Diagnosis of the External Environment
Rex C. Mitchell, Ph.D.
"Awareness of the environment is not a special project to be undertaken only
when warning of change becomes deafening." (Kenneth R. Andrews)
In the ongoing process of strategic management, the organization is considered as an "open
system" that affects and is affected by its environment. It is important to maintain an accurate
and current awareness of important aspects of and trends in the organization's external
environment.
Many major companies have lost dominance or gone out of business because of their failure
to recognize and adapt to changes in their environments, or by failing to be leaders in making
necessary changes. For example, Royal and Underwood were market leaders in typewriters, but
had no part in making word processors or their extension to personal computers. Maytag had a
dominant number one position in manufacturing wringer-type washing machines during the first
half of the 20th Century, but suffered a disastrous fall in market share from about 50% to 8% in
just a few years after WWII, due to a "substitute" product introduced by a newcomer,
Bendix.
In 1968, Switzerland dominated the world of watchmaking, with over 65% of the unit sales
in
the world and more than 85% of the profits. They were constant innovators and on the cutting
edge of research in all aspects of their watches. By 1980 their world market share had collapsed
to less than 10%, and 50,000 of the 62,000 watchmakers had lost their jobs. What happened? A
profound change in the external competitive environment, a change in the fundamental rules of
watchmaking. Everything the Swiss were good at -- making gears and bearings and mainsprings,
etc. -- was irrelevant to the new way. The irony was that this disaster was totally avoidable. The
Swiss themselves invented the electronic quartz movement at their research institute in
Neuchatel, Switzerland. Yet, when the Swiss researchers presented this revolutionary new idea
to the Swiss manufacturers in 1967, it was rejected. It couldn't possibly be the watch of the
future! So sure were the manufacturers of that conclusion that they let their researchers showcase
their "useless" invention at the World Watch Congress that year. Seiko took one look, and the
rest is history.
"It is not the strongest of the species that survive, nor the most intelligent, but
the ones most responsive to change." (Charles Darwin)
The key point is that an organization needs to be in tune with its often turbulent external
environment. There must be a strategic fit between what the environment wants and what the
organization has to offer (also a strategic fit between what the organization needs and what the
environment can provide.) However, since there is so much happening in the external universe,
we have to be selective and smart in scanning:
- "Things are always different -- the art is figuring out which differences matter."
(Laszlo Birinyi)
- For a given industry (sometimes is company-specific), certain aspects of the
external environment tend to be more important and should receive primary attention
(e.g., technology trends for a high-tech industry, relevant government actions for a highly
regulated industry, interest rates for a home lender)
- It helps to scan initially fairly quickly, then zoom in on areas where something of
importance seems to be happening
It is customary and convenient to break up the external environment into two parts: the
competitive (or task) environment and the general environment (sometimes called societal
environment or macroenvironment). These are discussed below.
COMPETITIVE ENVIRONMENT
Most of the external environment factors important to an organization are in its
industry/competitive environment. Industries differ widely in their characteristics. This means
that a company with multiple lines of business in multiple countries has to analyze and deal with
the complexities of many different country-industry environments. For each, the industry and
competitive analysis should develop insightful answers to seven questions (after T&S, i.e.,
Thompson & Strickland, 2005):
- What are the industry's dominant features, especially economic ones?
- What is competition like and how strong are each of the competitive forces?
- What is causing the industry's competitive structure and business environment to
change?
- Who are the major competitors and what are their relative competitive strengths?
- What strategic moves are rivals likely to make next?
- What are the key factors for competitive success?
- Is the industry attractive and what are the prospects for above-average profitability?
The primary model for diagnosing the industry/competitive environment is Michael Porter's
5-force model, which is very useful in the business world, as well as in the classroom. The
model involves identifying and evaluating key components of five forces that drive industry
competition. It is important to evaluate the relative strength/importance of the forces and focus
particularly on the important forces.
- Rivalry Among Existing Firms
This involves the direct competition in an industry, what is casually considered as the
"competitive
environment," although Porter helped us appreciate that the competitive environment is not
confined to this force. However, this is almost always an important force and usually the
strongest of the five forces. It deserves proportionate attention in the competitive analysis. Some
of the major factors that produce more intense rivalry are (adapted from H&W, 2004;
T&S, 2005, and other sources):
- Slow Market/Industry Growth Rate: in a rapidly growing market,
there tends to be "enough to go around." However, a slow growth or declining market, typical
of a mature industry, sets up price wars and other efforts to take business away from
competitors.
- Capacity Surpluses: excess capacity pushes both prices and
profitability down, especially when there are substantial fixed costs and/or high exit
barriers.
- Number & Size of Competitors: rivalry tends to increase when
there are relatively few competitors who are about equal in size and capabilities; they tend to
watch each other carefully and respond quickly to competitor actions.
- Diverse & Relatively New Competitors: new entrants/rivals with
different ideas on how to compete are likely to unknowingly challenge each other (adding to
the intentional challenges). Further, relatively new competitors haven't tested each other and
the competitive boundaries and are more likely to take more drastic actions, especially
when a strong company outside the industry has acquired a weak company in the industry
and wants to (and can afford to) try to transform their new acquisition.
- Product/Service Differentiation is Low (i.e., products/services are standardized
and regarded as commodities) if customers view the products or services as commodities,
competitors are forced to make more extreme competitive moves on pricing, promotion,
etc.
