STRATEGIC MANAGEMENT – LESSON 2

Assessing the external environment

Assessing the environment refers to external forces, conditions, situations, events, and relationships
over which the organization has little control. This analysis:

1. macroenvironment analysis;

2. competitive situation analysis.

Political and Legal Technological

Environment Environment
New
entrants

Suppliers Buyers
Rivalry
Power Power

Substitutes
Economic
Demographic Environment
Environment

Social
Environment

1. Macroenvironment

Within macroenvironment the following should be analyzed and conclusions be made:

• technological environment – scientific improvements, inventions, and the rate of technological

change in the industry

• political/legal – outcomes of elections, legislation, court judgments, decisions rendered by

various national and regional/local agencies, and the lobbying activities

• economic – GDP, short and long term interest rates, inflation, and value of the national currency

• social – traditions, values, societal trends, consumer psychology, and the public’s expectation of
business

• demographic – changing demographic trends, such as the aging of the population, population
moves, and so forth
 Industry life-cycle

One popular hypothesis about how industries change is that they often go through observable
evolutionary phases or life-cycle stages like products. The sequence of stages is usually: emerging
and development, growth, shake-out and consolidation, maturity, saturation and decline.

Whether industries will actually evolve in orderly sequence according to the life-cycle hypothesis is
debatable. Many do, but some do not. There are cases where industries have skipped maturity,
passing from rapid growth to decline very quickly. Sometimes growth reoccurs after a period of
decline (this occurred in the radio broadcasting, bicycle, and motorcycle industries). Sometimes the
paths of different industries collide, causing them to reform and merge as one industry (this is now
occurring among banks, savings and loan associations, and brokerage firms, which were in
distinctly separate industries but are now reforming into a single financial services industry). And
sometimes the growth phase of the cycle can be lengthened by product innovation. Because of these
facets, it is difficult to predict when the “usual” cycle pattern will hold, when it will not, and how
long the phases will last.

Hence, while it is worthwhile to diagnose where an industry is in the life cycle, it is equally fruitful
to identify what forces are at work causing important changes in the industry landscape. The most
dominant of these forces are called driving forces. These forces could be:

• Long-term industry growth rate;

• Changes the types of buyers and in the usage of the products;
• Product innovation;
• Process innovation;
• Marketing innovation;
• Entry or exit of major firms;
• Diffusion of proprietary knowledge;
• Changes in cost and efficiency;
• Regulatory influences and government policy changes.
 Stage Development Growth Shake-out & Consolidation Maturity Saturation Decline

Factor

Sales Moderate growth Rapid growth Moderate growth Attain maximum levels Decline Decrease rapidly

Competition Slight Increases Very fierce; start consolidation Very fierce with strong and Fierce Slow down
through mergers and acquisitions stable competitors

Innovations Frequent Continue at a slow Mostly in services maintenance and Mostly in marketing Appear niches No efforts paid
path repairs

Costs High Moderate Start declining as a result of scale Decrease as a result of Stable or slightly Steady
economies moving ahead on learning decrease
curves

Profits Small or even Constant growth Attain maximum level Continue to decrease Start to decrease Decrease rapidly
losses

Entry/exit Few Start to intensify Many Stabilize Stabilize Little

barriers

Prices High Start to decrease Decrease Decrease; start the price war Continue to be Relatively constant;
reduced for gaining could be slightly
market share increase if
competition weakened
 Drawing conclusions about industry attractiveness

While all of the foregoing analysis serves to deepen understanding of the industry environment, its
most important purpose is to develop reasoned conclusions about the relative attractiveness of the
overall industry environment, both short term and tong term. The factors to be especially alert for in
determining industry attractiveness are:

• Market size, growth potential, stage in the life cycle. Is the field of participants overcrowded? Is
a shake-out coming’? Is the industry dominated by a few very strong firms?

• Regulatory, political, societal, and environmental considerations.

• Technology and innovation factors (patents, proprietary know-how, the pace of innovation).

