MODULE 3: EXTERNAL ANALYSIS
GENERAL ENVIRONMENTAL ANALYSIS USING PEST(EL)
The external environment of a firm has a substantial influence on its performance and
long-term viability. There are some aspects of this external environment that are largely
outside the direct control of executives and leaders. This set of broad societal
forces that lay outside of the direct control of firm executives is collectively termed
the general environment. That said, because the general environment has a big impact
on the firm's success, executives should scan, monitor, and forecast changes in the
general environment, and assess the impact of these changes on firm strategy.
General Environmental Analysis
Remember that general environments are turbulent, complex, and global, and
information about them is uncertain, ambiguous, and incomplete. The only way for firm
executives to keep abreast of changes in the general environment is through this four-
step general environmental analysis process:
• Scanning – This step involves identifying early signals of changes in key
segments of the general environment. An easy way for executives to do this is to
talk to people within the organization that are intimately familiar with aspects of
the external environment. A leader may, for instance, talk with the firm's legal
team or even meet with elected officials to talk about potential changes in the
political-legal landscape.
• Monitoring – This second step involves detecting meaning through careful
observation over time. In the case of a global tech firm, after identifying early
signals of change in the corporate tax code for multi-national enterprises, the
leader may consult with the accounting and legal departments and heads of
global operations to figure out what these potential changes may mean for the
company.
• Forecasting – The third step in the process involves developing projections of
outcomes and determining their probabilities. The most probable outcome is
then selected for further analysis.
• Assessing – The final step in the process involves determining the significance
of identified changes and the most probable future outcome for the firm's
business. At this step, executives must also determine any actions they may take
to take advantage of opportunities or allay threats that emanate from the general
environment.
PEST(EL) Analysis
PEST(EL) analysis is an important tool that executives can use to organize factors within
the general environment and to identify how these factors influence their industries and
their firm. PEST(EL) is an anagram. In particular, PEST(EL) reflects the names of the six
segments of the general or macro environment: (1) political, (2) economic, (3) social, (4)
technological, (5) environmental (or ecological), and (6) legal. Executives should
carefully examine each of these six segments to identify major opportunities and threats.
P: Political Factors
Political factors in the macro environment include issues like taxation, tariffs, trade
agreements, labor issues, and environmental issues, among other political issues. It is
important for managers to pay attention to the political factors affecting their company.
For example, American Electric Power (AEP), a large company that generates and
distributes electricity, may be negatively impacted by environmental concerns that
restrict its ability to use coal to generate electricity. At the same time, because AEP
provides an economic necessity (can you imagine a world without electricity?), the
government makes certain allowances (e.g., exceptions from antitrust laws) to ensure
that the company remains profitable and can survive in the long run.
Remember that although firms do not directly make government policy decisions, many
industries and firms invest in lobbying efforts to try to influence government policy to
create opportunities or reduce threats. We spoke about Tesla's lobbying in class - a large
number of firms have taken to lobbying and political contributions to influence public
policy.
E: Economic Factors
All firms are impacted by the state of the national and global economies. Firms analyze
economic indicators to make decisions about entering or exiting geographic markets,
investing in expansion, and hiring or laying off employees. For example, employment
rates impact the quantity, quality, and cost of employees available to firms. Interest
rates impact sales of big-ticket items that consumers normally finance, such as
appliances, cars, and homes. Interest rates also impact the cost of capital for firms that
want to invest in expansion. Exchange rates present risks and opportunities to all firms
that operate internationally. And the price of oil impacts many industries, from airlines
and transportation companies to solar panel producers and plastic recycling companies.
Thus, it is important for managers to carefully think about the economic factors that can
impact their company. It's also important for managers to think about ways to mitigate
the impact of these economic issues. For example, airline companies like Air Canada
have long dabbled in commodity markets (e.g., using real options and future contracts)
to reduce the uncertainty in oil prices and obtain the jet fuel that's necessary for routine
operations. Similarly, auto companies have long been known to offer zero (or low) interest
rate loans to eligible customers to reduce the impact of varying interest rates on auto
purchases.
S: Sociocultural Factors
Sociocultural factors are a broad category and encompasses everything from changing
national demographics to fashion trends and many things in between. Demographics, a
subset of this category, includes facts about income, education levels, age groups, and
the ethnic and racial composition of a population. All of these demographic factors
present challenges as well as possibilities. Companies can target products to specific
market segments by studying the needs and preferences of demographic groups, such
as working parents (who might need day-care services but do not watch daytime
television), college students (who would be interested in affordable textbooks but
normally cannot afford new cars), or the elderly (who would be willing to pay for lawn-
mowing services but might not be interested in adventure tourism).
