Strategy

Week 2: The External Environment

business.ulster.ac.uk
 Strategic Position
• How to analyse an organisation’s
position in the external
environment.
• How to analyse the determinants of
strategic capability (internal)–
resources, competences and the
linkages between them.
• How to understand an
organisation’s purposes, taking
into account corporate
governance, stakeholder
expectations and business ethics.
Format
• Analyse the broad macro-environment of
organisations in terms of political, economic, social,
technological, environmental (‘green’) and legal
factors (PESTEL).
• Identify key drivers in this macro-environment and
use these…
• To construct alternative scenarios in order to address
possible environmental changes.
• Use Porter’s Five Forces analysis in order to define
the attractiveness of industries and markets and to
identify their potential for change.
The External Environment

• Understanding the competitive

environment is an essential part of
strategic management
The External Environment
• Why?
1. To identify opportunities & threats
2. To anticipate/influence environmental change
3. To improve quality of decision-making & overall
organisational performance
4. To inform current/future strategy

Porter – if you don’t understand the environment,

your strategy is very unlikely to succeed
Analysing the general environment

PESTEL

Identify

Key drivers
for change

Construct

Scenarios
Layers of the Business Environment

PESTEL

5 FORCES
The PESTEL Framework

• The PESTEL framework categorises environmental

influences into six main types:
Political Economic
Social Technological
Environmental Legal

• PESTEL provides a comprehensive list of

influences on the possible success/failure
of particular strategies.
PESTEL Factors (1)
• Political Factors: Role of the state, e.g. Government policies,
taxation changes, foreign trade regulations, political risk in
foreign markets, changes in trade blocks (EU).

• Economic Factors: Macroeconomic policies, e.g. business

cycles, interest rates, personal disposable income, exchange
rates, unemployment rates, GDP trends.

• Socio-cultural Factors: Including changing cultures and

demographics. Examples are the ageing population in Western
societies, income distribution, lifestyle changes, consumerism,
changes in culture and fashion.
PESTEL Factors (2)
• Technological Factors: New discoveries and
technology developments, e.g. developments on the
internet, nano-technology or the rise of new composite
materials.
• Environmental Factors: ‘Green’ environmental issues,
such as pollution waste and climate change,
environmental protection regulations, energy problems,
global warming, waste disposal and re-cycling.
• Legal Factors: Legislative and regulatory constraints or
changes. Examples are IPR, competition law, health and
safety law, employment law, liberalisation of trade law.
Example
Examples

http://www.bbc.co.uk/news/business-36438767
What does that tell us?
• Things change:
– “It is change, continuing change, inevitable change, that
is the dominant factor in our society today”
(Isaac Asimov, 1978)
• Relative importance of factors change over time –
why?
• The impact on the business can be positive or
negative (opportunity/threat)
• Guides strategy/strategic development
Using the PESTEL framework

• Apply selectively – identify specific factors which

impact on the industry, market and organisation in
question.
• Identify factors which are important currently but also
consider which will become more important in the
next few years.
• Use data to support the points and analyse trends
using up to date information.
• Identify opportunities and threats – the main point of
PESTEL.
PESTEL – some critique

• Helps to examine the environmental forces impacting

on the organisation, now and in the future
• PESTEL is not a ‘formula’, just a useful checklist – it
is wise to be selective
• Only as good as the individuals preparing it
• “PESTEL is purely a reminder list and should be
used selectively” (Lynch, 2015)
PESTEL – exercise

• Think of industries which have been impacted by

each of the PESTEL forces over time
• What has driven these changes?
• What does this tell us of the importance of PESTEL
analysis?
PESTEL – Exercise examples
• Books
• Music
• Newspapers
• Supermarkets
• Banking/financial services
• Tobacco
• Alcohol
• Airlines (booking)
• Confidential shredding
• Recycling
Key drivers of change

• The environmental factors likely to have a high

impact on the success or failure of strategy.
• Typically key drivers vary by industry or market.
• For example, retailers are concerned with social
changes and customer behaviour which have
driven a move to ‘out of town’ shopping. Personal
disposable income also drives demand for
retailers.
• Without clear sense of key drivers managers cannot
make most effective decisions
Key Drivers – Oil

What are the key drivers for the oil

industry?
Key Drivers – Oil

BP has announced its annual underlying

profits have fallen by 51% to $5.9bn (£4.1bn),
compared with $12.1bn in 2014.
http://www.bbc.co.uk/news/business-35469380

"We are continuing to move rapidly to

adapt and rebalance BP for the changing
environment," Bob Dudley (Chief Exec)
http://www.bbc.co.uk/news/business-35469383
Key Drivers – Oil
Key drivers – Oil

• Economic – oil prices ($30)