• Whether the industry will be favorably or unfavorably impacted by the prevailing driving
forces.

• Potential for the entry or exit of major firms (Low barriers to entry reduce attractiveness to
existing firms; the exit of a major firm or several weak firms opens more room for remaining
firms.)

• How favorable the industry’s price-cost-profit economics are.

• Capital requirements. (The larger the capital requirements the less attractive the industry, at least
to capital-short firms or risk-averse firms—unless, of course, the payback period is short and
profit prospects are high.)

• The stability/dependability of demand (as affected by seasonality, the business cycle, the
volatility of consumer preferences, inroads from substitutes, and the like).

• The severity of the problems or issues confronting the industry; the degrees of risk and
uncertainty; the industry’s overall prospects for prosperity and profitability.

• Whether competition is more or less intense than is “normal” in competitive markets.

• Industrywide opportunities and threats.

Aside from these general industry considerations, it is important to realize that an industry which is
relatively unattractive overall can still be very attractive to a particular firm, especially one that is
already favorably situated in the industry. Appraising industry attractiveness from the standpoint of
a particular firm means looking at the following additional aspects:

• The firm’s position in the industry (being the recognized leader in an otherwise lackluster
industry can still produce good profitability).

• The firm’s competitive strength and ability to capitalize on the vulnerabilities of weaker rivals.

• Whether continued participation in this industry adds importantly to the firm’s ability to be
successful in its other business activities.

• Whether the firm is at least partially insulated from, or else able to defend against, the factors
that make the industry as a whole unattractive.

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2. Competitive situation analysis

Even though each industry has its own particular set of competitive characteristics and “rules of the
game”, there are enough similarities in the nature of competitive forces from market to market to
allow for the use of a common analytical framework.

The following model of the competitive forces in the marketplace, which is represented by the
elements within the oval of the figure above, was developed by Professor Michael E. Porter of the
Harvard Business School and is known as “the Porter five forces model”.

• Rivalry

The center of the competitive arena is nearly always dominated by the competitive maneuvering of
rival firms. The vigor with which sellers jockey for a stronger market position and a competitive
edge over rivals is a solid indicator of the pulse of competition.

While many factors influence the strength of rivalry between firms, certain ones seem to crop up
again and again, therefore competition is intense if:

a) Competitors are many or competitors are few and equally balanced in size and capability. Up to
some point, the greater the number of competitors the greater the probability for fresh, creative
strategic initiatives; in addition, greater numbers reduce the effects of any one rival’s actions on
the others, thereby lessening somewhat the probability of direct retaliation. When rivals are
more equal in size and capability, the chances are better that they will compete on a fairly even
footing; this feature makes it harder for one or two firms to “win” the competitive battle and
then dominate the market on more or less their own terms.

b) Industry growth is slowly. In a rapidly expanding market, there tends to be enough business to
support growth in all competing firms; indeed, it may take all of a firm’s financial and
managerial resources just to keep abreast of the growth in buyer demand (much less devoting
efforts to steal the customers of rivals). But when growth slows, expansion-minded firms and/or
firms with excess capacity usually initiate price cuts and thereby ignite a battle for market share
that often results in a shake-out of the weak and less efficient firms. The industry “consolidates”
to a smaller, but individually stronger, group of sellers; anytime market share is a key driver of
profitability (and maybe even survival) some firms will initiate fresh strategic moves aimed at
taking customers away from rivals.

c) Fixed costs are high. Whenever fixed costs are high and marginal costs are low, firms are under
strong economic pressure to produce at or very near full capacity; hence, if market demand
weakens and capacity utilization declines, rival firms frequently resort to secret price
concessions, special discounts, rebates, and other sales-increasing tactics. A similar situation
arises when a product is perishable, seasonal, costly, or difficult to store or hold in inventory.

d) Products or services lack differentiation and there are no switching costs. Product
differentiation per se is not a restraint to competition; indeed, it can vitalize rivalry by forcing
firms to seek creative new ways of improving their price-quality-service-performance offering;
the strategic moves of one firm to differentiate its product may well result in important
countermoves from rivals. However, when rivals’ products are so strongly differentiated that
customers are locked in by the high costs of switching over to a rival brand, competition is
weaker because sellers are more insulated from attack on their customers.