Changes in people’s values and interests are also included in this category.
Environmental awareness has spurred demand for solar panels and electric and hybrid
cars. A general interest in health and fitness has created industries in gyms, home gym
equipment, and organic food. The popularity of social media has created an enormous
demand for instant access to information and services, not to mention smartphones.
Values and interests are constantly changing and vary from country to country, creating
new market opportunities as well as communication challenges for companies trying to
enter unfamiliar new markets.
T: Technological Factors
The rise of the internet may be the most disruptive technological change of the last
century. The globe has become more interconnected and interdependent because of the
fast, low-cost communications the Internet provides. Customer service agents in India
can serve customers in Kansas because technology has advanced to the point that the
customer’s account information can be instantly accessed by the service provider in
India. Entrepreneurs around the world can reach customers anywhere through
companies such as eBay, Alibaba, and Etsy, and they can get paid, regardless of their
customers’ currency, through PayPal.
How else have technological factors impacted business? The internet is not the only
technological advance that has transformed how businesses operate. Automation has
increased efficiency for manufacturers. MRP (materials requirement planning) systems
have changed how companies and their suppliers work together, and global-positioning
(GPS) technology has helped construction engineers manage large projects more
accurately. Consumers and firms have nearly unlimited access to information, and this
access has empowered consumers to make better-informed buying decisions and
challenged firms to develop ways to analyze the large amounts of data their businesses
generate.
E: Environmental Factors
The physical environment, which provides natural resources for manufacturing and
energy production, has always been a key part of human business activity. As resources
become scarce and more expensive, environmental factors impact businesses more
every day. Firms are developing technology to operate more cleanly and using fewer
resources. Political pressure on businesses to reduce their impact on the natural
environment has increased globally and dramatically in the 21st century.
This external environment category often overlaps with others in PESTEL because
concern for the environment is also a sociocultural trend, as more consumers look for
recycled products and buy electric and hybrid cars. On the political front, firms are facing
increased regulation around the world on their carbon emissions and natural resource
use.
L: Legal Factors
Legal factors often coincide with political factors because laws are enacted by
government entities. But this does not mean that the categories identify the same issues.
Although labor laws and environmental regulations have deep political connections,
other legal factors can impact business success.
For example, in the streaming video industry, licensing fees are a significant cost for
firms. Netflix pays billions of dollars every year to movie and television studios for the
right to broadcast their content. In addition to the legal requirement to pay the studios,
Netflix must consider that consumers may find illegal ways to view the movies they want
to see, making them less willing to pay to subscribe to Netflix. Thus, intellectual property
rights and patents are major legal issues for Netflix to consider.
Chances are that you are all somewhat familiar with PEST(EL) analysis, so I won't dwell
on this much further. But you should be equipped to conduct a general or macro
environmental analysis using the PEST(EL) framework. This framework is an important
tool to help executives plan for changes in the general environment - changes that may
be outside of their direct control, but demand an adjustment to firm strategy in order to
adapt and survive.
INDUSTRY ENVIRONMENT ANALYSIS USING PORTER'S FIVE FORCES
In order to assess the profitability potential of a narrowly-defined industry, Michael Porter
introduced the Five Forces Analysis tool. Put broadly, this tool holds that the profit
potential of an industry is largely determined by five forces that shape competition: the
threat of entry, power of suppliers, power of buyers, threat of substitutes, and rivalry
among competitors. We will talk about each of the five forces in some depth:
Threat of New Entrants
The threat of entry quantifies the risk that new firms will enter the industry, reducing the
size of the pie for incumbent firms (especially in a slow-growth or mature industry where
demand is stagnant or decreasing over time), and potentially leading to price wars and
other hypercompetitive tactics. New entrants not only threaten the market share of
existing competitors, but also bring additional production capacity, potentially increasing
supply and depressing prices for products and services of the industry.
The threat of new entrants into an industry is best thought of as a function of two things:
(1) the barriers to entry in the industry, and (2) the expected retaliation from incumbents.
A number of aspects may increase the barriers to entry into an industry. If incumbents in
an industry have established significant economies of scale by investing in their
production process and distribution of products, then new entrants will have to scale that
hurdle before their products can be priced competitively. An incumbent with significant
economies of scale can even deliberately price their products below the cost of
production for new entrants to discourage entry.
