External Environment: PEST, SWOT, Porter's five forces, Generic Strategy

INTRODUCTION

Although business organisations are different from each other in ways more than one, they all have one feature common to all of them, that is, they all convert input into output in order to make a profit. And this transformation takes place against a background of external influences which affect the firm and its activities. This set of elements that lie beyond the organisation’s boundary is called the external environment. It has been formally defined as those elements that are important to the tasks of the organisation-those elements “potentially relevant to goal setting and goal attainment”. (Dill, 1958; p. 409) The external environment has been an important area of study for businesses for years as external environmental analysis is central to strategic planning for businesses.

In this coursework, the significance of external analysis in crafting effective organisational strategy will be discussed by identifying the appropriate tools and techniques of environmental analysis. Further, the various tools of designing an effective organisational strategy will also be discussed.

The business strategic planning process:

Source: Adapted from Philip Kotler, Marketing Management, Prentice-Hall Inc, 2000, p29.

“Analysis of the external environment is crucial to the lasting success of organisation.”

An organisation’s success is very much dependent on the analysis of external environment. This is because the formulation of organisational strategy is best enabled by systematic scanning approach to external environment. (Mercado,Welford, & Prescott,2001; p 325) Organisational strategy must be consistent with characteristics of the organisation’s external environment. The external environment is complex, volatile and interactive. (Worthington & Britton, 2006; p3). Therefore, in order to survive over the longer term, organisations must be constantly aware of their external environment and be organised in such a way that they can respond to changes in it. Many organisations have faced difficulties because of the lack of consistency with the external environment.

Example 1. One such example is that of the British retail giant, Marks & Spencer. Since 1998, it was facing many difficulties mainly because of lack of consistency between strategy and needs of external environment. In Britain, M&S had failed to respond to sifting consumer preferences and new approaches to sourcing and supply chain management. (Grant, 2005; p14). Therefore “Analysis of the external environment is crucial to the lasting success of organisation.”

Source: Adapted from Quick MBA, viewed 4 December, 2007

TOOLS OF EXTERNAL ENVIRONMENT

External environment is analysed under the following sub-headings:

a. Political-legal environment: Political-legal environment consists of governmental legislation and regulation that can have significant effects on a company’s operations. (Baxter,1995 ;p130) Some of the major political-legal elements that may affect an organisation are anti-trust regulations, environmental protection laws, tax laws, special incentives, foreign trade regulations, attitudes towards foreign companies, laws on hiring and promotion, stability of government etc. Political-legal environment is very important for businesses to analyse because it may stabilise or de-stabilise national markets for products.

Example 2. A good example of an effect of political-legal factors on business is the difficulties faced by Mittal Steel before acquisition of French steel giant, Arcelor. Mittal Steel had to face many political obstacles because of attitude of French Government towards foreign corporate. Also the French government feared that the acquisition may lead to problems such as job losses and monopoly. Therefore Mittal Steel was not allowed by French government to acquire Arcelor initially. (Source: http://english.peopledaily.com.cn/200602/02/eng20060202_239695.html)

Example 3. Another example is of British Gas. Before 1996, British Gas had monopoly for supplying gas in UK. But in the year 1996, the British government passed the deregulation laws which opened the market for other private companies to enter in the business of supplying gas. Thus, providing huge competition for British Gas.

b. Economical environment: The economical environment of the country can have significant effects on the organisations and therefore they should analyse the economical environment carefully before crafting a strategy. Major elements of economical environment that businesses may consider are GDP and GNP trends, interest rates, inflation rates, purchasing power parity (PPP), cost of labour, unemployment levels, valuation of currency etc. For example, businesses may enter a new country for operations with relatively high PPP so that it can have high demand for its goods. Recently the countries like China and India have been key investments countries for foreign investors because of high GDP, high PPP and high interest rates. Example 4. An example of companies using economical factors in designing their strategy is that of British Telecom. It has based its call centres in India because of availability of cheap labour. This has helped British Telecom to cut costs and increase margin of profit.

