As a rule the weaker the collective impact of competitive pressures associated with the five

LEARNING OBJECTIVES

LO1 Identify factors in a company’s broad macro-environment that may have strategic significance.

LO2 Recognize the factors that cause competition in an industry to be fierce, more or less normal, or relatively weak.

LO3 Become adept at mapping the market positions of key groups of industry rivals.

LO4 Learn how to determine whether an industry’s outlook presents a company with sufficiently attractive opportunities for growth and profitability.

Evaluating a Company’s External Environment

3 chapter

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38 Part 1 Section B: Core Concepts and Analytical Tools

In Chapter 2, we learned that the strategy formulation, strategy execution process begins with an appraisal of the company’s present situation. The company’s situation includes two facets: (1) the competitive conditions in the industry in which the company operates—its external environment; and (2) its resources and organizational capabilities—its internal environment.

Charting a company’s long-term direction, conceiving its customer value proposition, setting objectives, or crafting a strategy without first gaining an understanding of the company’s external and internal environments ham- strings attempts to build competitive advantage and boost company perfor- mance. Indeed, the first test of a winning strategy inquires, “How well does the strategy fit the company’s situation?”

This chapter presents the concepts and analytical tools for zeroing in on a single-business company’s external environment. Attention centers on the competitive arena in which the company operates, the drivers of market change, the market positions of rival companies, and the factors that deter- mine competitive success. Chapter 4 explores the methods of evaluating a company’s internal circumstances and competitiveness.

Evaluating the Strategically Relevant Components of a Company’s Macro-Environment A company’s external environment includes the immediate industry and com- petitive environment and broader macro-environmental factors such as general economic conditions, societal values and cultural norms, political factors, the legal and regulatory environment, ecological considerations, and technologi- cal factors. These two levels of a company’s external environment—the broad outer ring macro-environment and immediate inner ring industry and com- petitive environment—are illustrated in Figure 3.1 . Strictly speaking, a com-

pany’s macro-environment encompasses all of the relevant factors making up the broad environmental context in which a company operates; by relevant, we mean the factors are important enough that they should shape management’s decisions regard- ing the company’s long-term direction, objectives, strategy, and business model. The relevance of macro- environmental factors can be evaluated using PESTEL analysis , an acronym for the six principal components of the macro-environment: political factors, economic conditions in the firm’s general environment, sociocultural forces, techno- logical factors, environmental forces, and legal/

regulatory factors. Table 3.1 provides a description of each of the six PESTEL components of the macro-environment.

The impact of outer ring macro-environmental factors on a company’s choice of strategy can be big or small. But even if the factors of the macro- environment change slowly or are likely to have a low impact on the company’s

LO1 Identify factors in a company’s broad macro-environment that may have strategic significance.

CORE CONCEPT The macro-environment encompasses the broad environmental context in which a company is situ- ated and is comprised of six principal components: political factors, economic conditions, sociocultural forces, technological factors, environmental fac- tors, and legal/regulatory conditions.

PESTEL analysis can be used to assess the stra- tegic relevance of the six principal components of the macro-environment: political, economic, social, technological, environmental, and legal forces.

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Chapter 3 Evaluating a Company’s External Environment 39

Component Description

Political factors These factors include political policies and processes, including the extent to which a government intervenes in the economy. They include such matters as tax policy, fiscal policy, tariffs, the political climate, and the strength of institutions such as the federal banking system. Some political factors, such as bailouts, are industry-specific. Others, such as energy policy, affect certain types of indus- tries (energy producers and heavy users of energy) more than others.

Economic conditions

Economic conditions include the general economic climate and specific factors such as interest rates, exchange rates, the inflation rate, the unemployment rate, the rate of economic growth, trade deficits or surpluses, savings rates, and per capita domestic product. Economic factors also include conditions in the markets for stocks and bonds, which can affect consumer confidence and dis- cretionary income. Some industries, such as construction, are particularly vulnerable to economic downturns but are positively affected by factors such as low interest rates. Others, such as discount retailing, may benefit when general economic conditions weaken, as consumers become more price-conscious.

