External Environment of a Firm | Strategic Management

In this article we will discuss about:- 1. General Environment of a Firm 2. Industry Structure of a Firm 3. Power of the Suppliers 4. Power of the Buyers 5. Threats of New Entrants 6. Threats of Substitutes 7. Rivalry among Existing Operators 8. Industry Structure Analysis and Strategic Understanding 9. Competition Analysis 10. Forecasting Industry Trends and Turning Points.

General Environment of a Firm:

The key environmental factors that can affect an organisation are:

a. Political and legal.

b. Economic technological.

c. Sociocultural.

What needs to be stressed here is that an in depth analysis of the general environment can give important insights into the key forces that are at work in the external environment. A detailed listing of the specific factors that influence the operations of the firm under each of the above four categories will be the starting point.

Once this is done, a short listing of key factors having significant impact-not just in the short-term but also in the medium to long-term-should be done to identify the environ­mental forces which are likely to drive change in the future (for example, assessment of the possible impact on company’s future business resulting from growing deregulations, rapid progresses in tech­nology, proliferation of products’ convergence of consumer tastes and also, expansion of trade be­tween countries).

The same analysis will also spell out the differential impact of various environmen­tal forces on individual firms in the industry and how their relative competitiveness may either get enhanced or hampered in the future due to such a differential impact. If a shortlist of key environmental forces is prepared, it is possible to build scenarios-spanning a three to five year period-that are essential to take a long-term view on strategy. The higher the capital and technology intensity of any industry, the greater will be the need for developing such scenarios in order to make correct judg­ments on future strategic initiatives.

Such scenario building is a must for developing a view of the future environment. Alternative scenarios-based on different combinations of key environmental forces-can be developed on the basis of historical data as well as the logic and foresight of the top management of the firm. The scenarios can be used to examine the relevance of each future strategic option being considered.

In the end, what comes out is a shared understanding among the senior management staff on the likely pattern of the future environment, and on actions to be initiated in the short term to either protect the firm from future vulnerabilities or to help it exploit the emerging opportunities. Such an analysis can also be used to expose the managers to the changing environ­ment, influence their thought processes and to develop a new paradigm that may be relevant for the future.

In the past, organisations did not give much attention to understanding the general environment partly because of their failure to appreciate the benefit of such understanding (one benefit is the ability to shape and influence the future) and-partly due to the absence of intense competition in most product-market segments. Today, however, things have changed and there is hardly any market which can be termed as ‘protected’. The mass market is not only getting split into fragmented, demassified markets, but also becoming an elusive and constantly shifting one.

Some of the key changes that have been sweeping the world in the 90s can be classified as follows:

i. Splitting of the mass market into a large number of small markets implying an expanding range of options, models, types, sizes, etc.; changing pattern of households, including the rise of nuclear families and singles;

ii. Steady erosion of advertised brands due to extensive product proliferations and the emergence of private label goods;

iii. New ways to shop and pay, thanks to the rapid progress made in information technology and telecommunication both in developed and developing countries; the use of non-traditional selling methods and retail outlets, home shopping networks, credit cards, etc. Even the use of home computers for shopping has now become a reality;

iv. Rapid progress in maintaining detailed databases on customer profile and purchase history using demographic and psychographic characteristics. With these databases, companies are now able to tailor their products better and service offerings to target segments thereby strength­ening their market positions as- well as providing customer satisfaction; the emergence of a service economy with more and more people getting directly or indirectly involved in the service sector. The manufacturers of products are now forced to wrap their core products with supplementary services;

v. The emerging information society which has enabled individual consumers to know about products, services, and also the companies that offer them.- More homes now have phones,

vi. Faxes and computers and can thus access any information they want, thereby making each consumer better educated and better informed;

vii. Proliferation of new products-bulk of which are line extensions thereby giving consumers more choice. However, since many of these products are duplications of existing products with no distinct value addition, retailers are increasingly resisting such proliferations. Even the companies that market such new products have failed to recover their investments in the short run.

viii. Multiplication of the distribution channels has helped companies adopt innovative ways of distributing their products (including the use of non-traditional channels);

ix. Ease in communicating one’s message to target segments effectively and affordably, given the sharp proliferation in media choices (such as network, spot TV, cable TV, magazines, newspa­pers, direct mail and interactive electronic media).

