MGMT project

Essential summary

The external environment is those conditions external to the organi- zation which influence the organization and its industry, especially those that influence the intensity of competition.

The PESTEL framework is a broad but useful mnemonic to group external environmental influences into political, economic, social, technological, environmental, and legal factors.

Structural breaks are fundamental and unpredictable events in the external environment which are likely to require a sudden rethinking about an organization’s purpose and strategy.

The industry life cycle likens the life of an industry to a living organism that goes through stages of introduction, growth, maturity, and decline; each stage exhibits distinct characteristics that should be considered against the purpose of the organization.

The five competitive forces are the primary influences affecting choice of industry and competitive positioning, which affect an orga- nization’s competitive advantage and profitability.

Hypercompetition is a dynamic state of constant disequilibrium and competitive change in an industry.

The external environment3

An organization’s external environment consists of the conditions outside the organization, including the people and organizations that influence the external changes in the organization’s industry, especially those that influ- ence the intensity of competition. External conditions are constantly chang- ing, and organizations need to monitor and review strategy continuously to effectively manage any emerging threats and to be able to exploit advanta- geous opportunities. Many changes are difficult to identify, and their con- sequences are often uncertain and even unknowable. The starting point is

C o p y r i g h t 2 0 2 0 . R o u t l e d g e .

A l l r i g h t s r e s e r v e d . M a y n o t b e r e p r o d u c e d i n a n y f o r m w i t h o u t p e r m i s s i o n f r o m t h e p u b l i s h e r , e x c e p t f a i r u s e s p e r m i t t e d u n d e r U . S . o r a p p l i c a b l e c o p y r i g h t l a w .

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The external environment 17

to monitor and review the background trends to identify and assess oppor- tunities and threats; this drives the strategic management process from the outside in.

The PESTEL framework The most comprehensive and most used approach for grouping and review- ing macro-environmental trends in strategic management is PESTEL, which is a mnemonic for political, economic, social, technological, environment, and legal factors. Changes over time in any of these areas are liable to lead to the transformation of industries. If an organization monitors and audits its external environment it will be better able to respond to trends and respond more quickly to change than its competitors. As the old saying goes – ‘The early bird catches the worm.’

While the framework comprises six categories, it is important to use it as an integrated, not compartmentalized view of trends and changes. Stra- tegic management is about seeing and understanding connections and is not concerned with isolated trends but with the management of the BIG picture. Of course, picking out critical details is vital for understanding how change may occur but only in terms of what this suggests for an organization’s strategic management. It is important to understand how trends may work together to drive change and innovation. There will be opportunities as well as risks. A periodic PESTEL review challenges strategists to think about long-term trends and raise questions, such as, ‘Will our overall strategy give enough flexibility to deal with new forms of competition?’

Political trends

Political factors include trends in not only the actions of local, national, and international governments and agencies but also the thinking and activi- ties of influential groups and individuals. Competition in many areas is shaped by government policies and regulatory decisions. For example, great uncertainty is hanging over global markets because of a possible trade war between the United States and China.

Economic trends

Economic trends include resource use and prices, interest rates, disposal income, economic growth, inflation, and productivity. Since the financial crisis of 2008, the emergent economies of China, India, and some other Asian countries have led the world in rates of economic growth. While glo- balization has slowed down in the wake of the global financial crisis, it shows every sign of continuing albeit at a slower pace.

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18 The external environment

Social trends

Social factors include demographic, social and lifestyle trends, group identi- ties and gender roles, national cultures, ethics, morality, and expectations. The post-WWII baby boom in Western countries brought into existence a sizeable and distinct group of consumers who, as they age, will spend more on health and leisure.

Technological trends

Technology includes the impact of new and developing technological change on resources, organizational behaviours, products and services, and operations. The prevalence of smartphones and price scanning applications and the increased use of the Internet are transforming the nature of shopping and the role of information more generally.

Environmental trends

Environmental factors include not only quality of life, sustainability, and recycling of resources but also logistical possibilities and infrastructure. Issues such as world resources, global warming, and pollution caused by plastic packaging and intensive farming are intensifying and will have to be taken into account by most organizations.

Legal trends

Legal factors include laws and regulatory action, standards, border require- ments, labour regulations, and so on. This may also include globalization issues dealing with international trade and competition law. National legal frameworks vary considerably, and their consequences for individual indus- tries are profound. One of the most significant trends is the tightening of regulatory accounting standards following large corporate failures – such as Enron, Tyco International, Peregrine Systems, and WorldCom – and the bursting of the dot.com bubble.