Similarly, if incumbents in an industry have established strong brands, product
ecosystems, and high levels of customer loyalty, such levels of differentiation and
associated customer switching costs may be enough to keep new entrants from coming
in and gaining market share. Think about the sheer amount of effort it would take for a
new processor manufacturer to compete with the likes of Intel and AMD, or for a new
mobile operating system to compete with iOS and Android. Even if a new company tried
to enter these heavily-fortified industries, they might face swift and ruthless retaliation
from Intel (did you know that Andy Grove, the former CEO of Intel, wrote a book
called Only the Paranoid Survive, where he talks about some crazy actions he had taken
to discourage new entrants?) and Google!
Power of Suppliers
The suppliers to an industry can impact its profit potential under certain conditions.
Powerful, consolidated suppliers can raise the cost of inputs into the production process
or even reduce the quality of the inputs while holding price constant. Consider the case
of the prototypical diamond jeweler making diamond rings, pendants and other jewelry.
Most companies in this industry are hostage to the large, consolidated, vertically-
integrated suppliers of diamonds like De Beers. De Beers can impact the prices of
diamonds by restricting supply. They can even provide lower quality diamonds to
jewelers, impacting the prices of the finished product and profitability of these firms.
Thus, De Beers and other diamond suppliers can exert a lot of pressure on smaller jewelry
firms by demanding higher prices and providing lower quality diamonds.
Generally speaking, the bargaining power of suppliers to an industry is high when:
• Suppliers are few in number and large in size (i.e., concentrated), compared to
firms in the industry they are supplying.
• Suppliers produce differentiated products (e.g., internally flawless large, natural
blue diamonds that are ethically sourced from company-owned mines) and
supply critical inputs to the industry in question.
• There are no strategically-equivalent substitutes for suppliers’ products (e.g., in
the jewelry industry, lab-made diamonds don't have the same appeal and
generate much lower demand).
• Firms face high switching costs due to the effectiveness of suppliers' products.
Power of Buyers
The buyers (or customers) of an industry can impact its profitability potential as well. It is
important to note here that I am referring to the immediate customers of an industry, who
may not be the end consumers of products and services created by that industry. For
example, the North American automobile industry (composed of firms like Ford, GM,
etc.) does not sell directly to end consumers - they are legally barred from doing so by
several state and provincial laws. The immediate customers of the North American
automobile industry happen to be independent automobile dealers and associations of
auto dealers (like NADA - the National Automobile Dealers Association).
Buyer power refers to the extent to which buyers (or customers of the industry) can exert
pressure on incumbent firms to lower prices and increase quality of products and
services. Let's consider the case of the U.S. automobile industry once again. Dealers and
trade associations like NADA have a lot of bargaining power in dealing with auto
manufacturers. Did you know that NADA was responsible for about 22.3% of total retail
sales in the U.S. in 2017, with sales of new vehicles from NADA surpassing $1 trillion?
These numbers give NADA-associated dealers a lot of bargaining power when it comes to
dealing with Ford, GM, FCA, Tesla, etc. In fact, NADA has successfully lobbied several
state and provincial governments to keep Tesla from selling directly to end consumers.
Buyer power is usually high when:
• Buyers are few in number and larger in size (i.e., buyer industry is more
consolidated) compared to the firms in the focal industry
• Buyers are organized into associations that can negotiate on behalf of members
• Buyers purchase a large portion of focal industry’s total output
• Buyers have low switching costs - they can easily move to buy from another
company in the focal industry
• The focal industry's products are undifferentiated or standardized, giving buyers
an opportunity to switch suppliers without losing product features or quality
Threat of Substitutes
Refers to the risk that products or services from outside the industry might adequately
meet the needs of current customers. This threat is especially salient if these products
or services perform same or similar functions at a more competitive price (i.e., the
substitute offers an attractive price-performance trade-off) and if the buyer’s cost of
switching to the substitute is low.
As an example, there are several software products that are substitutes to professional
tax services. Tax prep software such as Intuit’s TurboTax is a substitute for professional
services offered by H&R Block and others. Similarly, LegalZoom, an online legal
documentation service, is a threat to professional law firms. Other examples of
substitutes are energy drinks versus coffee, videoconferencing versus business travel,
gasoline versus biofuel, and wireless telephone services versus Voice over Internet
Protocol (VoIP). When the threat of substitutes is high, it limits the ability of firms in the
industry to charge higher premiums for their products and services, which in turn limits
their profitability potential.