Example 5. Another example of an effect of economical environment on businesses is that of European plane maker, Airbus. The recent weakness of the dollar is threatening the survival of Airbus. Here the economic factor that had an effect on the business was the fluctuation in the currency. (City A.M., Issue 540, 12 December 2007, p3)

	Technological factors Levels and foci of R&D expenditure Patterns and speed of technological change Product life cycles Technological imperatives

Macro environmental analysis (PEST framework)

Source: Johnson G and Scholes J, Exploring Corporate Strategy, Prentice Hall Inc, 1999, p. 99

Cited in Meek, H, Meek, R and Ensor, J, Strategic Marketing Management- Planning and Control, Butterworth Heinemann. 2002, p. 31

c. Social-cultural environment: The socio-cultural environment of a business is an important to be analysed as these factors can lead to political and societal changes. The socio-cultural environment consists of factors that build society. Some of the socio-cultural factors are attitude to health, wealth, age, gender, work and leisure, life-style changes, career expectations, consumer activism, rate of family formation, age distribution of population, growth rate of population, etc. These factors can influence people’s choices, societal beliefs, values and attitudes. (Source: http://www.marketing-intelligence.co.uk/help/Q&A/question14.htm)

Example 6. An example of the effect of socio-cultural environment on businesses is provided by Levi Strauss & Co. Since the average age of the population in the United States increased due to decline in birth rate and improvements in health care, the company had to introduce a new line of clothing to attract the older customers under the Dockers label. Here it is seen how changes in population demographics can make the businesses to change their strategy. (Source: http://www.referenceforbusiness.com/management/Log-Mar/Macroenvironmental-Forces.html)

Example 7. Another example of using socio-cultural environmental factors as part of their strategy is offered by McDonalds Restaurants. McDonalds change their menu in accordance the socio-cultural environment in which they operate. For instance, they don’t serve pork items in South-Asian countries because pork is considered unholy in most South-Asian countries like India. Similarly, they serve beer in their restaurants in Germany as it is considered as family drink in Germany.

d. Technological environment: Technological environment consists of the factors relating to technology that can affect the business. One such factor is the rapid advances in the technology. Technology advances has been so rapid that it has affected almost every business and keeping pace with the rapidly progressing technology has been a challenge for businesses. In fact, these rapidly advancing technology have given birth to new industries such as satellite TV stations, internet, DVDs, virtual reality, digital gaming consoles etc. And these are giving the old industries tuft competition for completely unexpected directions. (Blythe, 2004;p35)

Example 8. A good example is that of the SEGA games. SEGA games had to move out of gaming consoles market and become a platform-agnostic software company, due to the competition from the new digital gaming consoles like Sony PlayStation series and Microsoft Xbox series.

Example 9. Another example is that of Nokia. Nokia developed and launched a communicator phone much ahead of its competitors due to its technological advancement. This enabled Nokia to gain the advantages of first mover strategies.

e. Ecological and geographical environment: The Ecological and geographical environment consists of those ecological and geographical issues that affect a business’s decision making framework. The significance of these ecological and geographical issues was recognised nearly fifteen years ago. Factors such as increasing scarcity of raw materials, disposal of toxic waste materials, finding appropriate locations for establishing industries particularly those which have a major environmental impact, changing attitudes of customers towards green issues etc are some of the major factors of the ecological and geographical environment. (Blythe, 2004;p35)

Example 10. A good example would be of British gas & electricity giant, British Gas. Since 2005, it has laid more emphasis on generation of green, renewable energy and reducing its carbon emissions because of changing attitude of British consumers towards green issues. (Source: http://www.onlinereview.org.uk/article/energysavers.htm)

EXTERNAL ANALYSIS: OPPORTUNITIES AND THREATS

“The external environment is the source of opportunities and threats facing the business, with scenarios encapsulating environmental issues.” (Finlay,2000 p323) Formal reviews can help the organisation to identify the key opportunities open to the business and to highlight the possible threats. The potential opportunities and threats faced by business can be identified by a SWOT analysis matrix. The events and trends in the external environment have to be analysed carefully in order to formulate the organisational strategy.

Identifying the Organisation’s opportunities.

Source: Robbins, SP & Coulter M, Management, Prentice Hall, 7^th ed, 2003, p. 204.

Opportunities: An opportunity is a favourable situation in the external environment that can be used to the organisation’s advantage. For example generation of some trends at the macro-economic level by the national economy which may prove to be an advantage to the organisation. Further, developments like identification of new markets or segments, faster market growth, technological changes, creation of new, related or complementary products, changes in competitive and regulatory circumstances etc are opportunities. (Stapleton & Thomas, 1998; p79) Organisations must smell every opportunity, grab it and exploit it to the best of their capability; otherwise the competitors will grab the opportunity and this will beat the organisation badly.