The PESTEL process

The PESTEL process should be kept as simple as possible with the big picture always kept central. The use of the approach should follow this set of principles:

1 Someone should be in charge of the process, including meetings and discussions.

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The external environment 19

2 Before starting, think through the process and be clear what the objec- tives of the PESTEL analysis are.

3 Keep it simple; do not get bogged down in detail so that the big picture gets lost.

4 Involve a balance of pessimists and optimists; include outsiders with different perspectives and beware of vested interests and group-think.

5 Agree on appropriate sources and check inside the organization first for information.

6 Use visual tools and discussion aids. 7 Identify the most critical factor issues for strategy. 8 Produce a discussion document for wider circulation. 9 Use feedback and follow-up checks on actions and keep all PESTEL

participants informed on follow-up to encourage continual dialogue. 10 Decide which issues to monitor on an ongoing basis; link to existing

in-house processes for monitoring and reviewing change, especially for planning.

PESTEL is a useful framework to check and determine strategic priori- ties since managers are encouraged to look beyond their organization and industry and to be less insular. But beware of weaknesses in the method. It can be too easy to scan data and over time slip into lazily ticking boxes. A good PESTEL should go deep enough to consider the root causes behind the trends; things are not always as they appear. The analysis should not merely highlight the obvious; strategists should avoid information overload. Issues should be strategic, not operational, and always relevant to an organization’s purpose. There should be a concentration on those factors and issues of most relevance to driving change. Be mindful that ideas are always a question of creativity and judgement – be critically creative.

Black swans and structural breaks PESTEL analysis is primarily about monitoring and reviewing longer-term trends, but there are also single events that cannot easily be foreseen. These are structural breaks that subvert trends and change existing behavioural patterns. These will require organizations in general to rethink their purpose and overall strategy. Some are so potentially catastrophic that a societal and perhaps a world response are required. The World Health Organization’s projected the impact of influenza A/H5N1 pandemic (avian/bird flu) is 7 to 350 million deaths.

David Hume used the discovery of black swans in Australia to illustrate that no matter how many times something can be proved – that swans are always white – it takes only a single event to prove it untrue. This example

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20 The external environment

was developed by Nassim Taleb (2007) in his book The Black Swan, in which he wrote about events that cannot be predicted. When they occur, they have a massive impact that takes everyone by surprise. The global financial crisis in 2008 was a good example of a structural break.

Compliance requirements have helped to drive the documentation of stra- tegic risks in organizations. The US Securities and Exchange Commission requires publicly listed companies to document the key business areas and the underlying assumptions that are core to strategic success. This is central to strategic risk management – a systematic and overall approach for man- aging external events and trends that could seriously harm an organization’s effectiveness for achieving its longer-term purpose. It should be a central part of any organization’s strategic management.

Strategic risk management should have these key aspects:

1 A statement of an organization’s value proposition in relation to busi- ness objectives

2 A definition of risks based on the organization’s objectives and support- ing business strategy

3 A statement on the required corporate culture and behavioural expecta- tions with regard to risk taking

4 A definition of organizational ownership of risk management strategy at organizational levels

5 A description of the management framework or system being employed to deliver the above requirements

6 A definition of the performance criteria employed for reviewing the effectiveness of the risk management framework

While there is no useful way to see when structural breaks and the risks they bring will occur, a PESTEL analysis is likely to raise questions like ‘what if?’ Downturns in the world economy occur every few years, and there have been four global recessions in the last 50 years. While the timing of a future downturn is uncertain, it is possible to learn something from past events. Some industries, for instance, seem able to weather recessions better than others, such as utilities, telecommunication services, health care, and consumer staples, but these are less likely to grow significantly during an upturn. Industries also have their own periodic cycles.

Industry life cycle The industry life cycle likens the life of an industry to a living organism: markets expand over time, eventually maturing and finally declining. The life cycle has introduction, growth, maturity, and decline stages (see

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The external environment 21

Figure 3.1). The competitive conditions of the industry change as the stages change.

