CHAPTER 2

Analyzing the
External Environment
of the Firm:
Creating Competitive
Advantages

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 Enhancing Awareness of the External
Environment

-Managers add value when they have a sense of events

outside the company. By focusing on external events,
managers are able to stay a step ahead of competitors by
accurately anticipating and promptly responding to actions
that can impact the organization.
-CEOs awareness allows them to sense what’s coming.
Detecting early warning signals and keeping pace with
changes in the external environment, can sustain competitive
advantage.
-Managers become environmentally aware, by doing
scanning, monitoring, and gathering competitive intelligence.
These steps are used as inputs to develop forecasts.
-In addition , scenario planning and SWOT analysis can be
used to help anticipate major future changes in the external
environment.
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 Enhancing Awareness of the External Environment

Exhibit 2.1 Inputs to Forecasting

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 Environmental Scanning

-Environmental scanning involves observation

of a firm’s external environment(ex. obtaining
information from customers) to:
1. Predict environmental changes.
2. Detect changes already under way.
3. Allow a firm to be proactive.
-Environmental scanning alerts organization to
critical trends and events before changes develop
a distinct pattern and before competitors
recognize them. Otherwise, the firm may be
forced into a reactive mode.
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 Environmental Monitoring

-Environmental monitoring(intensive care) frames

the evolution of environmental trends, sequences of
events, or streams of activities. There may be trends
that the firm came across by accident or ones that were
brought to its attention from outside the organization.
- Environmental monitoring enables firms to evaluate
how dramatically environmental trends are changing the
competitive landscape.
-Ex. of indicators : Percentage of GDP spent on health
care, number of active hospital beds, the size and power
of purchasing agents ,all indicate the concentration of
buyers. Such indices are critical for in determining firm’s
strategic direction and resource allocation.
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 Competitive Intelligence

-Competitive intelligence defined as firm’s activities of:

1. Collecting and interpreting data on competitors.
2. Defining and understanding the industry.
3. Identifying competitors’ strength & weaknesses.
- If done properly, competitive intelligence helps a
company to avoid surprises by:-
1. Anticipating competitors’ moves.
2. Decreasing response time.
N.B: Aggressive efforts to gather competitive
intelligence may lead to unethical or illegal behaviors.

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 Environmental Forecasting

-Environmental forecasting purpose is to

predict change. It involves the development of
probable projections about the:
• Direction of environmental change.
• Scope of environmental change.
• Speed of environmental change.
• Intensity of environmental change.
- Environmental scanning, monitoring and
competitive intelligence are important inputs
for analyzing the external environment.
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 Scenario analysis

-Peter Schwartz defined scenarios as: “alternative,

reasonable, stories of how the world may develop. He
emphasised that the outcome is not an accurate forecast
of future events, but a deep understanding of the forces
that might push the future along different paths”. I.e.
bringing future-now.
-Scenarios are not future forecasts or predictions. The
end result is not an accurate picture of tomorrow, but
could help to take better decisions about the future.
-Scenario analysis and planning is a useful technique for
firms competing in industries characterized by
unpredictability and change.
-Forecasts and trends are only reliable in a relatively
stable environments.
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 SWOT Analysis

-To understand firm business environment, companies

need to analyze both the general environment and the
firm’s industry (direct) competitive environment.
- SWOT analysis is technique used for analyzing firm
and industry conditions. It provides a basic listing of
conditions both inside and surrounding a company.
A. Firm internal conditions = Strengths & Weaknesses ,
where the firm excels or where it may be lacking.
B. Environmental or external conditions = Opportunities
& Threats. These could be factors in either the general or
the competitive environment. 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
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 SWOT Analysis

- SWOT analysis advantages:

1. It forces managers to consider both internal and external
factors simultaneously.
2. Its emphasis on identifying opportunities and threats makes
firms act proactively rather than reactively.
3. It raises awareness about the role of strategy in creating a
match between the environmental conditions and the firm’s internal
strengths and weaknesses.
4. Its simplicity is achieved without sacrificing analytical
accuracy .
SWOT analysis limitations (disadvantages):
1. It is a static perspective.
2. Its potential to overemphasize a single dimension of a firm’s
strategy.
3. The likelihood that a firm’s strength do not necessarily help the
firm create
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 The Competitive Environment

-In addition to the general environment ( analyzed by

STEEP model), each firm must pay attention to its direct
competitive environment.
- The competitive environment (direct- industry)
consists of factors that are particularly relevant to a
firm’s strategy, namely:-
• Competitors (existing or potential) , including those
considering entry into an entirely new industry.
• Customers (or buyers).
• Suppliers , including those considering forward
integration.
-N.B: Forward integration, a form of vertical integration whereby a firm expands activities to
include control of the direct distribution of its products, e.g. a farmer sells his/her crops at
the local market rather than to a distribution center for eventual sale to a supermarket
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 Porter’s Five Forces Model of Industry Competition

