Chapter three - External Environment Analysis
- 1. Chapter Three: External Environment Analysis Admas University
- 2. Outline Outline 3.1 The nature of external audit 3.2 Sources of external information 3.3 Performing External audit 3.4 Competitive analysis: Porter’s five forces model 3.5 External Factors Evaluation(EFE) Matrix 3.6 Competitor Profile Matrix(CPM) 3.7 Case Work on external environment analysis:- Group work 2
- 3. An external audit sometimes called environmental scanning or industry analysis It focuses on Identifying & Evaluating factors beyond the control of a single firm 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. 3 The Nature of External Audit
- 4. 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. Prior to the developing its strategy, a company must perform a survey or audit of its external environment in order to identify potential external opportunities and threats to the company. 4 The Nature of External Audit.. Purpose: Develop a Finite List of: Opportunities- that could benefit a firm Threats to be minimized.
- 5. 2 Approaches to competitive advantage Industrial Organization Model 1 Resource-Based Model
- 6. 1. Resource-Based Model The Resource-Based Model suggests that above-average returns for any firm are largely determined by characteristics inside the firm. The Resource-Based view focuses on developing or obtaining valuable resources and capabilities which are difficult or impossible for rivals to imitate. According to this approach the source of competitive advantage lies in the Organization’s resources. Internal resources are more important for a firm than external factors in achieving and sustaining competitive advantage.
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- 8. I/O Model of Superior Returns The Industrial Organization Model suggests that above-average returns for any firm are largely determined by characteristics outside the firm. The I/O model largely focuses on industry structure or attractiveness of the external environment rather than internal characteristics of the firm. Not withstanding the above, it should be noted that effective integration and understanding of both external and internal factors is the key to securing and keeping a competitive advantage.
- 9. External forces can be divided into five broad categories: • (1) economic forces; • (2) social, cultural, demographic, and natural environment forces; • (3)political, governmental, and legal forces; • (4) technological forces; and • (5) competitive forces Relationships among these forces and an organization are depicted in Figure below. 9 Key External Forces
- 10. Relationships Between Key External Forces Relationships Between Key External Forces and an Organization and an Organization Key External Forces- Economic Social , Cultural, Political, Legal &Gov’tal Technological Competitive Competitors Suppliers Distributors Creditors Customers Employees Communities Managers Stockholders Labor Unions Special Interest Groups Products Services Opportunities & Threats
- 11. The Process of Performing an External Audit 1) Gather 1) Gather competitive intelligence competitive intelligence and and information on Key External information on Key External Forces Forces : : Must involve as many managers and employees as possible. Company Must involve as many managers and employees as possible. Company first must gather: first must gather: • Competitive intelligence Competitive intelligence • a systematic and ethical process a systematic and ethical process for for gathering and analyzing gathering and analyzing information about the competition’s activities and general business information about the competition’s activities and general business trends to further a business’ own goals trends to further a business’ own goals • And information about economic, social, cultural, demographic, environmental, And information about economic, social, cultural, demographic, environmental, political, governmental, legal, and technological trends. political, governmental, legal, and technological trends. 11 Objectives of Competitive Intelligence : Provide a general understanding of industry and competitors Identify areas where competitors are vulnerable and assess impact of actions on competitors Identify potential moves that a competitor might make
- 12. The Process of Performing an External Audit 2) 2) Assimilate and evaluate information (A meeting or series of meetings of managers is needed to collectively identify the most important opportunities and threats facing the firm). 3) Resulting in a list of the most important key external factors (A final list of important key external factors should be (A final list of important key external factors should be communicated and distributed in the organization). communicated and distributed in the organization). 12
- 13. Performing an External Audit Sources of information include: • Internet • Government reports • Libraries (corporate, university, public) • Suppliers • Distributors • Customers • Competitors • Consultants • Trade Journals , Newspaper articles etc
- 14. Economic Forces-Monitor Key Economic Variables:- Availability of credit Level of disposable income Interest rates Inflation rates Money market rates Federal government budget deficits/surplus Gross domestic product(GDP) trend Consumption patterns Unemployment trends Trends in dollar value relative to Birr Stock market trends Foreign countries’ economic conditions Import/export factors Demand shifts for goods/services Income differences by region/customer Price fluctuations Monetary policies