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e) The payoff from a successful strategic move is high. The greater the potential reward, the more
likely some firm will give in to the temptation of a particular strategic move; how big the
strategic payoff is varies partly with the speed of retaliation. When competitors can be expected
to respond slowly (or maybe even not at all), the initiator of a fresh competitive strategy can
reap the benefits in the intervening period and perhaps gain a first-mover advantage which is
riot easily surmounted. The greater the benefits of moving first, the more likely that some firm
will accept the risk of making the first move and the consequences of eventual retaliation.

f) Exit barriers are high. Rivalry tends to be more vigorous when it costs more to get out of a
business than to stay in and compete. The higher the exit barriers (and thus the more costly it is
to abandon a market), the stronger the incentive for firms to remain and compete as best they
can, even though they may be earning low profits or even incurring a loss.

g) Competitors are diverse. Rivalry becomes more volatile and unpredictable the more diverse
competitors are in terms of their strategies, personalities, corporate priorities, resources, and
countries of origin; a diverse range of views and approaches enhances the probability that one or
more firms will behave as “mavericks” and employ strategies that produce more competitive
interplay than would otherwise occur

h) Rivalry is increased when strong companies outside the industry acquire weak firms in the
industry and launch aggressive, well-funded moves to transform the newly acquired competitor
into a major market contender.

• The competitive force of potential new entrants

New entrants to a market bring new production capacity, the desire to establish a secure place in the
market, and sometimes substantial resources with which to compete. Just how serious the com-
petitive threat of entry is into a particular market depends on barriers to entry and the expected
reaction of firms to new entry. A barrier to entry exists whenever it is hard for a newcomer to break
into the market and/or if the economics of the business puts a potential entrant at a price/cost
disadvantage compared to its competitors.

The threat of entry is high if:

a) Companies within the industry do not operate with economies of scale. Scale-related barriers
may be encountered in advertising, marketing and distribution, financing, after-sale customer
service, raw materials purchasing, and R&D, as well as in production. The absence of scale
economies encourages entry because the potential entrant is not forced to enter the market on a
large-scale basis (a costly and perhaps risky move), or to accept a cost disadvantage (and lower
profitability). A large-scale entry could result in chronic overcapacity in the industry, and it
could threaten the market shares of existing firms that they are pushed into aggressive
competitive retaliation (in the form of price cuts, increased advertising and sales promotion, and
similar such steps) to maintain their position.

b) Learning and experience curve effects do not exist. The concept of learning and experience
curve effects has to do with the reduction in the unit cost with each doubling of cumulative
production experience. This production experience could be the result of: learning associated
with the repetitive performance of labor tasks, cost-effective improvements in product design,
the making of bit-by-bit improvements in the whole operating process (better use of materials,
more efficient inventory handling, more efficient distribution methods, computerization and
automation of assorted production), an increase scale of operation that yielded access to new
operating economies, enriched know-how in managing and operating the business, and such.
When achieving lower unit costs is partly or mostly a function of experience in producing the

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 product and other learning curve benefits, a new entrant is put at a disadvantage in competing
with older, established firms with more accumulated know-how, therefore the threat of new
entrants is low.

c) Products are standard within the industry (the absence of brand preferences and customer
loyalty and switching costs are low. When the products of rival sellers are differentiated, buyers
usually have some degree of attachment to existing brands. A potential entrant must therefore be
prepared to spend enough money on advertising and sales promotion to overcome customer
loyalties and build its own clientele; substantial time, as well as money, can be involved. A new
entrant may have to budget more funds for marketing than existing firms, which gives existing
firms a cost advantage. In addition, the capital invested in establishing a new brand (unlike the
capital invested in facilities and equipment) has no resale or recoverable value, which makes
such expenditures a riskier “investment”. Product differentiation can be costly to buyers who
switch brands, in which case the new entrant must persuade buyers that the changeover or
switching costs are worth incurring. This may require lower prices, better quality, better service,
or better performance features (which may result in lower expected profit margins for new
entrants—a significant barrier for start-up companies dependent on sizable, early profits to
support their new investments).

