
2 40
3 43
4 40
5 41

If actual demand in period 6 turns out to be 38, the moving average forecast for period 7 would
be

Note that in a moving average, as each new actual value becomes available, the forecast is
updated by adding the newest value and dropping the oldest and then recomposing the average.
Consequently, the forecast “moves” by reflecting only the most recent values.
Weighted Moving Average
A weighted average is similar to a moving average, except that it assigns more weight to the
most recent values in a time series. For instance, the most recent value might be assigned a
weight of 0.40, the next most recent value a weight of 0.30, the next after that a weight of 0.20,
and the next after that a weight of 0.10. Note that the weights must sum to 1.00, and that the
heaviest weights are assigned to the most recent values.

Where
wt = Weight for the period t, w t - 1 = Weight for period t - 1, etc.
A t = Actual value in period t, A t -1 = Actual value for period t - 1, etc.

Example: Given the following demand data,

a. Compute a weighted average forecast using a weight of 0.40 for the most recent period, 0.30
for the next most recent, 0.20 for the next, and 0.10 for the next.
b. If the actual demand for period 6 is 39, forecast demand for period 7 using the same weights
as in part a.
Period 1 2 3 4 5
Demand 42 40 43 40 41

a. F 6 =.10(40) + .20(43) + .30(40) + .40(41) = 41.0

b. F 7 = .10(43) + .20(40) + .30(41) + .40(39) = 40.2
Note that if four weights are used, only the four most recent demands are used to prepare the
forecast.
Exponential Smoothing
Exponential smoothing is a sophisticated weighted averaging method that is still relatively easy
to use and understand. Each new forecast is based on the previous forecast plus a percentage of
the difference between that forecast and the actual value of the series at that point. That is:
Next forecast = Previous forecast+ α (Actual - Previous forecast)
Where (Actual - Previous forecast) represents the forecast error and α is a percentage of the
error.
More concisely,

Where
F t = Forecast for period t
F t-1 =Forecast for the previous period (i.e., period t - 1)
α= Smoothing constant (percentage)
A t - 1 =Actual demand or sales for the previous period
The smoothing constant - represents a percentage of the forecast error.
Each new forecast is equal to the previous forecast plus a percentage of the previous error.
For example,
Suppose the previous forecast was 42 units, actual demand was 40 units, and percentage 0.10.
The new forecast would be computed as follows:
Ft = 42 + 0.10(40 - 42) = 41.8
Then, if the actual demand turns out to be 43, the next forecast would be
Ft = 41.8 + .10(43 - 41.8) = 41.92
The quickness of forecast adjustment to error is determined by the smoothing constant i.e. α
The closer its value is to zero, the slower the forecast will be to adjust to forecast errors (i.e., the
greater the smoothing). Conversely, the closer the value of is to 1.00, the greater the
responsiveness and the less the smoothing.
Selecting a smoothing constant is basically a matter of judgment or trial and error, using forecast
errors to guide the decision. The goal is to select a smoothing constant that balances the benefits
of smoothing random variations with the benefits of responding to real changes if and when they
occur. Commonly used values of α range from .05 to .50 Low values of α are used when the
underlying average tends to be stable; higher values are used when the underlying average is
susceptible to change.
Linear Regression Analysis
Regression can be defined as a functional relationship between two or more correlated variables.
It is used to predict one variable given the other. The relationship is usually developed from
observed data. The data should be plotted first to see if they appear linear or if at least parts of
the data are linear. Linear regression refers to the special class of regression where the
relationship between variables forms a straight line.
The linear regression line is of the form Y = a + bX,
Where Y is the value of the dependent variable that we are solving for, a is the Y intercept,
b is the slope, and X is the independent variable. (In time series analysis, X is units of time).
Linear regression is useful for long-term forecasting of major occurrences and aggregate
planning.
For example, linear regression would be very useful to forecast demands for product families.
Even though demand for individual products within a family may vary widely during a time
period, demand for the total product family is surprisingly smooth.
The major restriction in using linear regression forecasting is, as the name implies, that past data
and future projections are assumed to fall about a straight line. Although this does limit its
application, sometimes, if we use a shorter period of time, linear regression analysis can still be
used.
Example-1: A firm’s sale for a product line during the 12 quarters of the past three years was as
follows.
Quarter Sales Quarter Sales
1 600 7 2600
2 1550 8 2900
3 1500 9 3800
4 1500 10 4500
5 2400 11 4000
6 3100 12 4900

th
Forecast the sales for the 13, 14, 15 and 16 quarters using a hand-fit regression equation.