- 15. Social, Cultural, Demographic, and Natural Environmental Forces These forces have major Impact on firms decision on – • Products • Services • Markets • Customers Key Variables to monitor:-- 15
- 16. Social, Cultural, Demographic, and Natural Environmental Forces Childbearing rates Number of marriages Number of divorces Number of births Number of deaths Household pattern Religion and tradition Population pattern( e.g. aging society) Norm on Gender Life expectancy rates Per capita income Attitudes toward business Language Buying habits Ethical concerns Attitudes toward saving
- 17. Social, Cultural, Demographic, and Natural Environmental Forces Racial equality Average level of education Attitudes toward customer service Attitudes toward product quality Energy conservation Social responsibility Value placed on leisure time Recycling Waste management Air & water pollution Ozone depletion Endangered species
- 18. Political, Governmental, and Legal Forces • Government regulation/deregulation • Tax law and Tax law changes • Special tariffs • Patent laws and Change in Patent laws • Environmental protection laws • Equal employment legislation • Level of government subsidies • Import-export regulations • Political conditions in other countries • Location and severity of terrorist activities etc 18
- 19. Technological Forces Essential for nearly every strategic decision - No company or industry today is insulated against emerging technological developments. E.g online banking, E-books, E-ticket in airlines and etc…. -In high-tech industries, identification and evaluation of key technological opportunities and threats can be the most important part of the external strategic-management audit. Technological change eg.Internet, changes the nature of opportunities and threats -- Increases speed of distribution Creates new products and services Eases limitations of geographic markets Changes entry barriers 19
- 20. Competitive Forces Competition, in virtually all industries, definitely impose influences on firms strategic management endeavor. Hence, there is a need for competitive force analysis which basically mean that Identify Rival Firms’(i.e. firms with similar market focus and internal resource capacity) The above notwithstanding, competitive forces analysis should aims at understanding of the nature of competition within the given industry. Thus, apart from competitors, the influence of other actors i.e. suppliers, customers , distributers and so on must be analyzed( see porter model). 20 Identifying rival firms • Strengths • Weaknesses • Capabilities • Opportunities • Threats • Objectives • Strategies
- 21. Competitive Forces Key Questions Concerning Competitors-After identifying major rival firms, need for identify and analyze: • Their strengths • Their weaknesses • Their objectives and strategies • Their responses to all external variables (e.g. social, political, demographic, etc.) • Their vulnerability to our alternative strategies • Our vulnerability to strategic counterattack
- 22. Competitive Forces Key Questions Concerning Competitors- • Our product and service positioning relative to competitors • Entry and exit of firms in the industry • Key factors for our current position in industry • Sales and profit rankings of competitors over time • Nature of supplier and distributor relationships • The threat of substitute products or services
- 23. Competitive Analysis: Porter’s Five- Forces Model Porter’s Five-Forces Model of competitive analysis is a widely used approach for developing strategies in many industries The intensity of competition among firms varies widely across industries. • Intensity of competition is highest in lower investment return industries(period). 23
- 24. Competitive Analysis: Porter’s Five- Forces Model Potential development of substitute products Rivalry among competing firms Bargaining power of suppliers Potential entry of new competitors Bargaining power of consumers
- 25. The Five-Forces Model Rivalry among competing firms • Most powerful of the five forces • Focus on competitive advantage of strategies over other firms Conditions that Cause High Rivalry Among Competing Firms • High number of competing firms • Similar size of firms competing • Similar capability of firms competing • Falling demand for the industry’s products • Falling product/service prices in the industry • Consumers can switch brands easily e.g mobile industry • Barriers to entering the market are low • The product is perishable 25
- 26. The Five-Forces Model(Cont’d) (Cont’d) Potential Entry of New Competitors Whenever new firms can easily enter a particular industry, the intensity of competitiveness among firms increases. Barriers to entry can include • the need to gain technology and specialized know-how, • the lack of experience, • strong customer loyalty, • strong brand preferences, • large capital requirements, • lack of adequate distribution channels, • government regulatory policies, tariffs, • lack of access to raw materials, etc Barriers to entry are important • Quality, pricing, and marketing can overcome barriers 26
- 27. The Five-Forces Model(Cont’d) (Cont’d) Potential development of substitute products • Pressure increases when: •Prices of substitutes decrease •Large number of substitute products are available •Consumers’ switching costs decrease 27