d) Capital requirements are low. The larger the total dollar investment needed to enter the market
successfully, the more limited is the pool of potential entrants. The most obvious capital
requirements are associated with manufacturing plant and equipment, working capital to finance
inventories and customer credit, introductory advertising and sales promotion to establish a
clientele, and covering start-up losses.

e) Cost disadvantages independent of scale do not exist. Existing firms may enjoy cost advantages
not available to potential entrants, regardless of the entrant’s size. The most typical sources of
cost advantage include access to the best and cheapest raw materials, possession of patents and
proprietary technology, the benefits of any learning and experience curve effects, acquisition of
fixed assets at preinflation prices, favorable locations, and lower-cost access to financial capital
due to a strong income statement and balance sheet.

f) Access to distribution channels is easy. When a product is distributed through established

market channels, a potential entrant may face the barrier of gaining adequate distribution access.
Some distributors may be reluctant to take on a product that lacks buyer recognition. The more
limited the number of wholesale and retail outlets and the more that existing producers have
these tied up, the tougher entry will be. To overcome this barrier potential entrants may have to
lure distribution access by offering better margins to dealers and distributors or by giving
advertising allowances and other promotional incentives. As a result, the potential entrant’s
profits may be squeezed until its product gains such good market acceptance that distributors
and retailers want to carry it because of its popularity.

One additional point needs to be made about the threat of entry as a competitive force: Entry
barriers can rise or fall as economic and market conditions change. For example, the expiration of a
key patent can greatly increase the threat of entry. New technological discovery can create a big
scale economy where none existed before. New actions by incumbent firms to increase advertising,
strengthen distributor-dealer relations, accelerate R&D, or improve product quality can erect higher
road-blocks to entry.

• The competitive force of substitute products

Substitutes are products of industries that serve similar consumer needs of the industry being
analyzed. Therefore, firms in one industry are quite often in close competition with firms in another
industry because their respective products are good substitutes. Soft-drink producers are in

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competition with the sellers of fruit juices, milk, coffee, tea, powdered-mix drinks, and perhaps
some alcoholic beverages (wine and beer). The producers of wood stoves are in competition with
the producers of kerosene heaters and portable electric heaters. Sugar producers are in competition
with firms that produce artificial sweeteners. The producers of plastic containers are in competition
with the makers of glass bottles and jars, the manufacturers of tetra packs, and the producers of tin
and aluminum cans. The producers of rival brands of aspirin are in competition with the makers of
other pain relievers and headache remedies.

The competitive force of closely related substitute products impacts sellers in several ways.

First, the price and availability of acceptable substitutes for product X places a ceiling on the prices
which the producers of product X can charge; at the same time, the ceiling price places a limit on
the profit potential for product X.

Second, unless the sellers of product X can upgrade quality, reduce prices via cost reduction, or
otherwise differentiate their product from its substitutes, they risk a low growth rate in sales and
profits because of the inroads substitutes may make. The more sensitive the sales of X are to
changes in the prices of substitutes, the stronger is the competitive influence of the substitutes.

Third, the competition from substitutes is affected by the ease with which buyers can change over to
a substitute. A key consideration is usually the buyer’s switching costs - the one-time costs facing
the buyer in switching from use of X over to a substitute for X. Typical switching costs include
employee retraining, the costs to purchase additional equipment that will also be needed, payments
for technical help in making the changeover, time and money spent testing the quality and reliability
of the substitute, and the psychological costs of severing old supplier relationships and establishing
new ones. If buyers’ switching costs are high, then the sellers of substitutes must offer a major cost
or performance benefit in order to attract users away from X. If switching costs are low, it is easier
for sellers of substitutes to overcome the barrier of convincing buyers to change over from X to
their product.