All the above changes imply that there will be new rules of the game which will be played in a field hitherto unknown. With the focus shifting from mass marketing to individualised marketing, and given that profound changes are taking place in the social, political, economic and technological environment, companies will need to understand their context in the right perspective in order to develop innovative options to meet the emerging challenges.

Industry Structure of a Firm:

A correct understanding of industry structure is the key to strategic management of an organi­sation. A very useful tool is Porter’s modep6 which helps in gaining insights into the industry structure by taking a look at five forces that influence the extent of competitive intensity within an industry.

These five forces are:

(a) Power of the supplier;

(b) Power of the buyer;

(c) Threat of potential entrants;

(d)threat from substitutes;

(e)Intensity of rivalry among existing operators.

Any change in the above five forces alters both competitive rivalry and industry profitability. This being so, a strategist needs to understand each of these five forces in all their subtleties and complexities in order to develop the correct insights.

Power of the Suppliers in a Firm:

Suppliers to industry can affect overall profitability and also the competitiveness of individual firms by altering the input prices as well as their steady availability in the desired specifications and volumes. Supplies here include not only raw materials and utilities but also other inputs such as funds, support services, etc.

The suppliers’ bargaining power increases significantly, when:

i. There is a concentration of suppliers;

ii. Buyers are insignificant to the suppliers;

iii. Inputs of some suppliers are important to the buyers (for example, in cases where the inputs are branded or customised);

iv. Suppliers can forward integrate;

v. High ‘switching cost’ from one supplier to another.

With an increase in suppliers’ power, competitiveness of the industry declines. This indicates the need for developing a strategy that reduces the individual supplier’s power. The companies that are able to neutralise the supplier’s power [through various means, such as, entering into a long-term agreement, setting up captive production units, tying up with suppliers who have good products but are not performing well and are also suffering from cash shortages (which the buyer can resolve), development of either substitutes or alternative sources of supply, etc.] will obviously have greater competitiveness, and hence, profitability vis-a-vis those who are not able to do so.

Power of the Buyers in a Firm:

As in the case of supplier’s power, buyers rising power can also affect industry profitability and competitiveness adversely. Essentially, what happens is a reduction in the industry’s bargaining power to produce and supply inputs at the specifications (products as well as services) and terms that are favourable to it.

The bargaining power of buyers increases under the following conditions:

(a) There is concentration of buyers;

(b) Volume of purchase by each buyer is large;

(c) There are a large number of suppliers whose inputs are undifferentiated and hence buyers can ‘shop around’;

(d) Switching cost is low;

(e) The inputs purchased constitute a major component of total cost of production of the buyer (and hence there is always a pressure to reduce input prices);

The buyers can backward integrate, if they wish. Against this background, the competitiveness of an individual firm can be enhanced through offering a product or service which is high on intan­gibles, has a uniqueness in overall package, and is capable of adding value to the customers’ products or processes.

In situations where there are a large number of suppliers, all of whom have a similar quality or cost structure, and where product specifications are fairly standardised, focusing on value creation through emphasising service factors (such as timely delivery, hassle-free business transaction, information sharing on products and processes, technical training of customers’ operators, etc.) can help in protecting and strengthening a particular firm’s position vis-a-vis its competitors. The em­phasis on service factors can build entry barriers and create high switching costs so far as customers are concerned.

Threats of New Entrants in a Firm:

Threats of new entrants get reduced if there are high entry barriers.