- 28. The Five-Forces Model(Cont’d) (Cont’d) Bargaining Power of Suppliers is increased when there are: • Smaller numbers of suppliers • Few substitute-Uniqueness of each supplier’s product • Costs of switching raw materials is high Backward integration is gaining control or ownership of suppliers 28
- 29. The Five-Forces Model (Cont’d) (Cont’d) Bargaining power of Buyers (consumers)- increases when there are • Customers being concentrated or buying in volume affects intensity of competition(high size of each customer order) • Consumer power is higher where products are standard or undifferentiated • Buyer’s ability to substitute • Buyer’s information availability 29
- 30. The Five-Forces Model(Cont’d) (Cont’d) N.B. The collective impact of competitive forces is so brutal in some industries that the market is clearly “unattractive” from a profit-making standpoint. Rivalry among existing firms is severe, new rivals can enter the industry with relative ease, and both suppliers and customers can exercise considerable bargaining leverage. 30
- 31. Industry Analysis: The External Factor Evaluation(EFE) Matrix An External Factor Evaluation (EFE) Matrix allows strategists to summarize and evaluate economic, social, cultural, demographic, environmental, political, governmental, legal, technological, and competitive information. The EFE Matrix can be developed in five steps: 31 External Factor Evaluation Matrix External Factor Evaluation Matrix Summarize & evaluate: Competitive Political Cultural Technological Environmental Social Governmental Demographic Economic
- 32. EFE Matrix Steps 1) List key external factors (15 to 20 OT factors) 2) Weight from 0 to 1: Assign to each factor a weight that ranges from 0.0 (not important) to 1.0 (very important). 3) Rate effectiveness of current strategies: Assign a rating between 1 and 4 to each key external 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. 4) Multiply weight * rating i.e Multiply each factor’s weight by its rating to determine a weighted score 5) Sum weighted scores i.e. Sum the weighted scores for each variable to determine the total weighted score for the organization. 32
- 33. EFE Matrix Steps N.B. 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 effects of external threats. A total score of 1.0 indicates that • The firm’s strategies are not capitalizing on opportunities or avoiding external threats. 33
- 34. Table 3.1-EFE Matrix for a Local –Theater Cinema Complex Key External Factor Weight Rating Weighted Score Opportunities 1. The city is growing 8% annually in population 0.05 3 0.15 2. The nearby University is expanding 5% annually 0.08 4 0.32 3. Major Competitors across city recently ceased operations 0.08 3 0.24 4.Demand for going cinema is growing 10% annually 0.07 2 0.14 5. Two new neighborhoods being developed within 3 miles 0.09 1 0.09 6. Disposal income among citizens grew 5% in prior years 0.06 3 0.18 7.Unemployment rate in the country declined to 5% 0.03 2 0.06
- 35. Table 3.1-EFE Matrix for a Local –Theater Cinema Complex Key External Factor Weight Rating Weighted Score Threats 8. Demand for Online Movie and DVD is growing 10% annually 0.06 2 0.12 9. Commercial property adjacent to cinemas for sale 0.06 3 0.18 10. The nearby University is installing an on- campus movie theater 0.04 3 0.12 11. Tax rates in city is increasing 25% this year 0.08 2 0.16 12. Local Religious group objects/opposes some movies being shown 0.04 3 0.12 13. Movies rented from local store up 12% 0.08 2 0.16 14. Bad Media Exposure for Theater 0.12 4 0.48 15. Movies rented last quarter from nearby store up 15% 0.06 1 0.06 Total 1.00 2.58
- 36. Industry Analysis: Competitive Profile Matrix (CPM) Identifies firm’s major competitors and their strengths & weaknesses in relation to a sample firm’s strategic positions The weights and total weighted scores in both a CPM and an EFE have the same meaning. However, critical success factors in a CPM include both internal and external issues; therefore, the ratings refer to strengths and weaknesses, where 4 = major strength, 3 = minor strength, 2 = minor weakness, and 1 = major weakness. The critical success factors in a CPM are not grouped into opportunities and threats as they are in an EFE. In a CPM, the ratings and total weighted scores for rival firms can be compared to the sample firm. This comparative analysis provides important internal strategic information. 36
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- 38. Industry Analysis: Competitive Profile Matrix (CPM) A word on interpretation: Just because one firm receives a 3.2 rating and another receives a 2.80 rating in a Competitive Profile Matrix, it does not follow that the first firm is 10 percent better than the second. Numbers reveal the relative strengths of firms, but their implied precision is an illusion. Numbers are not magic. The aim is not to arrive at a single number, but rather to assimilate and evaluate information in a meaningful way that aids in decision making. 38
- 39. Group Work-Case Analysis Task 1: Given your selected case organization, reflect on the various environmental forces(economic, social, cultural, demographic, natural environment, political, governmental, legal, technological and competitive forces) that may affect the organization and comment critically on the opportunities and threats. Task2: Given the opportunities and threats identified in task 1, construct the external factors evaluation matrix Task 3-Identify two major rival organizations to your selected organization and construct Competitive profile matrix(CPM) 39
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