Sociocultural forces

Sociocultural forces include the societal values, attitudes, cultural factors, and lifestyles that impact businesses, as well as demographic factors such as the population size, growth rate, and age distribu- tion. Sociocultural forces vary by locale and change over time. An example is the trend toward healthier lifestyles, which can shift spending toward exercise equipment and health clubs and away from alcohol and snack foods. Population demographics can have large implications for industries such as health care, where costs and service needs vary with demographic factors such as age and income distribution.

Technological factors

Technological factors include the pace of technological change and technical developments that have the potential for wide-ranging effects on society, such as genetic engineering and nanotechnology. They include institutions involved in creating knowledge and controlling the use of technology, such as R&D consortia, university-sponsored technology incubators, patent and copyright laws, and govern- ment control over the Internet. Technological change can encourage the birth of new industries, such as those based on nanotechnology, and disrupt others, such as the recording industry.

TABLE 3.1

The Six Components of the Macro-Environment Included in a PESTEL Analysis

FIGURE 3.1 The Components of a Company’s External Environment

Ind ustry

and Competitive Environment

Company

Macro-Environment

Suppliers

Rival Firms

New Entrants

Buyers

Substitute Products

Economic conditions

Sociocultural Forces

Political Factors

Legal/Regulatory Factors

Environmental Forces

Technological Factors

(continued)

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40 Part 1 Section B: Core Concepts and Analytical Tools

business situation, they still merit a watchful eye. Motor vehicle companies must adapt their strategies to customer concerns about carbon emissions and high gasoline prices. Changes in lifestyles, attitudes toward nutrition and fit- ness, and leisure preferences have begun to have strategy-shaping effects on companies competing in the processed food, restaurant, and fitness industries. As company managers scan the external environment, they must be alert for potentially important outer ring developments, assess their impact and influ- ence, and adapt the company’s direction and strategy as needed.

However, the factors and forces in a company’s macro-environment that have the biggest strategy-shaping impact typically pertain to the company’s immediate inner ring industry and competitive environment—competitive pressures, the actions of rival firms, buyer behavior, supplier-related consid- erations, and so on. Consequently, this chapter concentrates on a company’s industry and competitive environment.

Assessing the Company’s Industry and Competitive Environment Thinking strategically about a company’s industry and competitive environ- ment entails using some well-validated concepts and analytical tools to get clear answers to seven questions:

1. Do the dominant economic characteristics of the industry offer sellers opportunities for growth and attractive profits?

2. What kinds of competitive forces are industry members facing, and how strong is each force?

3. What forces are driving industry change, and what impact will these changes have on competitive intensity and industry profitability?

4. What market positions do industry rivals occupy—who is strongly posi- tioned and who is not?

5. What strategic moves are rivals likely to make next? 6. What are the key factors of competitive success? 7. Does the industry outlook offer good prospects for profitability?

Component Description

Environmental forces

These include ecological and environmental forces such as weather, climate, climate change, and associated factors like water shortages. These factors can directly impact industries such as insur- ance, farming, energy production, and tourism. They may have an indirect but substantial effect on other industries such as transportation and utilities.

Legal and regulatory factors

These factors include the regulations and laws with which companies must comply such as con- sumer laws, labor laws, antitrust laws, and occupational health and safety regulation. Some factors, such as banking deregulation, are industry-specific. Others, such as minimum wage legislation, affect certain types of industries (low-wage, labor-intensive industries) more than others.

TABLE 3.1 (continued)

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Chapter 3 Evaluating a Company’s External Environment 41

Analysis-based answers to these questions are prerequisites for a strategy offering good fit with the external situation. The remainder of this chapter is devoted to describing the methods of obtaining solid answers to the seven questions above.

