Amy's work on Chapter 2 External environment analysis: Assessment of opportunities and threats
2.1 Introduction
Every organization depends on linkages with its environment to get the human, financial, technical and material resources it needs. In recent years, "the environment" has taken on a specialised meaning: it involves 'green' issue and the positioning of our planet by human activity. These concerns also are a part of topic in this thesis, but the term 'environment' will be used in a much broader sense to describe everything and everyone who is beyond the industry and organisation in this chapter, it includes customers, competitors, suppliers, distributors, government and social institution. By definition the firm's external environment is composed of those elements that lie outside the firm but more or less influence the decisions the company's executive must make if they are to obtain long-term above average returns. In order to develop the future strategies, an organisation has to be familiar with the factors in the external environment that are likely to affect the organization. To do this, it is important that the organisations distinguish between two levels of environment: the general/macro-environment and the industry / microenvironment.
PESTL framework shows some of the general/macro-environment influences, which might affect organisations. It is not intended to provide an exhaustive list, but it gives examples of ways in which strategies are affected by such influences and some of ways in which organisations seek to handle aspects of their environment. (Fahey and Narayanan, 1986) It categorises environmental influences into six main types: political, economic, social, technological, environmental and legal. It provides a summery of some of the questions to ask about key forces at work in the general/macro-environment. In general, the macro-environment has no direct impact on the organization whilst certain events may influence how the organization changes over time. Because events or trends favourable or harmful to the organization may develop in the macro-environment, it is necessary to know how to identify them, either to take advantage of them or to try to counter them.
The micro/industry environment is the set of factors that directly influences an organization and its actions and responses (Hansel, et al, 2001). The term is concerned with all the external stakeholders such as partners, regulators and competitors etc., which are in direct contact with an organization. These players influence the actions of the organization. Some have a positive effect by creating demand or supplying resources, while others have a negative impact by imposing constraints upon the organisation or by being detrimental to the organisation's development.
Therefore, the organization's external environmental context is made up of all the conditions and factors external to the organizations, which can positively or negatively affect the life, orientations, structures, development and the future of the organizations.
In today's business world, the environmental conditions facing firms in the global economy differ from those firms faced previously. Technological changes and the explosion in information gathering and processing capabilities demand more timely and effective competitive actions and responses. (Fombrun, 1992) The rapid sociological changes occurring in many countries affect labour practices and the nature of products demanded by increasingly diverse consumers. Governmental policies and laws affect where and how firms choose to compete. (Ricks and Squeo, 1999) Deregulation and local government changes affect the general competitive environment, as well as the strategic decisions that will be made by organization competing internationally. All of these make the organisation's external context increasingly difficult to interpret. To cope with often incomplete and ambiguous contextual data, and to increase their understanding of the general external context, organizations engage in a process called 'external environmental analysis' (Hanson et al, 2001)
2.2 Process of external environmental analysis
The process is conducted on a continuous basis, including four activities: scanning, monitoring, forecasting and assessing (see Table 2.1). It is difficult, yet significant, activity to complete this analysis of the external environment.
Table 2.1 Process of the external environmental analysis
| Scanning | Identifying early signals of environmental changes and trends |
| Monitoring | Detecting meaning through ongoing observations of environmental changes and trends |
| Forecasting | Developing projections of anticipated outcomes based on monitored changes and trends |
| Assessing | Determining the timing and importance of environmental changes and trends for firms' strategies and their management |
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 (Elenkow, 1997). When scanning, the firm often deals with ambiguous, incomplete or unconnected data and information. Environmental scanning is critically important for firms competing in highly volatile environments (Hilmetz and Bridge, 1999). In addition, scanning activities must be aligned with the organisational context.
When monitoring, analysts observe environmental changes to see if an important trend is emerging from among those spotted by scanning (Aggarwal, 1999). Critical to successful monitoring is the ability to detect meaning in different environmental events. For example, a new law permitting shopping on Sunday for 'tourist items' was introduced in eastern Germany
Scanning and monitoring are concerned with events 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 (Fahey, 1999) 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.
The objective of assessing is to determine the timing and significance of the effects of environmental changes and trends on the strategic management of a firm (Fahey, 1999). Through scanning, monitoring and forecasting, analysts are able to understand the general environment. Going a step further, the intent of assessment is to specify the implications of that understanding for the organisation. Without assessment, the firm is left with data that are interesting, but of unknown competitive relevance. In the US Toyota
2.3 Function of external environment analysis
An important objective of studying the external environment is identifying opportunities and threats (Hanson et al, 2001). An opportunity is conditions in the external environment that may help an organisation achieve strategic competitiveness.
Opportunities arise when an organization can take advantage of conditions in its external environment to formulate and implement strategies that enable it to improve performance. A threat is a condition in the general environment that may hinder a company's efforts to achieve strategic competitiveness (Prior, 1999). Threats arise when conditions in the external environment endanger the integrity of the organization's activities
A number of models exist that can help managers in analysing the external environment. Such models provide a framework to identify external opportunities and threats. Among these models, the typical ones are PEST analysis relating to general environment analysis and Porter's Five Forces Model regarding industry environment analysis.