Introduction stage

In the beginning, production is low, costs are high, and demand is very low. There may be a large variety of products and services and diverse orga- nizations. Small entrepreneurial organizations are typically involved, but well-established organizations from other industries may be diversifying and entering a new industry to test the water. An important barrier to entry may be based on knowledge of a developing technology, and large organiza- tions acquire this by taking over small specialist firms. The first to perfect a robust design and applications may be able to capture a significant part of the future market as a first mover. Success is not necessarily based on either best function or lowest cost but rather a robust product supported by a mar- keting mix that locks in first users, who often buy for reasons of novelty, and early adopters, who are into the personality of the brand.

Growth stage

This is the time when first movers become well established and take domi- nant positions in their industries. Expansion comes as customers, distribu- tors, and retailers become familiar with the new products and as supplier organizations gain experience and exploit greater economies of scale to offer

Figure 3.1 Industry life cycle stages

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22 The external environment

lower prices. A tipping point is reached at a sales threshold when a band- wagon effect gathers force and the number of competing organizations first rises and then reduces to a handful as a dominant design establishes itself.

Maturity stage

A mature industry is relatively stable, and competition has reduced to a handful of rivals. The term category killer is sometimes used by observers to describe an organization that has been able to eliminate most of the com- petition for a category of product or service. During the maturity stage, it is no longer possible to maintain individual growth rates without capturing market shares from other rivals. Generally, because of large-scale produc- tion advantages, prices are low and rivals compete through distribution and brand loyalty. Economies of scale and branding constitute significant bar- riers to entry to the industry. If the number of surviving companies is fairly large and similar in size, oligopolistic positions may mean they are well placed to avoid price wars and be able to take advantage of high prices and earn high profits. The maturity stage is also a time when a basic product or service is developed as a range of different but related offers. Each offer is subject to its own product life cycle when the marketing programme is changed to suit the evolving needs of the segment.

Decline stage

The reasons for decline may lie embedded in the general environment and in any of the PESTEL factors. An important reason is a change in technology, although sometimes old technology can rally – a ‘sailing ship effect’ – when steam ships were introduced, sailing technology actually became more effi- cient. In modern times the convergence of computing, telecommunications, and media technology has transformed industries, bringing about new life cycles.

Do industry life cycle models work?

An industry life cycle model helps strategists identify the opportunities and threats that characterize different industry environments. Managers need to design their strategy to take account of changing conditions. How- ever, it is often difficult to identify a stage precisely and even more dif- ficult to forecast since there is no universally recognized standard length of life cycles. The strength of the concept lies in its use as a powerful tool for clarifying strategic options as industries and markets develop broadly along trajectories from uncertain beginnings through typically chaotic and

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The external environment 23

intensely competitive growth and afterwards reach more mature and rela- tively stable states.

The industry life cycle focuses on the characteristics of an industry’s stages of development. Nevertheless, it may not be the stages as such but actually how rivals in those stages compete with each other that is impor- tant. It is not just the general conditions of an industry and its markets but how rival organizations compete against each other to survive – and the fittest survive:

Some make the deep-seated error of considering the physical condi- tions . . . as the most important for its inhabitants; whereas it cannot, I think, be disputed that the nature of the other inhabitants with which each has to compete is generally a far more important element of success.’

(Charles Darwin, 1859)

The five competitive forces Arguably the most influential contribution to thinking about competitive strategy has come from Michael Porter (1980), who introduced the industry profitability and five competitive forces framework (see Figure 3.2). The cen- tral force is the intensity of the rivalry between existing competitors; this is influenced by four others – the threat of new business, the bargaining power

Threat of new

business Bargaining power of

customers

Threat of substitute products

or services

Bargaining power of suppliers

Rivalry among current competitors

Figure 3.2 The five competitive forces

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24 The external environment

of customers, the bargaining power of suppliers, and the threat of substitute products and services. The strength of these forces and the way they influ- ence each other determine an industry’s profitability and shape its structure.

Porter contrasts the global automotive industry, the international art mar- ket, and the regulated health care industry in Europe and observes that, while each is different on the surface, the profitability of each industry is conditioned by the same underlying driving forces of competition. The prin- ciple facing the strategist is how an organization can sustain an advanta- geous position in its industry.