As a rule, then, the lower the price of substitutes, the higher their quality and performance, and the
lower the user’s switching costs, the more intense are the competitive pressures posed by substitute
products. One very telling indicator of the strength of competitive pressures emanating from the
producers of substitutes is their growth rate in sales; other indicators are their plans for expansion of
capacity and the profits they are earning.

• The bargaining power of suppliers

The competitive impact suppliers can have on an industry is chiefly a function of how significant
the input they supply is to the buyer. When the input of a particular group of suppliers makes up a
sizable proportion of total costs, is crucial to the buyer’s production process, or significantly affects
the quality of the industry’s product, then the potential bargaining power and influence of suppliers
over firms in the buying industry is enhanced. Suppliers are powerful if:

a) The supplier’s product is an important input to the buyer’s business.

b) Suppliers are more concentrated than the industry it sells to. When a few large producers
dominate the supplier industry who enjoy reasonably secure market positions.

c) Supplier’s products are differentiated and there are switching costs associated with the
supplier’s product. When suppliers’ respective products are differentiated to such an extent that
it is difficult or costly for buyers to switch from one supplier to another.

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d) The industry is not an important customer of the supplier group. In such instances, suppliers are
not constrained by the fact that their own well-being is tied to the industry they are supplying.
They have no overriding incentive to protect the customer industry via reasonable prices,
improved quality, or new products which might well enhance the buying industry’s sales and
profits.

e) Suppliers are not obliged to contend with other substitute products for sale to the industry. For
instance, the power of the suppliers of glass bottles to the soft drink bottlers is checked by the
ability of the soft drink firms to use aluminum cans and plastic bottles.

f) When one or more suppliers pose a credible threat of forward integration into the business of the
buyer industry (attracted, perhaps, by the prospect of higher profits than it can earn in its own
market).

g) When the buying firms display no inclination toward backward integration into the suppliers’
business.

The power of suppliers can be an important economic factor in the marketplace because of the
impact they can have on their customers’ profits. Powerful suppliers can squeeze the profits of a
customer industry via price increases which the latter is unable to pass on fully to the buyers of its
own products. An industry’s suppliers can also jeopardize industry profits through reductions in the
quality of materials they supply.

• The bargaining power of buyers

Just as powerful suppliers can exert a competitive influence over an industry, so also can powerful
customers. The buyers are powerful if:

a) The buyers are more concentrated than the industry or purchase in large volumes relative to
industry sales. Large customer groups often have success using their volume-buying leverage to
obtain important price concessions and other favorable terms and conditions of sale.

b) The product that the buyer purchase from the industry represents a significant fraction of the
buyer’s costs or purchase and/or represents a sizable percentage of the selling industry’s total
sales.

c) The supplying industry is comprised of large numbers of relatively small sellers (a few big
buyers are often able to dominate a group of smaller suppliers).

d) The industry product is standard or undifferentiated and there are few switching costs. When the
item being purchased is sufficiently standardized among sellers that customers can not only find
alternative sellers but they can also switch suppliers at virtually zero cost.

e) The customers pose a credible threat of backward integration, attracted by the prospects of
earning greater profits or by the benefits of reliable prices and delivery.

f) The sellers pose little threat of forward integration into the product market of their customers.

g) The item being bought is not an important input for buyers.

h) It is economically feasible for buyers to purchase the input from several suppliers rather than
one.

i) The product or service being bought does not save the customer money.

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j) Buyers earn low profits. If buyers earns low profits, it will pressure industry to lower its costs.

k) The buyer has full information.

A firm can enhance its profitability and market standing by seeking out customers who are in a
comparatively weak position to exercise adverse power. Rarely are all buyer groups in a position to
exercise equal degrees of bargaining power, and some may be less sensitive to price, quality, or
service than others.