Some examples of entry barriers are:

(a) Economies of scale; implying that in industries where the economies of scale are very high, the rate of entry will be comparatively low since the task of building volumes to break-even and make profit will be a daunting one;

(b) Capital cost requirement; if it is high, due to such reasons as technology or scale, it can act as an entry barrier since raising the required funds will not be easy for all firms; also high capital costs can be serviced only if the capacity utilisation is above a threshold level, and this may not be feasible given the demand and competitive profile of the industry;

(c) Loyalty to existing brands;

(d) Access to distribution channel;

(e) Extent of differentiation achieved by existing operators (for making the ‘switching cost’ high);

(f) Experience curve effect; giving existing operators clear advantages over new entrants in such areas as cost of production, knowledge about operating problems and how to resolve them, relationship and network with customers and suppliers, etc.;

(g) Anticipated retaliation by existing operators;

(h) Tariff and non-tariff barriers (applicable particularly to imported goods).

The entry barriers listed above are not exhaustive in nature. They differ from one industry to another in terms of relative importance. However, a deep understanding of these entry barriers is a must for all firms, whether they are planning to enter a new industry or evaluate actions to stop new entrants from entering the industry. It must also be noted that, in addition to general entry barriers to an industry, a firm can also create entry barriers to defend its own position vis-a-vis other existing competitors.

Threats of Substitutes in a Firm:

The availability of substitutes which meet the same needs as the existing products intensifies competition within an industry. An attractive price performance ratio as well as wide availability tempts certain categories of customers to switch from existing suppliers to producers of substitute products. Such substitutes can be direct, such as cellular phone vs. pager.

This problem can also occur indirectly when different products or services compete for the same discretionary expenditure (for example, consumer durables, entertainment, car, house, holidaying etc., compete for the same dispos­able income). The pressure from substitute products can be quite an intense one if there is constant innovation that leads to continuous improvements in the price-performance ratio and when custom­ers switching costs are low.

Rivalry among Existing Operators:

The intensity of competition also gets heightened with rising rivalry among existing players.

The intensity is directly proportional to the following key factors:

(a) Rising power of suppliers and customers;

(b) Slow rate of growth in demand;

(c) Too many operators, having a roughly equal market power; high fixed-costs like interest, depreciation, overheads, etc.; absence of product differentiation and brand equity; high exit barriers;

(d) Addition of capacity in high increments.

Industry Structure Analysis and Strategic Understanding:

Porter’s model provides us with a framework for assessing the relative impact of various factors on the intensity of competition, and the growth prospects and profitability of an industry. An in depth examination of each of these five forces from the specific point of view of an industry can give a deep insight on industry operations.

Such an analysis can help find out the following:

(a) Key forces that influence the competitive environment; underlying forces that are driving the competitive forces;

(b) Possible pattern of change in each of the five forces and when such changes are expected to take place;

(c) Relative position of major competitors with respect to each of the five forces;

(d) Steps that can be taken to influence the competitive forces to the advantage of a particular firm (such as building barriers to entry, increase in power over suppliers or buyers, etc.).

The structural analysis can also help assess if certain industries are inherently more attractive than others (due to such reasons as high entry barriers or low buyers’ or suppliers’ power). Needless to say, like all other models or frameworks, industry structure analysis can also give only broad patterns and understanding, but it cannot fully explain why certain industries are more attractive and profitable.

The profitability of a firm in an industry depends to a large extent on whether such a firm facing competition within a particular industry (characterised by rising suppliers’ and buyers’ power, intense rivalry as well as threats of entry and of substitute products) is able to create and retain value for its customers over a sustained period of time. The five forces described above together determine who will be able to create and deliver these values most competitively.

For example, new entrants can compete by giving more value to their customers or by raising the costs of competing for the existing players. Similarly, buyers and suppliers can be powerful enough to appropriate and retain the value, leaving the firms in the middle with a small margin.