Example 11. A good example of exploiting opportunities is that of Tata steel. The Indian steel giant sensed a brilliant opportunity of entering the UK steel market by acquiring the Anglo-Dutch Corus Group steel company. It acquired it beating all the other bidders, and entered the UK market. (http://news.bbc.co.uk/1/hi/world/south_asia/6071090.stm)

Threats: A threat is an unfavourable development in the external environment which can affect the organisation in a negative way. Some of the major threats face by businesses are new competitors in the industry, rising sales of substitute products, slower market growth, adverse business policies, growing bargaining power of suppliers or customers, adverse demographic changes, technological changes, inhibiting regulations etc.

Example 12. An example of the threat faced by business is that of Nokia. The entry of Apple computers in the mobile phone market with the iphone has posed a serious threat to Nokia market share in cellular phones market. (source: http://online.wsj.com/article/SB119266000394862595.html)

Source: Smart Draw, viewed 4 December, 2007,

PORTERS FIVE FORCES MODEL:

Another important tool of designing an effective organisational strategy is the Porters Five Forces Model. This model is one of the widely used models in strategic management. Michael Porter’s five forces model helps an organisation to craft future strategy by evaluating the forces driving competition in an industry, assessing the industry’s attractiveness for entry or exit and analysing the competitive trends. (Kahn,2001 ;p 138) The five forces are:

· threats of new entrants to the industry

· threats of substitute products

· power of buyers or customers

· power of suppliers (to businesses in the industry)

· rivalry among businesses in the industry

Porter’s five forces model

Source: Adapted from Porter, M (1980), Competitive Strategy, New York Free Press, p4

Cited in Howes. R (2003), Strategic Management Applied to International Construction, Thomas Telford ltd, p60

Threats of new entrants to the industry: The threat of new firms to enter an industry is always an important issue for businesses. If businesses fail to analyse it properly it may lose its market share. Usually industries that have low entrance barriers see more entrance of new players into the industry, thus proving more competitions to the existing players. However, industries with high entrance barriers must also not overlook the possibility of new players entering the industry.

Example 13. An example of Harley-Davidson justifies the above statement. In the 1970s, the upscale motorcycle maker thought that the entry to the upscale American motorcycle industry was not easy because of capital requirements and customer loyalty. Therefore they did not pay much attention to the Japanese entrants partly because they entered at the low-priced end of the market. But the Japanese firms did serious damage to Harley-Davidson by making dramatic sales into the higher end American motorcycle market with both low price and high quality. (Stahl & Grigsby, 1997; p146)

Threats of substitute products: Increasing availability of substitutes for an industry’s product and services can harms organisation’s control over prices and terms of business. If the substitutes are equally useful for the purpose, it can pose serious threat to the product. Therefore firms must consider the threats from substitutes seriously.

Example 14. A good example of a competitive force arising from substitution is the substitution of coffee for tea for many individuals in countries like India. Companies like Tata tea are facing huge fight from substitutes offered by Nescafe, the coffee producer.

Power of buyers or customers: “Buying power is the capability of the buyers, purchasing agents, and the customers of the industry to influence the price and the terms of purchase.”(Stahl & Grigsby, 1997; p146) When the buyers are few in number and are well organised, the buying power may be high. If the bargaining power of buyers is high then the profit margin of firms becomes low.

Example 15. For example, in the retail industry, big players like Tesco have large number of buyers and therefore bargaining power of buyers is limited and therefore they can’t easily get a concession from the retailer.

Power of suppliers (to businesses in the industry): “Supplier power is the capability of suppliers and vendors to decide the prices and the terms of supply.”(Stahl & Grigsby, 1997; p147) When the suppliers are few in number, the bargaining power of suppliers is high. When the bargaining power of suppliers is high, the profit margin of the firms tends to be low and vice-versa. Example 16. For example, supermarket giant, Wal-Mart, source their products from suppliers who have low bargaining power, thus keeping its profit margin high.

Competitive rivalry among businesses in the industry: Competitive rivalry among firms means the extent to which the firms respond to the competitive moves of the other firms in the same industry. There might be cut-throat competition between companies where the competitive moves of the competitors are monitored and countered closely or there might be “live and let live” principle followed within the industry where companies seem to respect each other’s market niches.

