Chapter Three

External Environmental Analysis

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 Introduction

 Understanding the environment that surrounds an

organization is important because:
1. it provides resources that an organization needs in order to
create goods and services.

2. it is a source of opportunities and threats to an

organization.

3. it shapes the various strategic decisions that executives

make as they attempt to lead their organizations to success.

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 Environment is:
o Complex: The environment consists of a number of factors, events,
conditions, and influences arising from different sources.
 All these do not exist in isolation, but interact with each other to
create entirely new sets of influences.
o Dynamic: The environment is constantly changing in nature.

 Due to the many and varied influence operating, there is dynamism

in the environment, causing it to change its shape and character
continuously.
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o Multifaceted: What shape and character an environment will
assume depends on the perception of the observer.

 A particular change in the environment, or a new development,

may be viewed differently by different observers.

 A far-reaching impact: An occurrence in the environment now

may have an impact that will stay for a long time.

 The growth and profitability of an organization depend critically

on the environment in which it exists.

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 The Nature of External Audit
 The purpose of an external audit is:
◦ To develop a finite list of opportunities that could benefit a firm
and Threats that should be minimized.
◦ As the term finite suggests, the external audit is not aimed

at developing an exhaustive list of every possible factor

that could influence the business; rather, it is aimed at
identifying key variables that offer actionable responses.
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 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.

 Most firms face external environments that are highly turbulent,

complex, and global conditions that make interpreting them increasingly
difficult.

 To cope with what are often ambiguous and incomplete environmental

data and to increase their understanding of the general environment,
firms engage in a process called external environmental analysis.

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 Components of the External Environment Analysis
A. Scanning

 Identifying early signals of environmental changes and trends.

 Scanning entails the study of all segments in the general environment.

 Environmental scanning is critically important for firms competing in

highly volatile environments.

 In addition, scanning activities must be aligned with the

organizational context; a scanning system designed for a volatile
environment is inappropriate for a firm in a stable environment.

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B. Monitoring

o When monitoring, analysts observe environmental changes to

see if an important trend is emerging from among those spotted by
scanning.

o Critical to successful monitoring is the firm’s ability to detect

meaning in different environmental events and trends.

o By monitoring trends, firms can be prepared to introduce new goods

and services at the appropriate time to take advantage of the
opportunities identified trends provides.
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C. Forecasting
o Developing projections of anticipated outcomes based on

monitored changes and trends.

o Scanning and monitoring is concerned with events and trends in

the general environment at a point in time.

o 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.

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D. Assessing

 The objective of assessing is to determine the timing and

significance of the effects of environmental changes and trends in
the strategic management of the firm.

 Through scanning, monitoring, and forecasting, analysts are able

to understand the general environment.

 Going a step further, the intent of the assessment is to specify the

implications of that understanding for the organization.

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 The Process of Performing an External Audit
 The process of performing an external audit must involve

as many managers and employees as possible.

 Individuals appreciate having the opportunity to contribute

ideas and to gain a better understanding of their firms’
industry, competitors, and markets.

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 To perform an external audit companies may follow the ff. steps:

1. Gather competitive intelligence and information:

 A company gathers competitive intelligence and information about

economic, social, cultural, demographic, environmental, political,
governmental, legal, and technological trends.

 Individuals can be asked to monitor various sources of information,

such as key magazines, trade journals, and newspapers.

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 2. Assimilation and evaluation:

 Once information is gathered, it should be assimilated and evaluated.

 A meeting or series of meetings of managers is needed to collectively

identify the most important opportunities and threats facing the firm.

 A prioritized list of these factors could be obtained by requesting that

all managers rank the factors identified, from the most important
opportunity/threat to the least important opportunity/threat.

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 These key external factors should be:

(a) Important to achieving long-term and annual objectives

(b) Measurable

(c) Applicable to all competing firms

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

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 3. Communicate and distribute key external factors:

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

communicated and distributed widely in the organization.

 Both opportunities and threats can be key external factors.

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 Analysis of Key External Factors

 Firm’s external environment is divided into three major areas:

I. General external factors

II. Industry analysis

III. Competitive Forces/Competitor’s analysis

 An important objective of studying the external environment is

identifying opportunities and threats.

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 sdx

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 I. General External Factors
 The general environment is composed of dimensions in the broader
society that influence an industry and the firms within it.

 Its aim is to identify opportunities and threats. An opportunity is a

condition in the general environment that, if exploited, helps a
company achieves strategic competitiveness.

 Firms cannot directly control the general environment’s segments and

elements.


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 Segments of the general environment

 The general environment is composed of segments that are

external to the firm.

 Although the degree of impact varies, these environmental

segments affect each industry and its firms.

 These efforts should result in recognition of environmental

changes, trends, opportunities, and threats. It is PESTEL analysis.

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 1. Political segment
The political segment centers on the role of governments in
shaping business.

This segment includes elements: tax policies, changes in

trade restrictions and tariffs, the stability of governments and
immigration policy.