While an individual firm needs to adopt strategies to reduce the intensity of the five forces, the inherent attractiveness of the industry due to factors external to the firms (such as high entry barriers, government protection, shortages in supply vis-a-vis demand, fast growth rate, etc.) are often the reasons behind the high profitability of many firms rather than their conscious strategy to neutralise the five forces.

Competition Analysis of a Firm:

Ideally, a firm, trying to understand its competition comprehensively, must have detailed information on major competitors in a number of areas, viz:

(a) Objectives (market share, profits, return on investment, etc.) and how important are these to individual competitors;

(b) Resource base, including their strengths and weaknesses (technology, capacity, brands, distribu­tion network, people);

(c) Access to certain strategic assets (such as location, preferential access to raw materials, etc.); track record of performance over the years and main reasons for success and failure;

(d) Current strategic initiatives (cost, differentiation or niche); and approach adopted to pursue growth (internal development, joint venture, strategic alliance or acquisition).

An important concept for understanding competition is the ‘strategic group’ analysis proposed by Porter. Such an analysis helps in assessing the competitive position of a firm in relation to the strategic initiatives undertaken by other firms in the industry. It identifies broadly the firms that are competing on the same or a similar basis.

Since there can be numerous competitors in an industry- each characterised by its relative strengths and weaknesses, strategies and product/service offerings- there is a need to classify them into certain homogeneous categories, with respect to the strategic initiatives undertaken. There can be a number of bases along which such strategic grouping can be done and the exact choice differs from industry to industry. For a particular industry, its historical development and drivers that are at work, in addition to its competitive activities, will be the key determinants.

These can be one or more of the following:

(a) Product/service diversity

(b) Geographic coverage

(c) Market segments served

(d) Marketing effort/pricing strategy

(e) Extent of forward and backward integration leadership in technology/R&D

(f) Cost position

(g) Ownership structure

Strategic group analysis, as described above, can help a firm in a number of ways, such as:

i. Understanding the sources of rivalry and competitiveness of each firm within a strategic group;

ii. Determining the possibility of movement of firms from one strategic group to another (the higher the mobility barrier, the more protected the firms in that particular strategic group); and

iii. Projecting the possible market changes and the resulting opportunities by identifying ‘vacant’ spaces that are attractive enough for future initiatives.

In order to understand competition, it is useful to segment the total market into certain homo­geneous categories and then to examine the competitive forces within the specific segment(s) being targeted. Kotler provides a systematic approach to segmentation and the same can be used to develop an understanding in this regard.

Once the segmentation is arrived at and the needs of customers are derived, one can locate the companies that meet or can meet these needs through using existing or substitute products. Such an analysis-which has to be carried out in the context of the industry structure analysis presented above-enables a company to find out the broader set of actual and potential competition and helps in long-term strategic market planning.

In addition to finding out who the competitors are by using the concept of industry structure and market segmentation, it is important to assess the following aspects, with respect to all present and potential competitors:

(a) Strengths and weaknesses;

(b) Objectives and strategies;

(c) Retaliation power.

To understand the strengths and weaknesses of competitors, a company needs to have in depth data on each of its major competitors in such areas as reputation, volumetric sales, market share (segment wise), brand equity, distribution reach, profit margins, return on investment (ROI), cash flows, capacity utilization, direction of new investments, profiles of key people and organisation, quality, customer perception and performance along key financial and operating dimensions.

Most organisations do not have adequate data on each of these areas partly because such data are not easily available, and partly due to lack of awareness as well as seriousness among managers while collecting such information. Managers of successful companies are as much aware of the minutest details about their competitors as they are about their own companies, and they spend time and resources in understanding the assumptions made by their competitors while taking strategic and tactical deci­sions.

Developing an insight into the competitors’ objectives and strategies is an essential part of any competitive analysis. Questions, such as what each competitor is seeking in the marketplace or what drives the competitors’ behaviour, are important considerations. Stereotyped assumptions on ob­jectives, such as profit maximisation, can be faulty since different organisations pursue different trade-offs between short-term profit maximisation and-longer-term market shares.