Example 17. The cut-throat competition has been evident between cola companies, Coca cola and Pepsi is a good example of the rivalry between businesses in the industry. These cola companies have been trying to fight each other with destructive campaigns in order to invade each other’s market share.

Example 18. Another example of such cut throat competition is the ongoing price war between Sky and Virgin media where both of them are trying to outrun each other in terms of low prices in order to win maximum customers.

Each of these forces directly affects an organisation’s competitive positioning. Therefore organisations must determine the relative strength of each of these forces so that it can position itself in such a manner that it can take advantage of the opportunities and overcome the threats. It may then design its strategy to exploit the competitive forces at work within the industry. (Houston, Campbell & Stonehouse, 2002; pp 135-144)

GENERIC STRATEGY

According to Porter (1980), there are three generic types of competitive strategies which can be equally applied to any business organisation.

They are:

a. Cost leadership

b. Differentiation

c. Market niche focus

Porter's Generic Strategies

Source: Porter, M (1985), Competitive Advantage, The Free Press, NY, p12.

a. Cost leadership: Cost leadership means that the firms produces its goods and services at relatively low cost by taking advantage of economies of scale and the experience curve effect. In order to use this strategy the firm has to reduce costs at each stage of the business. But in order to make this strategy successful the firm has to have significantly exclusive control on the cost of the inputs required by the firm such as raw materials, labour, etc. otherwise the competitors can easily mimic the same strategy leading to price based competition and low profitability.

Cost leadership can help an organisation to be successful if carried out properly. Example 19. Wal-Mart's success story is a classic example of a company, which became successful by rigorously pursuing its core philosophy of cost leadership, right from the day it began operations in 1962. From the very beginning, Walton, the founder of Wal-mart made efforts to procure products at the lowest prices possible from manufacturers. And today Wal-Mart is one of the biggest companies of the world.(Source:http://www.icmrindia.org/casestudies/catalogue/Business%20Strategy2/Wal-Mart%20Cost%20Leadership%20Strategy.htm)

Example 20. Another example of Cost leadership is provided by Hyundai. The South-Korean car giant went on to become the sixth largest car maker in the world by adopting the cost-leadership strategy.

. b. Differentiation: Differentiation means differentiating a product on the basis of superior performance in an important consumer benefit area. Differentiation is another generic strategy mentioned by Porter (1980) that can help firm gain competitive advantage. The concept of differentiation is idea of producing a product that is perceived unique by consumers thus giving it an edge over product. By using differentiation as a strategy firms can often command more prices for its products. It also helps the product to be less susceptible to elastic demand; and also helps the firm to create barrier of entry for other firms. Firms can differentiate its product in the following ways:

i. Superior product performance by adding features, improving reliability, durability, quality etc.

ii. Superiority of product perception achieved by marketing communication,

iii. Distributing the product effectively, making the product more conveniently available than the competitors

iv. Providing high service levels, better sales support and more affordable financing.

Example 21. General Motors is a good example of achieving success by adopting a differentiation strategy. In 1921, General motors were badly beaten by the competition given by Ford in US until it pursued a differentiation strategy. It made its cars stylish and offered closed sedans to compete with the Ford open coupe. As a result Ford was struggling, its market share which was 62% by the end of 1921 reduced to 28% in 1926. (Daly, 2001: p47)

Example 22. Sony is another example of using differentiation as a strategy. Sony made its product different from its competitors on the basis of high quality and design. This helped Sony to create a huge demand of its product and also made customers loyal to the brand.

c. Market niche focus: Market niche focus strategy is a strategy in which firms concentrate on the needs of a specific niche within the market. Focus strategies helps firms to shield themselves from market forces such as competitors by targeting a specific market segment. This specific market segment is also known as market niche. The focus strategies can be through any element of marketing mix-price, product, packaging, service etc. (Longenecker,2003; p64) A focus strategy is very useful for firms who want to escape direct co9mpetition with industry giants and to gain competitive advantage especially small firms. According to Porter (1985), (stated in Carter & Evans, 2006; p414) the focus strategy is the most appropriate for smaller businesses as it can optimise its strategy in the target segments to achieve competitive advantage.