-The “five forces” model developed by Michael E. Porter is an analytical tool for examining the
competitive environment (industry). It describes the industry 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.
-Each of above five forces affects firm’s ability to compete in a given market. Together, they
determine the profit potential for a particular industry. A manager should be familiar with the five
forces model for several reasons:-
1. It helps to decide whether the firm should remain in or exit an industry.
2. It provides the rationale for increasing or decreasing resource commitments.
3. It helps to assess how to improve firm’s competitive position with regard to each of the five
forces. For example, one can use the five forces model to understand how higher entry
barriers discourage new rivals from competing with you. Or one can see how to develop
strong relationships with distribution channels.
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 Porter’s Five Forces Model of Industry Competition

Exhibit 2.4 Porter’s Five Forces Model of Industry Competition

Source: From Michael E. Porter, “The Five Competitive Forces That Shape Strategy,” Special Issue on HBS Centennial.. Harvard Business
Review 86, No. 1 (January 2008), 78-93. Reprinted with permission of Michael E. Porter.
Jump to Appendix 1 for long description.
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 The Threat of New Entrants

-It 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(retaliation).
- 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. Six major sources of entry barriers.
1. 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. Both are undesirable options.
2. Product Differentiation: When existing competitors have strong brands and
customer loyalty. This creates a barrier to entry by forcing entrants to spend
heavily to overcome existing customer loyalties.
3. Capital Requirements: The need to invest large financial resources to
compete , especially if the capital is required for risky or unrecoverable up-front
advertising or research and development (R&D).
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 The Threat of New Entrants

4 Switching costs: A barrier to entry is created by the

existence of one-time costs that the buyer faces when
switching from one supplier to another.
5. Access to Distribution Channels: The new entrant’s
need to secure distribution for its product which could be
occupied by incumbents.
6. Cost Disadvantages Independent of Scale: 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 and favorable government policies.
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 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:
1. 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. Large-volume buyers also are powerful in industries with high
fixed costs (e.g., steel manufacturing).
2. 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, as in commodity products.
3. The buyer faces few switching costs. Switching costs lock the
buyerEducation.
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 The Bargaining Power of Buyers

4. It earns low profits. Low profits create incentives to

lower purchasing costs. On the other hand, highly
profitable buyers are generally less price-sensitive.
5. 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.
6. The industry’s product is unimportant to the
quality of the buyer’s products or services. When
the quality of the buyer’s products is not affected by the
industry’s product, the buyer is more price-sensitive.

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 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. A supplier group
will be powerful when:
1. 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.
2. The supplier group is not obliged to contend with
substitute products for sale to the industry. The power of even
large, powerful suppliers can be checked if they compete with
substitutes.
3. The industry is not an important customer of the supplier
group. When suppliers sell to several industries and a particular
industry
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Education.
 The Bargaining Power of Suppliers

4. 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.
5. The supplier group’s products are differentiated,
or it has built up switching costs for the
buyer. Differentiation or switching costs facing the
buyers cut off their options to play one supplier against
another.
6. 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
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The Threat of Substitute Products & 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 capture 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. 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
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 The Intensity of Rivalry among
Competitors in an Industry
- Firms use tactics like price competition, advertising, product introductions, and
increased customer service or warranties. Rivalry occurs when competitors sense the
pressure or act on an opportunity to improve their position.
-Some forms of competition, such as price competition, are highly destabilizing and
are likely to erode the average level of profitability in an industry. On the other hand,
advertising battles expand overall demand or enhance the level of product
differentiation for the benefit of all firms in the industry.
- In some industries, rivalry is characterized as warlike, harsh , or fierce , whereas in
other industries it is referred to as polite and gentlemanly. Intense rivalry is the result
of several interacting factors, including:-
1.Numerous or equally balanced competitors. When there are many firms in an
industry, the likelihood of mavericks (one of a kind) 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.
2.Slow industry growth. Slow industry growth turns competition into a fight for
market share, since firms seek to expand their sales.
3. 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.
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 The Intensity of Rivalry among
Competitors in an Industry
4. 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
5. Capacity augmented in large increments. Where economies
of scale require that capacity must be added in large increments,
capacity additions can be disruptive to the industry supply/demand
balance.
6. High exit barriers. Exit barriers are economic, strategic, and
emotional factors that keep firms in the industry 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
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