The Industrial Organization

(I/O) View

The Industrial Organization (I/O) approach to competitive advantage advocates that

external (industry) factors are more important than internal factors in a firm for achieving
competitive advantage.
 Economic Forces

Social, Cultural, Demographic, and Natural Environmental Forces

 U.S. Facts (2014)

 Aging population

 Less white

 Widening gap between rich & poor

 2025 = 18.5% population > 65 years

 2075 = no ethnic or racial majority

 Facts (2014)

 World population 7 billion

 World population = 8 billion by 2028

 World population = 9 billion by 2054

  U.S. population > 310 million

Key Social, Cultural, Demographic, and Natural Environment Variables

Political, Governmental, and Legal Forces

The increasing global interdependence among economies, markets, governments, and

organizations makes it imperative that firms consider the possible impact of political variables on
the formulation and implementation of competitive strategies.

Political, Government, and Legal Variables

 Labor Unions

 The extent that a state is unionized can be a significant political factor in strategic
planning decisions as related to manufacturing plant location and other operational
matters

 The size of American labor unions has fallen sharply in the last decade due in large part
to erosion of the U.S. manufacturing base

Technological Forces

 Technological forces represent major opportunities and threats that must be considered
in formulating strategies. Technological advancements can dramatically affect
organizations’ products, services, markets, supplier’s distributors competitors,
customers, manufacturing processes, marketing practices, and competitive position.

The Internet has changed the very nature of opportunities and threats by:

 altering the life cycles of products,

 increasing the speed of distribution,

  creating new products and services,

 erasing limitations of traditional geographic markets,

 changing the historical trade-off between production standardization and flexibility.

 The Internet is altering economies of scale, changing entry barriers, and redefining the
relationship between industries and various suppliers, creditors, customers, and
competitors

 Many firms now have a Chief Information Officer (CIO) and a Chief Technology
Officer (CTO) who work together to ensure that information needed to formulate,
implement, and evaluate strategies is available where and when it is needed

Technological advancements can:

 Create new markets,

 Result in a proliferation of new and improved products,

 Change the relative competitive cost positions in an industry,

 Render existing products and services obsolete.

Competitive Forces
 An important part of an external audit is identifying rival firms and determining their
strengths, weaknesses, capabilities, opportunities, threats, objectives, and strategies

Characteristics of the most competitive companies:

1. Market share matters

2. Understand and remember precisely what business you are in

3. Whether it’s broke or not, fix it–make it better

4. Innovate or evaporate

5. Acquisition is essential to growth

6. People make a difference

 7. There is no substitute for quality

Key Questions About Competitors

Competitive Intelligence Programs

 Competitive intelligence (CI)

 a systematic and ethical process for gathering and analyzing information about the
competition’s activities and general business trends to further a business’s own
goals

The three basic objectives of a CI program are:

1. to provide a general understanding of an industry and its competitors

2. to identify areas in which competitors are vulnerable and to assess the impact strategic
actions would have on competitors

3. to identify potential moves that a competitor might make that would endanger a firm’s
position in the market

The Five-Forces Model of Competition

The Five-Forces Model of Competition

1. Identify key aspects or elements of each competitive force that impact the firm.

2. Evaluate how strong and important each element is for the firm.

3. Decide whether the collective strength of the elements is worth the firm entering or
staying in the industry.

Industry Analysis: The External Factor Evaluation (EFE) Matrix

-Economic - Political

-Social -Governmental
-Cultural -Technological
-Demographic - Competitive
-Environmental - Legal

EFE Matrix Steps

1. List key external factors
2. Weight from 0(Not important) to 1(very important)
3. Rate effectiveness of current strategies (1-4)
4. Multiply weight * rating (= Weighted Score)
5. Sum weighted scores

4= the response is superior, 3 = the response is above average,

2 = the response is average, and 1 = the response is poor.

EFE Matrix for a Local Ten-Theater Cinema Complex

Industry Analysis: Competitive Profile Matrix (CPM)

 Identifies firm’s major competitors and their strengths & weaknesses in relation to a
sample firm’s strategic positions
 Critical success factors include internal and external issues
An Example Competitive Profile Matrix