- High Exit Barriers: when it is difficult for a firm to leave the industry,
the competitors are forced to stay and compete with "whatever it takes." - e.g., when fixed
costs and asset specialization are high, strategic stakes are high
- Potential New Entrants
There are two main factors to consider relative to this force: the likelihood of a new entrant and
the seriousness of a potential entry. This is a relatively important force only when both factors
are reasonably high.
- A new entrant is more likely when there are low customer switching costs and low
barriers to entry. Some of the possible barriers to entry are: major or special resources in
existing firms (economies of scale, finances, technology, proprietary knowledge, experience
curve advantages, brand identification, etc), capital requirements, differentiated products or
services, limited access to raw materials and distribution channels, regulatory restrictions,
tariffs and international trade restrictions.
- The seriousness of a potential entry is high when a potential entrant brings (or could
bring) some special characteristics that are not already present or not easily matched by
existing competitors, e.g., greater financial resources, special technology, unusual access to
distribution channels and/or government favor, synergy with the entrant's other lines of
business.
In addition, the following factors increase the likelihood of new entrants:
- Product differentiation is low
- Brand identification is low
- Incumbents' control of access to raw materials and distribution are low
- Substitute Products or Services
This competitive force becomes stronger as the probability of an effective substitute becomes
higher (not just a hypothetical threat).The potential threats from substitutes come in two
varieties
- Existing products (or services) from other industries that could satisfy the same need
as a product in our industry under analysis (e.g., tea as a substitute for coffee, email as a
substitute for the U.S. Postal Service and other companies in an industry providing
overnight document delivery)
- New products (or services) that did not exist previously, but that offer major
improvements over existing ones. These might originate within or outside the industry. In
addition to the three examples mentioned earlier (word processors over typewriters,
automatic washers over wringer-types, and quartz crystal over mechanical watches),
consider the many generations of media for recording sound, each of which substituted for
and generally eliminated its predecessors (Edison wax cylinders, acoustic & later
electric 78 rpm records, 45 rpm records, 33 rpm records, wire recorders, reel-to-reel tape,
8-track tapes, cassette tapes, CDs, DVDs, computer and Internet-based music files...)
In addition, the following factors increase the likelihood or threat of substitutes:
- The industry is attractive (e.g., profitable and growing)
- Alternatives are readily available
- Some alternatives have especially attractive characteristics
- Improvements in price-performance of alternatives is high
- Customer switching costs are low
- Bargaining Power of Suppliers
This force becomes stronger when suppliers are more powerful and have more options than the
firms in the industry who purchase from them. Some of the factors that produce such a condition
are:
- There are few suppliers and demand is high relative to supply
- The suppliers have many customers and options for selling their pr
oducts
- Products are unique and suppliers have specialized knowledge, technology, facilities,
workers, government approvals, access to key materials, locations, access)
- The suppliers' products/services are very important in the output of the target industry
firms
- Switching costs for industry firms are high
- Suppliers are larger and have greater resources than the industry firms
- The purchasing industry buys only a small portion of the suppliers' goods/services
- Suppliers could integrate forward
- Buyers
Notwithstanding the adage, "the buyer is always right," there is more to be considered in
analyzing this competitive force, and it is not necessarily a strong force. This force is an
analogue of the supplier force, in the sense that the industry firms are the buyers for their
suppliers, and the industry firms are the suppliers for their buyers. Consequently, some of the
factors that result in significant buyer power are:
- There are few buyers and demand is low relative to supply (e.g., because there are
many firms in the industry competing for limited buyer purchases)
- The buyers have many sources and options for buying products
- Products are not unique (little differentiation) and companies have little of
specialized knowledge, technology, facilities, workers, government approvals, access to key
materials, location]
- Switching costs for buyers are low
- Buyers are larger and have greater resources than the industry firms
- The buyers' group buys a major portion of the industry's goods/services
- Some close-substitute products are available
- Buyers' ability to integrate backward is high.
GENERAL ENVIRONMENT
Although usually only a few factors and trends in the general environment will be of much
importance, it is important to scan, analyze, and evaluate this broader macroenvironment to
identify and understand any factors and trends of importance. It is useful to think of four main
aspects of the general environment, to remind ourselves to look in all these categories, listed with
some examples of potentially important variables and trends:
- Technological (note connections with technology under internal environment analysis)
- Relevant, new developments in and/or outside the industry
- New products
- Focus of technological efforts in the industry
- Trends in manufacturing automation and productivity
- Industry and government spending on R&D
- Political-Legal
- Changes in laws and/or regulations affecting the industry
- Changes in foreign trade regulations
- Environmental protection law and regulation changes
- Changes in goverment administrations and/or key bodies
- Economic
- General economy trends, including GNP growth rate and financial markets
- Inflation rates, interest rates, and money supply
- Unemployment levels
- Energy supply and cost
- Social-Cultural
- Growth rate of population
- Age distribution of population
- Regional shifts in population
- Family demographics
- Lifestyle changes, e.g., diet, exercise, health practices, smoking, drugs
- Consumer activism re certain topics
These four dimensions of the general environment are listed above in roughly descending
order of rapidity of change (in the USA at this time). Technological changes can be very rapid.
While political-legal changes can be while rapid in some other countries, they usually have fair
advance warning and lead times in the USA. Economic swings, again, are relatively slow in this
country. Finally, social-cultural changes are the slowest of the four.
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