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 2. The Economic Segment
o The economic environment refers to the nature and direction of
the economy in which a firm competes or may compete.

o Because nations are interconnected as a result of the global

economy, firms must scan, monitor, forecast, and assess the health
of economies outside their host nation.

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o It includes elements such as:

 Interest rates, inflation rates, gross domestic product,

unemployment rates, levels of disposable income, trade deficits
or surpluses, monetary policies, fiscal policies the general
growth or decline of the economy.
 Rising unemployment discouraged consumers from purchasing
expensive, nonessential goods: automobiles and television sets.

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 3. Socio-cultural segment
 Factors related to human relationship within a society; the

development, forms and functions of such a relationship; and the

learnt and shared behavior of groups of human beings, which have

a bearing on the business of an organization.

 Demographic characteristics includes population size, ethnic

mix, age structure, income distribution, geographic distribution.

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 Socio-cultural attitudes and values: social customs, beliefs,
rituals and practices, changing lifestyle patterns and materialism;
women in the workforce, concerns about the environment,
workforce diversity, shifts in work and career preferences,
attitudes about the quality and shifts in preferences regarding
product and service characteristics

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 4. Technological segment
 Factors related to the knowledge applied and the materials
and machines used in the production of goods and services,
which have an impact on the business of an organization.

 Includes changes in the rate of new product development,

increases in automation, product innovations, focus of private
and government, applications of knowledge, advancements in
service industry delivery.

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 The Internet has changed the 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, and changing the
historical trade-off between production standardization and
flexibility.

 The Internet has lowered entry barriers and redefined the

relationship between industries and various suppliers, creditors,
customers, and competitors.

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 5. Environmental segment
 Involves the physical conditions within which organizations operate.
It includes factors: natural disasters, pollution levels, weather patterns,
climate change.

 Changes in temperature can affect many industries including farming,

tourism and insurance.

 With major climate changes, occurring due to global warming and

with greater environmental awareness this external factor is becoming a
significant issue for firms to consider.

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 6. Legal segment
 Business Organizations prefer to operate in a country where there
is a sound legal system.

 Examples of important legal factors include employment laws;

health and safety regulations, discrimination laws, antitrust laws.

 Intellectual property rights are a particularly daunting aspect of

the legal segment for many organizations.

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 II. Industry analysis
 An industry is a group of firms producing products that are close
substitutes: soft drinks or financial services.

 Industry analysis refers to an in-depth examination of key factors

within a corporation’s task environment.

 In the course of competition, these firms influence one another.

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The Porter’s “Five-Forces” competition Model: A key
Analytical Tool

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 a. The Threat of New Entrants to the Industry
 A new entrant into industry represents a competitive threat to
existing firms.

 It adds new production capacity and potential to erode the market

share of the existing industry.

 Existing (established) organizations try to discourage potential

competitors from entering, since the more organizations enter in to
an industry, the more difficult it becomes for established
organizations to hold their share of the market and to generate
success.
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 The principal sources of barriers to entry are:

 Economies of scale are derived from incremental efficiency

improvements through experience, as a firm gets larger.

o Therefore, as the quantity of a product produced during a given

period increases the cost of manufacturing each unit declines.

o Economies of scale can be developed in most business

functions… Increasing economies of scale enhances a firm’s

flexibility.

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 Product Differentiation: Over time, customers may come to
believe that a firm’s product is unique.

o Customers valuing a product’s uniqueness tend to become loyal

to both the product and the company producing it.

 Capital Requirements: Competing in a new industry requires a

firm to have resources to invest.

o In addition to physical facilities, capital is needed for

inventories, marketing activities, and other critical business
functions.
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o Switching Costs: Switching costs are the one-time costs
customers incur when they buy from a different supplier.

o For example, a decision made by manufacturers to produce a

new, innovative product creates high switching costs for the final
consumer.

o If switching costs are high, a new entrant must offer either a

substantially lower price or a much better product to attract
buyers.

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o Usually, the more established the relationship between parties,
the greater is the cost incurred to switch to an alternative offering.

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 Access to Distribution Channels: Over time, industry
participants typically develop effective means of distributing
products.

o Once a relationship with its distributors has been developed, a

firm will nurture it to create switching costs for the distributors.

o Access to distribution channels can be a strong entry barrier

for new entrants, particularly in consumer nondurable goods
industries (for example, in grocery stores where shelf space is
limited) and in international markets.
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o New entrants have to persuade distributors to carry their
products, either in addition to or in place of those currently
distributed.

o Price breaks and cooperative advertising allowances may be

used for this purpose; however, those practices reduce the new
entrant’s profit potential.

 Government Policy: Through licensing and permit

requirements, governments can also control entry into an industry.

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 Retaliation by established producer: Firms seeking to enter

an industry also anticipate the reactions of firms in the

industry.

o For example, any firm attempting to enter the auto industry

at the current time can expect significant retaliation from

existing competitors due to the overcapacity.