If the competitive forces are intense, an organization is unlikely to earn attractive returns on its investment. If they are weak, above-average returns are possible. Many factors have an influence on short-term profitability, but it is important to realize that the five competitive forces are factors that apply to the longer-term. For example, while the price of food moves up and down depend- ing upon the weather and the cost of fuel for storage and transport, the general and longer-term profitability of supermarkets rests on the bargaining power of the retail chains in relation to their suppliers and customers. The threat of new entrants is low, and the scope for substitutes for groceries is limited.

An individual organization must consider its industry structure as well as its own strategic position within the industry if it is going to defend itself and shape an industry’s forces in its favour. The nature of the forces differs by industry, and the strongest force may not be obvious. For example, the threat of new business has been low for supermarkets. Traditionally, the value created for customers of supermarkets lies in their convenience and low costs, and this has critically depended for the customer on the location of the stores. However, Internet shopping now poses uncertainty for longer-term profitability.

The threat of new entrants (new business)

New competition from outside brings additional capacity pressures on exist- ing market shares that influence prices, costs, and investment in an industry. For this reason many existing firms in a threatened industry may hold down profitability to make their industry less attractive to possible entrants. If entry barriers are low and industry profitability is high, new business can enter the industry and drive down prices and raise costs for the existing competitors. The challenge for new entrants is to find ways to overcome the entry barriers without the heavy costs of investment that cancel out the profitability of operating in the industry. There are eight sources of barriers to entry that entrants have to consider and overcome:

1 Supply-side economies of scale – incumbents have a cost advantage over incumbents from economies of scale and can sustain lower prices.

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The external environment 25

2 Demand-side benefits of scale – incumbents have a reputation for qual- ity and service that comes from size.

3 Customer switching costs – there is a high cost to customers of incum- bents in switching to entrants.

4 Capital requirements – cost and availability for investment in new areas are likely to be high for entrants.

5 Incumbency advantages independent of size – there are advantages stemming from first advantage, such as proprietary technology, access to resources, and locations.

6 Unequal access to distribution channels – fewer wholesale and retail channels may mean these are tied up by incumbents.

7 Restrictive government policy – competition policy, regulation, and licensing may foreclose entry to entrants from overseas.

8 Expected retaliation – the ability and history of incumbents to retaliate when faced with new competition may deter entrants.

The bargaining power of customers

Powerful customers or groups of customers can force suppliers in an indus- try to lower prices, demand more customized features, and force up service and quality levels. This activity drives down an organization’s profitability and shifts the balance of power and value in favour of buyers. Customers have an advantage if the following conditions apply:

1 Customers are few and buy in quantities that are large in relation to the size of suppliers: if the fixed costs of suppliers are high and marginal costs are low, there are likely to be attempts to keep capacity filled through discounting.

2 The industry’s products are standardized or undifferentiated: if buyers can find equivalent products elsewhere, suppliers can be played off against each other.

3 Customers have low switching costs in changing suppliers. 4 Customers can produce the product themselves if a supplier is too costly.

Buyers are likely to be sensitive to prices if the cost of the product or service is a significant proportion of its costs and are likely to search for best deals and to negotiate hard. The opposite is true when price forms a low percentage of a buyer’s costs. In general, however, price is less important when the quality of the supplied product and its influence on the buyer’s own products are vital considerations. The importance of service, especially when quick response and advice are required from the supplier, can be much more important than price. Also, cash-rich and profitable business customers with healthy enterprises may

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26 The external environment

be less sensitive to levels of price. Intermediate customers and customers who are not the end-user of the final product, such as in distribution, are similarly less motivated by price. Producers often attempt to reduce the power of chan- nels through exclusive arrangements with distributors and retailers.

The bargaining power of suppliers

The strength of suppliers will influence the profitability of customer organi- zations; if this is strong, suppliers can negotiate higher prices to their advan- tage. This is likely to apply if any of the following conditions apply to an industry’s suppliers:

1 Supply is more concentrated than the industry’s customers. 2 Suppliers are not dependent upon a single industry for their revenues. 3 Suppliers have customers with high switching costs and close supply

chain relations with customers. 4 Suppliers with differentiated products and services are less dependent

on individual customers. 5 Suppliers have products and services for which there are no substitutes. 6 Suppliers have a potential to integrate forward and enter a customer’s

market.

The threat of substitute products and services

Substitutes are nearly always present but are difficult to identify if they appear different in form from an industry’s products or services. However, the threat of substitutes influences an industry’s profitability because it may enable an industry’s customers to go elsewhere. The threat of substitutes is high if it is apparent that alternatives offer an attractive price-performance trade-off to the industry’s offer. The customer’s switching cost must be low not just in terms of costs but also in terms of convenience and assurance.