Example 23. A good example of adopting market niche focus strategy is that of Tag Heuer, the watchmaker. Tag Heuer has adopted a focus differentiation strategy. It sells its only rugged waterproof watches to active consumers. (Griffin, 2003; p72)

Therefore Michael E. Porter’s generic strategies one of the important tools of crafting an effective strategy for an organisation. Business organisations can use the generic strategies to achieve competitive advantage. Porter argues that the organisations that tries to follow a combination of competitive strategies, i.e. cost leadership and differentiation, will achieve only average or below average performance. However it may be noted that some organisations have used a combination of Porter’s competitive strategies and are still successful. Example 24. British Airways pursues all the three generic strategies by offering first class and Concorde (differentiation focus), business class (differentiation), and economy class (cost leadership).

CONCLUSION:

Therefore, in order to formulate an effective strategy for an organisation, environmental analysis is must. However, one may observe that the main significance of external environmental analysis lies in predicting the future external environment and not the present. If the firms are correct in predicting how the future external environment is likely to be, they can design strategy well in advance to adjust to external environment. Therefore, here it understood that forecasting is a key issue while analysing the external environment.

Further one may also conclude that the PEST analysis and analysis of external opportunities and threats is also an important tool of analysing the macro-environment and micro-environment respectively. However, due to rapid changes in the external environment, firms must use these tools on a regular basis, so that the firms are not dealing with outdated information.

Last but not the least; one cannot ignore the models suggested by Michael E. Porter, that is, Porters Five forces model and Generic Strategy Model in order to craft an effective strategy. Porter’s five forces framework is important because it directs manager's towards those aspects most significant to long-term advantage. It serves as a checklist for getting started and also highlights the possible sources that could e the driving forces in businesses. The Generic strategy model is useful as helps in characterising the “strategic positions at the simplest and broadest level”. (Source: http://www.stanford.edu/class/msande473/483primerV3.doc)

Business must try and use as many tools as possible in order to come out with the best strategy for the organisation. However, firms must try and evade the limitations of these tools so as to formulate the best strategy.

REFERENCES:

Books:

1. Baxter, M (1995), Product Design: A Practical Guide to Systematic Methods of New Product, CRC Press, p 130.

2. Blythe, J (2005), Essentials Of Marketing, Pearson Education, p 35.

3. Campbell, D, Stonehouse, G & Houston, B (2002), Business Strategy: An Introduction, Elsevier, pp 135-144.

4. Carter, S & Jones-Evans, D (2006), Enterprise and Small Business: Principles, Practice and Policy, Pearson Education, p 414.

5. Daly, JL (2001), Pricing for Profitability: Activity-based Pricing for Competitive Advantage, John Wiley and Sons, p 47.

6. Dill W. R. (1958). "Environment as an Influence on Managerial Autonomy." Administrative Science Quarterly, p 409.

7. Finlay, P (2000), Strategic Management: an Introduction to Business and Corporate level strategy, Pearson Education, p 323.

8. Grant, R.M (2005), Contemporary Strategy Analysis, Blackwell Publishing, p 14.

9. Griffins (2003), Fundamentals of Management- Coreconcepts and applications,Haughton Mifflin Co, p72.

10. Howes. R (2003), Strategic Management Applied to International Construction, Thomas Telford Ltd., p 60.

11. Johnson, G & Scholes, J (1999), Exploring Corporate Strategy, Prentice-Hall Inc, p99.

12. Kahn, KB (2001), Product Planning Essentials, Sage Publications ltd., p 138.

13. Kotler, P (2000), Marketing Management, Prentice-Hall Inc, p29.

14. Longenecker, JG (2006), Small Business Management: An Entrepreneurial Emphasis, Thomson South-Western, p 64.

15. Meek, H & Meek, R & Ensor J (2002), Strategic Marketing Management- Planning and Control, Butterworth Heinemann, p31.

16. Mercado, S, Welford, R & Prescott, K (2001), European Business, Pearson Education, p325.

17. Porter, M (1985), Competitive Advantage, The Free Press, NY, p12.

18. Porter, M (1980), Competitive Advantage: Techniques for analysing Industries and Competitors, The Free Press, NY, p 4.

19. Robbins, SP & Coulter M, (2003) Management, Prentice Hall, 7^th ed, p. 204.

20. Stahl, MJ & Grigsby, DW (1997), Strategic Management: Total Quality and Global Competition, Blackwell Publishing, pp. 146-147.

21. Stapleton, J & Thomas, MJ (1998), How to Prepare a Marketing Plan: A Guide to Reaching the Consumer Market, Gover Publishing Ltd., p 79.

22. Worthington, I & Britton, Chris (2006), This Business Environment, Pearson Education, p 3.

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