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B. Rivalry among Established/Existing Firms

An industry’s firms are mutually dependent, actions taken by

one company usually invite competitive responses.

Competitive rivalry intensifies when a firm is challenged by

a competitor’s actions or when a company recognizes an

opportunity to improve its market position.

 Price competition limits profitability by reducing the

margins that can be earned on sales.

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 Generally, the factors that tend to precipitate intense rivalries in
an industry are:
◦ Numerous or equally balanced competitors

◦ Rate of industry growth

◦ Lack of differentiation or low switching costs

◦ High Exit Barriers

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 c. The Bargaining Power of Buyers
 … refers to the ability of buyers to bargain down prices

charged by companies in the industry or to raise the costs of

companies in the industry by demanding better product
quality and service.

 To reduce their price, buyers bargain for higher quality,

greater levels of service, and lower prices.

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 Customers (buyer groups) are powerful when:

 They purchase a large portion of an industry’s total output.

 The sales of the product being purchased account for a

significant portion of the seller’s annual revenues.

 They could switch to another product at little, if any, cost.

 The industry’s products are undifferentiated or

standardized, and the buyers pose a credible threat if they

were to integrate backward into the sellers’ industry.

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 The sellers’ product is not critical in one way or another to the
buyer.

 When buyers can threaten to enter the industry and produce the
product themselves and thus supply their own needs, also a
tactic for forcing down industry prices.

 When the supply industry depends on the buyers for a large

percentage of its total orders.

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 D. The Bargaining Power of Suppliers
o The bargaining power of suppliers refers to the ability of
suppliers to raise input prices, or to raise the costs of the industry
in other ways for example, by providing poor quality inputs or
poor service.

o Thus, powerful suppliers are a threat.

o Alternatively, if suppliers are weak, companies in the industry

have the opportunity to force down input prices and demand
higher- quality inputs (e.g., more productive labor).
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 Suppliers are most powerful in the following situations:

 The product that suppliers sell has few substitutes and is vital to the

companies in an industry.

 The profitability of suppliers is not significantly affected by the purchases

of companies in a particular industry, in other words, when the industry is

not an important customer to the suppliers.

 Companies in an industry would experience significant switching

costs if they moved to the product of a different supplier because a

particular supplier’s products are unique or different.

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 Suppliers can threaten to enter their customers’ industry and use
their inputs to produce products that would compete directly
with those of companies already in the industry.

 Companies in the industry cannot threaten to enter their

suppliers’ industry and make their own inputs as a tactic for
lowering the price of inputs.

 Suppliers’ product is differentiated

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 E. The Threat of Substitute Products
 Substitutes are offerings that differ from the goods and
services provided by the competitors in an industry but that
fill similar needs to what the industry offer.

 How strong of a threat substitutes are depends on how

effective substitutes are in serving an industry’s customers.

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 For example, companies in the coffee industry compete indirectly
with those in the tea and soft drink industries because all three serve
customer needs for nonalcoholic drinks.

 The existence of close substitutes is a strong competitive threat

because this limits the price that companies in one industry can charge
for their product, and thus industry profitability.

 If the price of coffee rises too much relative to that of tea or soft
drinks, coffee drinkers may switch to those substitutes.

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 III. Competitive Forces/Competitor’s analysis
 Identifying rival firms and determining their strengths,
weaknesses, capabilities, opportunities, threats, objectives, and
strategies.

 Collecting and evaluating information on competitors is

essential for successful strategy formulation.

 Identifying major competitors is not always easy because many

firms have divisions that compete in different industries.
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 Seven characteristics describe the most competitive
companies:

1. Strive to continually increase market share.

2. Use the vision/mission as a guide for all decisions.

3. Realize that the old adage “if it’s not broke, don’t fix it” has
been replaced by “whether it’s broke or not, fix it;” in other words,
continually strive to improve everything about the firm

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4. Continually adapt, innovate, and improve – especially when the
firm is successful.

5. Strive to grow through acquisition whenever possible

6. Hire and retain the best employees and managers possible

7. Strive to stay cost-competitive on a global basis

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 Sources of External Information
 Unpublished sources include customer surveys, market research,
speeches at professional and shareholders’ meetings, television
programs, interviews, and conversations with stakeholders.

 Published sources of strategic information include periodicals,

journals, reports, government documents, abstracts, books, directories,
newspapers, and manuals.

 The Internet has made it easier for firms to gather, assimilate, and
evaluate information.

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 Forecasting tools and techniques
 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.

 No forecast is perfect, and some forecasts are even wildly

inaccurate.

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Forecasting tools can be broadly categorized into two groups:

1. Qualitative methods
 Expert opinion method

 Delphi method

 Brainstorming

2. Quantitative methods
 Time series analysis

 Causal Forecasting Methods

 Regression
 Correlation

 E.g. demand forecasting by using moving average

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 Attention!!
o Therefore, external environment auditing is the
second activity in strategic formulation!

o Needs great attention since it is beyond the control

of firms!

o Significantly affects organizations!

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 Thank you for your
attention!!!

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