2.4 External environment
Before examining the models of industry environment analysis, it is necessary to have general understanding of the composition of the external environment. According to Hanson et al (2001), an organization's external environment has two major parts: 1) general /macro-environment and 2) Industry/Microenvironment. Figure 2.1 outlines the composition of the external environment.
Figure 2.1 the external environment
New entrants
Product/service substitutes
Industry environment
Technology Economic
General environment
Source: Hanson et al, (2001)
As demonstrated in figure 2.1, the general environment is composed of social, economic, political and technological elements in the broader society that can influence an industry and the organizations within it. The industry environment is the set of factors that directly influences an organization and its actions and responses. Managers have to analyse competitive forces in an industry's environment in order to identify the opportunities and threats confronting an organization. A popular framework for doing this is Michael Porter's 'five-forces' model. This model identifies five competitive forces that shape industry's profit potential: (1) the bargaining power of suppliers, (2) the threat of new entrants, (3) the threat of product substitutes, (4) the bargaining power of buyers and (5) the intensity of rivalry among established organizations within an industry (Porter, 1980)
2.5 General environment analysis: PEST analysis
The general environment is composed of elements in the broader society that can influence an industry and the organizations within it. These elements are grouped into four environmental segments. Examples of elements analysed in each of these segments are shown in table 2.1.
Table 2.2 the general environment: segments and elements
| Political/legal segment |
|
|
| Economic segment |
|
|
| Socio-cultural segment |
|
|
| Technological segment |
|
|
Source: Hanson et al, (2001)
The political/legal segment is the arena where organisations compete for attention, resources and a voice in overseeing the body of laws and regulations guiding the interactions among nations. Essentially, this segment represents how organisations try to influence government and how governments influence them. Constantly changing, the segment influences the nature of competition. In terms of this, organizations must carefully analyse a new administration's business-related policies and philosophies. Antitrust laws, taxation laws, industries chosen for deregulation, labour training laws and the degree of commitment to educational institutions are areas where an administration's policies can affect the operations and profitability of industries and individual firms.
The economic environment is concerned with the nature and direction of the economy where a firm competes or may compete. The health of a country's economy affects the performance of specific organizations and industries. Because of this, companies study the economic environment to identify changes, trends and their strategic implications. Owing to the interconnectedness among countries that is resulting from the global economy, organizations need to scan, monitor, forecast and assess the health of economies outside their host nation.
The socio-cultural segment refers to a society's attitudes and cultural values. Because attitudes and values form the cornerstone of a society, they often drive demographic, economic, political/legal and technological conditions and changes.
The technological segment includes the institutions and activities involved with creating new knowledge and translating that knowledge into new outputs, products, processes and materials. It is pervasive and diversified in scope that technological changes affect many parts of societies. Their effects occur primarily through new products, processes and materials.
The general environment is composed of segments that are external to the firm (see Table 2.1). Although the degree of impact varies, these environmental segments affect each industry and organizations within it. The challenge is to scan, monitor, forecast and assess those elements in each segment that are of the greatest importance. This process of analyzing the general environment is labeled as PEST analysis. The results of an external environmental analysis should recognise environmental changes, trends, opportunities and threats. Opportunities are then matched with a firm's core competencies. Through proper matches, the firm achieves strategic competitiveness and earns above-average returns.
In short, PEST analysis help the strategists to examine the macro-environmental factors affecting an industry, recognize the key factors affecting an industry's competitive environment and then identify strengthen and weakness, opportunities and threats in the industry as well. It is believed that the PEST analysis provides a useful starting point to any analysis of the external environment surrounding an industry.
2.6 Industry environment analysis: Five Force Model
An industry is a group of firms producing products that are close substitutes. In the course of competition, these firms influence one another (Hanson et al, 2001). Typically, industries include a rich mix of competitive strategies that companies use in pursuing strategic competitiveness and above-average returns. In part, these strategies are chosen because of the influence of the effects of an industry's characteristics (Brush, Bromiley and Hendrickx, 1999).
The industry environment is the set of factors such as the threat of new entrants, suppliers, buyers, product substitutes and the intensity of rivalry among competitors, which directly influences an organization and its competitive actions and responses. Generally the interactions among these five factors determine an industry's profit potential. The challenge is to locate a position within an industry where an organization can favourably influence those factors or where it can successfully defend against their influence. The greater a firm's capacity to favourably influence its industry environment, the greater is the likelihood that the firm will earn above-average returns.
In comparison to the general environment, the industry environment has a more direct effect on strategic competitiveness and above-average returns. The intensity of industry competition and an industry's profit potential are a function of five competitive forces: the threats posed by new entrants, suppliers, buyers, product substitutes, and the intensity of rivalry among competitors (see Figure 2.2).