• Environmental – crises/disasters
(financial/reputational)
• Legal – ban on tendering – link to
economic
• Social – links to environmental
(‘greener’); alternative sources of fuel
• Threats or opportunities
Scenarios
Scenarios are plausible views of how the environment of
an organisation might develop in the future based on key
drivers of change about which there is a high level of
uncertainty.
• Build on PESTEL analysis and drivers of change.
• Offer more than a single view. An organisation will
typically develop a few alternative scenarios (2–4) to
explore and evaluate future strategic options.
• Scenario analysis is used in industries with long
planning horizons, for example the oil industry or
airlines industry.
Carrying out scenario analysis (1)

• Identify the most relevant scope of the study – the

relevant product/market and time span.
• Identify key drivers of change – PESTEL factors which
will have the most impact in the future but which have
uncertain outcomes and are mutually independent.
• For each key driver select opposing outcomes where
each leads to very different consequences.
Carrying out scenario analysis (2)

• Develop scenario ‘stories’. That is, coherent and

plausible descriptions of the environment that result from
opposing outcomes.
• Identify the impact of each scenario on the
organisation and evaluate future strategies in the light of
the anticipated scenarios.
• Establish early warning systems. Identify indicators
that might give an early warning of the way the
environment is changing and monitor such indicators.
Industries & sector analysis

• Necessary to conduct analysis at an industry/

sector level to determine how to cope with
competition & use to develop competitive
advantage
• How?
– Porter’s Five Forces*

* - Porter, M.E. (2008) The Five Competitive Forces that Shape

Strategy, Harvard Business Review, Vol. 86, Iss. 1, pp. 78-93.
Assessing Industry Attractiveness:
Porter’s Five Forces Framework (1980,
2008)
Porter’s five forces framework helps identify the
attractiveness of an industry in terms of five
competitive forces:
• the threat of entry,
• the threat of substitutes,
• the bargaining power of buyers,
• the bargaining power of suppliers and
• the extent of rivalry between competitors.
The five forces constitute an industry’s ‘structure’.
The Five Forces framework (Porter)

Source: Adapted from Competitive Strategy: Techniques for Analyzing Industries and
Competitors The Free Press by Michael E. Porter, copyright © 1980, by The Free Press.
All rights reserved.
The Five Forces Framework (Porter)

• Used to assess the attractiveness (&

profitability/profit potential) of different
industries/sectors
• Helps understand the strength of competitive
forces in a given industry/sector
• How organisation needs to form strategy to
develop opportunities in environment & protect
itself against competition & threats
• Where five forces are high – industries/ sectors
not attractive to compete in
The Threat of Entry
• Barriers to entry are the factors that need to be
overcome by new entrants if they are to compete.
• The threat of entry is low when the barriers to entry are
high and vice versa.
• The main barriers to entry are:
 Economies of scale/high fixed costs
 Experience and learning
 Access to supply and distribution channels
 Differentiation and market penetration costs
 Legislation or government restrictions (e.g. licensing)
 Expected retaliation from incumbents.
Threat of potential new entrants

• New entrants come into marketplace when:

– Profit margins are attractive
– Barriers to entry are low
• Threat of entry puts cap on profit potential of an
industry.
• When threat is high, incumbents must hold
down their prices or boost investment to deter
new competitors.
Threat of Substitutes
• Substitutes are products or services that offer a similar benefit to an
industry’s products or services, but are from outside the industry.

Customers will switch to alternatives (and thus the threat increases) if:
• The price/performance ratio of the substitute is superior (e.g.
Aluminium is more expensive than steel but it is more cost efficient for
car parts) Any others?
• The substitute benefits from an innovation that improves customer
satisfaction (e.g. high speed trains can be quicker than airlines from
city centre to city centre on short haul routes).
• The buyer’s cost of switching to the substitute is low
– e.g. Switching costs from a branded to a generic drug are minimal,
so shift to generics (& fall in price) is substantial & rapid
• e.g skype v. long distance calls; f2f meeting v videoconferencing
Threat of Substitutes
• More threats of substitution there are, the less
attractive the industry is likely to be
• When the threat of substitutes is high, industry
profitability suffers
• “Substitute products or services limit an industry’s
profit potential by placing a ceiling on prices. If an
industry does not distance itself from substitutes
through product performance, marketing, or other
means, it will suffer in terms of profitability – and
often growth potential.” (Porter, 2008)
The bargaining power of buyers

• Powerful buyers/customers can capture more

value by:
– forcing down prices;
– demanding better quality or more service
(thereby driving up costs); and
– generally playing industry participants off
against one another…
• All at the expense of industry profitability
 The bargaining power of buyers
• Buyers are the organisation’s immediate customers,
not necessarily the ultimate consumers.
• If buyers are powerful, then they can demand cheap
prices or product/service improvements to reduce
profits.
• Buyer power is likely to be high when:
• Buyers are concentrated
• Buyers have low switching costs
• Buyers can supply their own inputs (backward vertical
integration) - e.g. TESCO – high buying power has become
major source of pressure for companies supplying them
The bargaining power of buyers