Intensity of Rivalry
One final force that impacts the profitability of an industry is the intensity of rivalry within
that industry. The intensity with which companies in the same industry fight for market
share and profitability has several implications for firm profitability.
In a perfectly competitive market, firms compete to such an extent that no one firm has
any control over the prices charged for products and services. In an oligopoly, on the
other hand, firms have some pricing power, but refrain from competitive attacks knowing
that such an attack may bring about a swift and impactful response in the form of a price
war.
Generally speaking, the intensity of rivalry within an industry is high when:
There are numerous and/or equally balanced competitors.
There is lack of differentiation or low switching costs for customers of the industry.
Industry growth is slow.
Exit barriers are high because of specialized assets or fixed costs of exit, giving incumbent
firms no way out of the industry.
STRATEGIC GROUPS
Until this point, we have examined the general environment and the industry environment
of a firm. Now we move on to examining performance differences within the same
industry.
Strategic Groups
A strategic group comprises of a set of companies in a specific industry that pursue the
same strategy. If you can look at all the companies within an industry and identify sub-
groups of companies based on their strategic positions and customer value propositions,
you will have identified a couple of strategic groups. Consider, for example, the
members of the domestic airline industry in the U.S. Can you identify two sub-
groups here based on strategic positions of the companies? (You might be able to,
depending on whether you've traveled from Canada to the US!)
Based on the airline's customer value proposition (i.e., low prices vs. convenience and
full service), there are two sub-groups that come to light. American Airlines, Delta and
United are all about convenience and enhanced service. All three carriers offer first and
business class service in addition to premium economy, economy, and base economy
services. All three carriers use a hub-and-spoke model to get you between any two
points. You can fly from Duluth, MN (about 3.5 hours south of Thunder Bay) to La Crosse,
WI (where I worked for six years), and then onward to Fayetteville, AR (where I went to grad
school for seven years) on American Airlines or Delta, with minimal stopovers. You can
even fly first class, with priority boarding, curbside check-in, and a full suite of amenities.
On the other hand, the remaining five airlines (Southwest, Sun Country, Jet Blue, etc.) are
all low-cost point-to-point airlines that offer very limited service. If you wanted to get from
Thunder Bay to Fayetteville, AR using Southwest, you'd have to drive to Minneapolis
(about 6 hours from TB), fly to Tulsa (with a layover in Denver, which happens to be
nowhere near either city!), and then drive another two hours from Tulsa to Fayetteville.
Southwest only operates out of secondary airports (like Chicago Midway, Houston
Hobby, and Dallas Lovefield) located near large population catchment areas to minimize
the costs of leasing gates and terminals at primary airports like O'Hare and Dallas/Fort
Worth Intl. Most other airlines within its strategic group do the same thing.
Strategic Group Mapping
Strategic Group Mapping is the technique used to identify the major players in an industry
and determine the strategically-relevant characteristics that distinguish companies in
the industry. For example, depending on the industry you're analyzing, you may find sub-
groups of companies emerge based on characteristics like quality or price or products or
services, breadth of distribution network, domestic vs. global operations, product-line
breadth, level of vertical integration (e.g., some companies may be heavily vertically
integrated with very complex operations across several stages in the value chain, while
other companies may only occupy one stage in the value chain - more on this in a future
module!), breadth of geographic markets, etc.
For example, in the above exercise, you may notice two different subgroups emerge
based on ticket prices and the number of routes served:
There are a number of insights to be hand from mapping out a firm's strategic group.
Usually, rivalry is strongest within a strategic group - firms within a strategic group
monitor each other’s actions and respond to competitive moves. Southwest might be
least bothered if Delta came up with a new class of service (perhaps something between
premium economy and business!). On the other hand, American Airlines might be
tempted to closely scrutinize Delta's every move and contemplate making changes
themselves.
Furthermore, changes in the external environment affect strategic groups differently.
Low-cost point-to-point airlines may not be as affected by a reduction in consumer
spending. However, American Airlines, Delta and United might see some of their most
profitable seats (First/Business) go unfilled. To complicate matters even further, even the
five forces can affect strategic groups differently. As an example, American Airlines,
Delta and United may easily pass on supplier cost increases (from Boeing and Airbus) to
their higher-paying customers. JetBlue and Sun Country may not be able to deal with
powerful suppliers like Boeing and Airbus as easily owing to their smaller size, lower
negotiating power, and smaller margins.