Drawing conclusions from the competitive situation

This analysis determines what competitive forces exist and how strong they are in a given market
and, ultimately, the profits that industry participants will be able to earn. In addition, the analysis
focus attention of the strategists to the competitors by gathering and analyzing in the next step
information about:

• Rival’s priorities and performance objectives;

• Rival’s current strategy;

• Rival’s ability to compete effectively;

• Predicting competitors next moves.

In coping with the five competitive forces, it make sense for a firm to search out a market position
and competitive approach that will (1) insulate it as much as possible from the forces of
competition, (2) influence the industry’s competitive rules in its favor, and (3) give it a strong
position from which to “play the game” of competition.

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 Technique of industry and competitive analysis - The External Factor Evaluation (EFE)
Matrix

1. An External Factor Evaluation (EFE) Matrix allows strategists to summarize and evaluate
economic, social, cultural, demographic, environmental, political, governmental, legal,
technological, and competitive information. There are five steps in developing an EFE
Matrix:

2. List critical success factors as identified in the external-audit process. Include a total of from
ten to twenty factors, including both opportunities and threats affecting the firm and its
industry. List the opportunities first and then the threats. Be as specific as possible, using
percentages, ratios, and comparative numbers whenever possible.

3. Assign to each factor a weight that ranges from 0.0 (not important) to 1.0 (very important).
The weight indicates the relative importance of that factor to being successful in the firm’s
industry. Opportunities often receive higher weights than threats, but threats too can receive
high weights if they are especially severe or threatening. Appropriate weights can be
determined by comparing successful with unsuccessful competitors or by discussing the
factor and reaching a group consensus. The summation of all weights assigned to the factors
must equal 1.0.

4. Assign a 1-to-4 rating to each critical success factor to indicate how effectively the firm’s
current strategies respond to the factor, where 4 = the response is superior, 3 = the response
is above average, 2 = the response is average, and 1 = the response is poor. Ratings are based
on effectiveness of the firm’s strategies. Ratings are thus company-based, whereas the weights
in Step 2 are industry-based!

5. Multiply each factor’s weight by its rating to determine a weighted score.

6. Sum the weighted scores for each variable to determine the total weighted score for the
organization.

Regardless of the number of key opportunities and threats included in an EFE Matrix, the highest
possible total weighted score for an organization is 4.0 and the lowest possible total weighted
score is 1.0. The average total weighted score is 2.5. A total weighted score of 4.0 indicates that
an organization is responding in an outstanding way to existing opportunities and threats in its
industry. In other words, the firm’s strategies effectively take advantage of existing opportunities
and minimize the potential adverse effect of external threats. A total score of 1.0 indicates the
firm’s strategies are not capitalizing on opportunities or avoiding external threats.

An example of an EFE Matrix is provided in next Table. Note that “consumers are more willing
to pay for biodegradable packages” is the most important factor affecting this industry, as
indicated by the weight of 0.14. The firm in this example is pursuing strategies that effectively
capitalize on this opportunity, as indicated by the rating of 4. The total weighted score of 2.64
indicates that this firm is just above average in its effort to pursue strategies that capitalize on
external opportunities and avoid threats. It is important to note here that a thorough understanding
of the factors being used in the EFE Matrix is more important than the actual weights and ratings
assigned.

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Critical success Factor Weight Rating Weighted
Score

OPPORTUNITIES

1. The CEFTA Free Trade Agreement .08 3 .24

is stimulating growth

2. Equity markets are healthy .06 2 .12

3. Disposable income is increasing 3% .11 1 .11

annually

4. Consumers are more willing to pay .14 4 .56

for biodegradable packages

5. New software can shorten product .09 4 .36

life-cycle

THREATS

1. Markets of Rep. of moldova are .10 2 .20

closed to many Romanian products

2. Japan has imposed new tariffs .12 4 .48

3. The Russian Republic is unstable .07 3 .21

politically

4. State support for business is 2 .26

.13
declining

5. Unemployment rates are increasing .10 1 .10

TOTAL 1.00 2.64

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