Question 1: What Are the Industry’s Dominant Economic Characteristics? Analyzing a company’s industry and competitive environment begins with identifying the industry’s dominant economic characteristics. While the gen- eral economic conditions of the macro-environment identified through PESTEL analysis may prove to be strategically relevant, it is the economic characteris- tics of the industry that will have a greater bearing on the industry’s prospects for growth and attractive profits. An industry’s dominant economic charac- teristics include such factors as market size and growth rate, the geographic boundaries of the market (which can extend from local to worldwide), market demand-supply conditions, market segmentation, and the pace of technologi- cal change. Table 3.2 summarizes analytical questions that define the indus- try’s dominant economic features.

Getting a handle on an industry’s distinguishing economic features not only provides a broad overview of the attractiveness of the industry, but also

Economic Characteristic Questions to Answer

Market size and growth rate • How big is the industry and how fast is it growing?

• What does the industry’s position in the life cycle (early development, rapid growth and takeoff, early maturity and slowing growth, saturation and stagnation, decline) reveal about the industry’s growth prospects?

Scope of competitive rivalry • Is the geographic area over which most compa- nies compete local, regional, national, multina- tional, or global?

Demand-supply conditions • Is a surplus of capacity pushing prices and profit margins down?

• Is the industry overcrowded with too many competitors?

Market segmentation • Is the industry characterized by various product characteristics or customer wants, needs, or preferences that divide the market into distinct segments?

Pace of technological change • What role does advancing technology play in this industry?

• Do most industry members have or need strong technological capabilities? Why?

TABLE 3.2

What to Consider in Identifying an Industry’s Dominant Economic Features

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42 Part 1 Section B: Core Concepts and Analytical Tools

promotes understanding of the kinds of strategic moves that industry mem- bers are likely to employ. For example, industries that are characterized by rapid technological change may require substantial investments in R&D and the development of strong product innovation capabilities—continuous prod- uct innovation is primarily a survival strategy in such industries as video games, computers, and pharmaceuticals.

Question 2: How Strong Are the Industry’s Competitive Forces? After gaining an understanding of the industry’s general economic charac- teristics, industry and competitive analysis should focus on the competitive dynamics of the industry. The nature and subtleties of competitive forces are never the same from one industry to another and must be wholly under- stood to accurately assess the company’s current situation. Far and away the most powerful and widely used tool for assessing the strength of the indus- try’s competitive forces is the five-forces model of competition. 1 This model, as depicted in Figure 3.2 , holds that competitive forces affecting industry attrac- tiveness go beyond rivalry among competing sellers and include pressures stemming from four coexisting sources. The five competitive forces affecting industry attractiveness are listed below.

1. Competitive pressures stemming from buyer bargaining power. 2. Competitive pressures coming from companies in other industries to win

buyers over to substitute products. 3. Competitive pressures stemming from supplier bargaining power. 4. Competitive pressures associated with the threat of new entrants into the

market. 5. Competitive pressures associated with rivalry among competing sellers to

attract customers. This is usually the strongest of the five competitive forces.

The Competitive Force of Buyer Bargaining Power Whether seller-buyer relationships represent a minor or significant competi- tive force depends on (1) whether some or many buyers have sufficient bar- gaining leverage to obtain price concessions and other favorable terms, and (2) the extent to which buyers are price sensitive. Buyers with strong bargain- ing power can limit industry profitability by demanding price concessions, better payment terms, or additional features and services that increase indus- try members’ costs. Buyer price sensitivity limits the profit potential of indus- try members by restricting the ability of sellers to raise prices without losing volume or unit sales.

The leverage that buyers have in negotiating favorable terms of the sale can range from weak to strong. Individual consumers, for example, rarely have much bargaining power in negotiating price concessions or other favorable terms with sellers. The primary exceptions involve situations in which price

LO2 Recognize the factors that cause competition in an industry to be fierce, more or less normal, or relatively weak.