Depending on their size, history, current performance and economies, the competitors differ with regard to their objec­tives in such areas as new product launch, finding new market niches, technological leadership, maximisation of market share, excellence in service network, etc. A company needs to understand these objectives clearly if it desires to develop the right strategy.

Having understood the competitors’ strengths and weaknesses as well as objectives, the next task would be to understand the broad strategies being pursued by them. The concept of strategic groups, can be used to get an idea in this regard. Essentially, what is needed is to find out the specific functional strategies of each competitor in such areas as marketing, manufacturing, R&D, financial and human resources, and also their broad strategic predispositions; such as, cost leadership, differentiation or focus. The company also needs a clear understanding of whether the target competitor(s) is (are) pursuing a strategy to defend the existing market share or is expanding the same by taking the share of other players or creating new opportunities). There is well-researched literature on both the defender’s strategies and the attacker’s strategies. A company needs to under­stand the motives and abilities of various competitors in order to adopt one or more of these strate­gies in a specific industry context.

Estimating the retaliation power of competitors is an essential part of any competition analysis. Such retaliation power is not only dependent on an individual firm’s cost structure and aggressive­ness but also on its guiding beliefs and internal culture. For example, some competitors may be laid back in general while some others may react sharply to certain specific types of initiatives by oppo­nents (such as price cuts).

Also, there are firms that are aggressive by nature and do not leave any initiative taken by their opponents un attacked. An understanding of retaliation power is essential to get a feel of ‘competitive equilibrium’ and to know the underlying competitive situation which in turn give an idea about how best to deal with competitors. Needless to say, if all competitors are nearly identical in their strategy and competitive power, there will be instability in the marketplace.

Forecasting Industry Trends and Turning Points:

The five forces identified by Porter influence each other in an interactive/ counteractive manner to achieve equilibrium. But the equilibrium thus Achieved is itself a dynamic one, since the same can become unstable by myriad external (such as demographic shifts, changes in government and other regulations, shift in customer preferences, and technological discontinuities) and internal factors (such as the emergence of collusive strategy, entry barriers, strategic alliances, etc.). In view of this, organisations aiming to dominate the future industry leadership must build capabilities to identify turning points.

A turning point can be termed as a time frame in which the equilibrium dynamics of a particu­lar industry changes. It is triggered by internal and/ or external forces (termed as ‘triggers’) that change the rules of the game.

It is manifested as changes in:

(a) Industrial performance parameters (like profitability, ROI, new product innovation, etc.)

(b) Industrial structural parameters (such as concentration of players, changes in entry/exit barri­ers, supply of substitutes, etc.), and also in

(c) Other ‘physical parameters’ (such as total industry turnover, import/ export, market share in global markets, etc.).

One needs to be very careful while identifying a turning point from among other gradual structural changes, such as slow evolution of industry in the natural course and short-term ripples that do not bring about any paradigm shift. To pinpoint the real turning points, one has to anticipate the various trends in the industry, identify the duration of each such trend and assess the effect of the same on the majority of industry players.

Theoretical and empirical studies in industrial economics and organisation define such points (in which turning occurs) as ‘strategic inflection points’ in the performance curve of the industry. A key task of leading industry players will be to ensure proper identification of such a change and develop a proactive strategy to respond to the same; the aim being to convert unfavourable shifts into favourable ones through building appropriate capabilities in advance.

In developing a firm’s strategy to respond to the ‘breakpoints’ and effect the required ‘paradigm shifts’, it should be borne in mind that, however powerful a company may be in its field it cannot reverse the fundamental changes that are sure to attack the industry rules. There are examples galore where a basic structural change in industry has made the core competencies of leading players ineffec­tive. This being so, proper scanning of the industrial environment, including identifying signals that indicate possibilities of major changes, and development of flexibility to realign the company to the changes, will be the key tasks at the firm level.