Rivalry among existing competitors

This competitive force is influenced by the other four and is the most pow- erful, depending upon how aggressively rivals are using the other forces to strengthen positions, increase revenue, and save costs. Rivalry is strong when competitors are roughly of equal power and size and are numerous. In this case it is difficult for any organization to win customers without taking them from rivals. Unless the industry has an industry leader which sets the competitive conditions for the industry, competition is likely to be unstable and costly for the industry as a whole.

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The external environment 27

Slow industry growth, which is a characteristic of mature markets, can stimulate intense competition for market share. This is especially so if exit barriers are high, when organizations are locked into technologies and have specialized resources that are limited in resale value to other industries. Too many suppliers in an industry may lead to chronic excess capacity that is likely to encourage discounting.

Organizations are often present in an industry for a variety of reasons, including non-profit ones, such as the presence of public-service organiza- tions that have social objectives. There may also be organizations that are part of larger groups and are primarily interested in having the experience of the industry’s technology and business, which they use to develop products and services in other industries. This may lead to lower profitability in the industry and make it less attractive.

The importance of the five forces

Michael Porter revisited his five force framework in an article published in 2008, in which he summed up its importance:

Understanding the forces that shape industry competition is the starting point for developing strategy. Every company should already know what the average profitability of its industry is and how it has been changing over time. The five forces reveal why industry profitability is what it is. Only then can a company incorporate industry conditions into strategy.

An organization’s competitive strategy can be based on building defences against the five forces or on finding a position in an industry where the forces are weakest. Porter warns that an organization should be careful not to set in motion dynamics that will undermine the attractiveness of the industry in the longer-term. However, for some industries, especially those emerging from new technologies, the short-term may be more important.

Hypercompetition The short-term is important in conditions of hypercompetition, described by Richard D’Aveni (1994) as a competitive state of constant disequilibrium and change. The concept gained popularity in the early years of the Internet and the rise of the new dot.com enterprises. In emerging and rapidly changing markets competitive advantage is transient rather than sustainable, and orga- nizations typically move on before competitors can react. There is an empha- sis on renewing rather than protecting an existing market. A related idea is disruptive innovation, an idea described by Clayton Christensen (1997) as a

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28 The external environment

revolutionary product that replaces existing ways of competing. There are two basic forms: the first acts to create new competition with new markets and customers; the second acts to generate new value for existing custom- ers who are located in a low value-added part of a market, where existing competition is concentrating effort up-market rather than defending low- end segments.

Michael Porter (1999) has noted that new competition generated by e-commerce has encouraged many observers to claim that there can be little advantage in sustaining a competitive strategy over time and that organiza- tions instead should be nimble, quick, and able to learn as change happens. While this may be true, Porter suggests the danger is that this leads organiza- tions to compete only on best practice rather than on competitive difference. In the end, because rivals do similar things and offer similar products and services, customers choose only on prices, and the resulting price competi- tion will eventually undermine industry profitability.

Strategic fit Strategic fit is matching the opportunities of the external environment with an organization’s internal capabilities. The opportunities and threats sug- gested by PESTEL, the industry life cycle, and the five competitive forces have to be assessed against the strengths and weakness of the organization’s internal environment. How good this fit is will be an important determinant of the strategic success of the organization in achieving its purpose.

References Christensen, C. M. (1997), The Innovator’s Dilemma: When New Technologies

Cause Great Firms to Fall, Boston, MA: Harvard Business School Press. D’Aveni, R. (1994), Hypercompetition: Managing the Dynamics of Strategic

Manoeuvring, New York: Free Press. Darwin, C. (1859), On the Origins of Species, London: John Murray. Porter, M. E. (1980), Competitive Strategy: Techniques for Analyzing Industries and

Competitors, Boston, MA: Free Press. Porter, M. E. (1999), A conversation with Michael Porter: A “significant extension”

toward operational improvement and positioning, an interview by Richard M. Hodgetts, Organizational Dynamics, 28(1), 24–33.

Porter, M. E. (2008), The five competitive forces that shape strategy, Harvard Busi- ness Review, January, 79–93.

Taleb, N. N. (2007), The Black Swan: The Impact of the Highly Improbable, New York: Random House.

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