• “Buyers are powerful if they have negotiating

leverage relative to industry participants,
especially if they are price sensitive, using their
clout primarily to pressure price reductions.”
(Porter, 2008)
The bargaining power of suppliers
• Suppliers are those who supply what organisations
need to produce the product or service. Powerful
suppliers can reduce an organisation’s profits. (e.g.
Microsoft eroded profitability among PC makers by
raising prices on operating systems. Difficult for PC
manufacturers to pass on.)
• Supplier power is likely to be high when:
• The suppliers are concentrated (few of them)
• Suppliers provide a specialist or rare input
• Switching costs are high (it is disruptive or expensive to
change suppliers – e.g. MS OS)
• Suppliers can integrate forwards (e.g. low-cost airlines have
cut out the use of travel agents).
Rivalry between existing competitors
• Competitive rivals are organisations with similar
products and services aimed at the same customer
group and are direct competitors in the same
industry/market (distinct from substitutes) – EGS?
The degree of rivalry increases when:
 Competitors are of roughly equal size
 Competitors are aggressive in seeking leadership
 The market is mature or declining
 There are high fixed costs
 The exit barriers are high
 There is a low level of differentiation.
The extent of competitive rivalry

• Rivalry among existing competitors takes many

forms:
– price discounting,
– new product introductions,
– advertising campaigns, and
– service improvements.
• High rivalry limits the profitability of an
industry
A word from Porter himself…

• http://www.youtube.com/watch?v=mYF2_FBCvXw
Implications of Five Forces analysis

• Which industries/markets to enter or leave – it helps

identify the attractiveness of industries.
• What influence can be exerted? Identifies strategies
that can influence the impact of the five forces. E.g.
building barriers to entry by becoming more vertically
integrated.
• The forces may have a different impact on different
organisations. e.g. large firms can deal with barriers to
entry more easily than small firms.
Issues in Five Forces analysis
• Defining the ‘right’ industry – Applying the model at the
most appropriate level – not necessarily the whole industry.
E.g. the European low-cost airline industry rather than
airlines globally.
• Converging industries – particularly in the high tech
arenas – where industries overlap (e.g. digital industries –
mobile phones/cameras/mp3 players).
• Complementary organisations – which enhance the
attractiveness of a business to customers or suppliers.
Microsoft Windows and McAfee computer security systems
are complementors. This can almost be considered as a
sixth force.
Critique of the Five Forces Model
(Advantages) 1
• Reveals the most significant aspects of the
competitive environment.
• Understand attractive/unattractive industry sectors
• Provides a baseline for sizing up a company’s
strengths and weaknesses: Where does the
company stand versus buyers, suppliers, entrants,
rivals, and substitutes?
Critique of the Five Forces Model
(Advantages) 2
• Understanding of industry structure guides
managers toward possibilities for strategic action,
such as:
– positioning the company to better cope with
the current competitive forces;
– anticipating and exploiting shifts in the forces;
and
– shaping the balance of forces to create a new
industry structure that is more favorable to the
company.
Critique of the Five Forces Model
(Limitations) 1
• Analytical framework is static; not so in practice
• Assumes organisation’s own interests come first
(charities, public sector?)
• Assumes buyers (customers) have no greater
importance than any other aspect – questionable
Critique of the Five Forces Model
(Limitations) 2
• Starting point is that the environment (suppliers and
buyers) poses a threat to the organisation; but
some companies have found it useful to have closer
cooperation with suppliers
• Ignores human resource aspects of strategy
(country culture, management skills)
• Assumes prescriptive rather than emergent strategy
The industry life cycle
• Power of five forces varies with stages of the industry
life cycle
In summary…
• Understanding the competitive external
environment is essential for organisations from
a strategy perspective
• Why?
1. Identifying opportunities & threats (actual, current &
potential, future)
2. Anticipate/influence environmental change
3. Improves quality of decision-making
4. Helps identify attractiveness/profitability of industries
But…
• The firm must also consider its internal
capabilities in relation to opportunities/
threats in the external environment
Reading

• Ghemawat, P. (2010) Strategy and the Business

Landscape, 3rd Edition, Boston: Pearson, Chapter 2.
• Johnson, G., Whittington, R., Scholes, K., Angwin, D. and
Regnér, P. (2014) Exploring Strategy: Text and Cases,
10th Edition, Harlow: Pearson Education, Chapter 2.
• Lynch, R.L. (2009) Corporate Strategy, 5th Edition,
Harlow, Financial Times Prentice Hall, Chapter 2.
• Porter, M.E. (2008) The Five Competitive Forces that
Shape Strategy, Harvard Business Review, Vol. 86, Iss. 1,
pp. 78-93.