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Chapter 3 Evaluating a Company’s External Environment 43

haggling is customary, such as the purchase of new and used motor vehicles, homes, and other big-ticket items such as jewelry and pleasure boats. For most consumer goods and services, individual buyers have no bargaining lever- age—their option is to pay the seller’s posted price, delay their purchase until prices and terms improve, or take their business elsewhere.

In contrast, large retail chains such as Walmart, Best Buy, Staples, and Home Depot typically have considerable negotiating leverage in purchas- ing products from manufacturers because retailers usually stock just two or three competing brands of a product and rarely carry all competing brands. In addition, the strong bargaining power of major supermarket chains such as Kroger, Safeway, and Albertsons allows them to demand promotional allow- ances and lump-sum payments (called slotting fees) from food products man- ufacturers in return for stocking certain brands or putting them in the best shelf locations. Motor vehicle manufacturers have strong bargaining power in negotiating to buy original equipment tires from Goodyear, Michelin, Bridge- stone/Firestone, Continental, and Pirelli not only because they buy in large

Rivalry among Competing

Sellers Competitive pressures

created by the jockeying of rival sellers for

better market position and competitive

advantage

Buyers

Competitive pressures stemming

from seller- buyer

collaboration and

bargaining

Competitive pressures stemming

from supplier-

seller collaboration

and bargaining

Competitive pressures coming from the threat of entry of new rivals

Suppliers of Raw Materials, Parts,

Components, or Other

Resource Inputs

Competitive pressures coming from the market attempts of outsiders to win buyers over to their products

Firms in Other Industries Offering Substitute Products

Potential New Entrants

FIGURE 3.2 The Five-Forces Model of Competition

Sources: Based on Michael E. Porter, “How Competitive Forces Shape Strategy,” Harvard Business Review 57, no. 2 (March–April 1979), pp. 137–45; and Michael E. Porter, “The Five Competitive Forces That Shape Strategy,” Harvard Business Review 86, no. 1 (January 2008), pp. 80–86.

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44 Part 1 Section B: Core Concepts and Analytical Tools

quantities, but also because tire makers have judged original equipment tires to be important contributors to brand awareness and brand loyalty.

Even if buyers do not purchase in large quantities or offer a seller important market exposure or prestige, they gain a degree of bargaining leverage in the following circumstances:

• If buyers’ costs of switching to competing brands or substitutes are relatively low. Buyers who can readily switch between several sellers have more negotiating leverage than buyers who have high switching costs. When the products of rival sellers are virtually identical, it is relatively easy for buyers to switch from seller to seller at little or no cost. For example, the screws, rivets, steel, and capacitors used in the production of large home appliances such as washers and dryers are all commodity-like and avail- able from many sellers. The potential for buyers to easily switch from one seller to another encourages sellers to make concessions to win or retain a buyer’s business.

• If the number of buyers is small or if a customer is particularly important to a seller. The smaller the number of buyers, the less easy it is for sellers to find alternative buyers when a customer is lost to a competitor. The prospect of losing a customer who is not easily replaced often makes a seller more will- ing to grant concessions of one kind or another. Because of the relatively small number of digital camera brands, the sellers of lenses and other com- ponents used in the manufacture of digital cameras are in a weak bargain- ing position in their negotiations with buyers of their components.

• If buyer demand is weak. Weak or declining demand creates a “buyers’ market”; conversely, strong or rapidly growing demand creates a “sellers’ market” and shifts bargaining power to sellers.

• If buyers are well informed about sellers’ products, prices, and costs. The more information buyers have, the better bargaining position they are in. The mushrooming availability of product information on the Internet is giv- ing added bargaining power to individuals. It has become common for automobile shoppers to arrive at dealerships armed with invoice prices, dealer holdback information, a summary of incentives, and manufactur- ers’ financing terms.

• If buyers pose a credible threat of integrating backward into the business of sell- ers. Companies such as Anheuser-Busch, Coors, and Heinz have inte- grated backward into metal can manufacturing to gain bargaining power in obtaining the balance of their can requirements from otherwise power- ful metal can manufacturers.