Figure 2.2 the five forces model of competition
Source: Porter, 1980
2.6.1 Threat of new entrants
Evidence suggests that companies have always found it difficult to identify new competitors (McGahan, 1994). This is a pity that new entrants often have the potential to be quite threatening to incumbents. One reason new entrants pose such a threat is that they bring additional production capacity. If the demand for a good or service is not increasing, additional capacity holds consumers' costs down, resulting in less revenue and lower returns for an industry's organizations. New entrants often have substantial resources and a keen interest in getting a large market share. As a result, new competitors may force existing organizations to be more effective and efficient and to learn how to compete on new dimensions. The likelihood that organizations will enter an industry is a function of two factors: barriers to entry and the retaliation expected from current industry participants. Normally entry barriers exist when organizations find entry into a new industry difficult, or when they are at a competitive disadvantage entering a new industry.
2.6.2 Bargaining power of suppliers
Increasing prices and reducing the quality of products sold are potential means through which suppliers can exert power over firms competing within an industry. Unless an organization is able to recover cost increases through its pricing structure, its profitability is reduced by its suppliers' actions. A supplier group is powerful when:
- It is dominated by a few large companies and is more concentrated than the industry to which it sells;
- Satisfactory substitute products are not available to industry firms;
- Industry firms are not a significant customer for the supplier group;
- Suppliers' goods are critical to buyers' marketplace success;
- The effectiveness of suppliers' products has created high switching costs for industry firms; and
- Suppliers are a credible threat to integrate forward into the buyers' industry. Credibility is enhanced when suppliers have substantial resources and provide the industry's firms with a highly differentiated product.
(Source: Hanson et al, 2001, p62)
2.6.3 Bargaining power of buyers
Organizations seek to maximise the return on their invested capital. Buyers want to buy products at the lowest possible price, at which the industry earns the lowest acceptable rate of return on its invested capital. To reduce their costs, buyers bargain for higher quality, greater levels of service and lower prices. These outcomes are achieved by encouraging competitive battles among the industry's firms. Buyer groups are powerful when:
• They purchase a large portion of an industry's total output.
• The product being purchased from an industry accounts for a significant portion of the buyers' costs;
• They could switch to another product at little, if any, cost; and
• The industry's products are undifferentiated or standardised, and the buyers pose a credible threat if they were to integrate backward into the sellers' industry.
(Source: Hanson et al, 2001, p62)
2.6.4 Threat of substitute products
Substitute products are different goods or services from outside a given industry that perform similar or the same functions as a product that the industry produces. For example, as a sugar substitute, Nutrasweet places an upper limit on sugar manufacturers' prices (that is, Nutrasweet and sugar perform the same function, but with different characteristics). Other product substitutes include plastic containers rather than glass jars, paper bags in place of plastic bags, and tea substituted for coffee (Browder, 1997). Generally product substitutes are a strong threat to an organization when customers face few switching costs and when the substitute product's price is lower or its quality and performance capabilities are equal to or greater than those of the competing product. Differentiating a product along dimensions that customer's value reduces a substitute's attractiveness.
2.6.5 Intensity of rivalry among competitors
Because an industry's organizations are mutually dependent, actions taken by a company normally invite competitive retaliation. Therefore, in many industries organizations compete actively and vigorously when they pursue strategic competitiveness and above average returns. Competitive rivalry intensifies while an organization is challenged by a competitor's actions or when an opportunity to improve a market position is recognised. Visible dimensions on which rivalry is based include price, quality and innovation. Typically, organizations seek to differentiate their products from competitors' offerings in terms of dimensions that customer's value and where the organizations have a competitive advantage.
The above discussion demonstrates that the five forces model of competition expands the arena for competitive analysis. Historically, when studying the competitive environment, organizations concentrated on companies with which they competed directly. However, today competition is viewed as a grouping of alternative ways for customers to obtain the value they desire, instead of as a battle among direct competitors. This is particularly important, because in recent years industry boundaries have become blurred. For example, telecommunications companies now compete with broadcasters, software manufacturers also provide personal financial services and automobile manufacturers sell insurance and provide financing (Hanson et al, 2001).
In sum, the Five Force Model helps to investigate how the organization needs to form its strategy in order to effectively and efficiently develop opportunities in its environment and protect itself against competition and other threats. It is still an effective and efficient industry analysis method in spite of some critical comments.
2.7 conclusion
The firm's external environment is challenging and complex. The external environment has two major parts: (1) the general environment (elements in the broader society that affect industries and their firms); (2) the industry environment (factors that influence a firm, its competitive actions and responses and the industry's profit potential; the threats of entry, suppliers, buyers and product substitutes; and the intensity of rivalry among competitors). Because of the effect the external environment has on performance, organizations must develop the skills required to identify opportunities and threats existing in that environment. PEST analysis provides a start point in the analysis of the environment. In addition to this, the five forces model of competition includes characteristics that determine the industry's profit potential. By studying these forces, the firm finds a position in an industry whereby it can influence the forces in its favour or whereby it can isolate itself from the power of the forces to reduce its ability to earn above-average returns. In short, through effective external environment analysis, opportunities and threats in a specific industry can be identified which is vital for the development of all the industry's organizations.
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