What Is Strategy and Why Is It Important? What w

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CHAPTER 3

Evaluating a Company’s External Environment

Learning Objectives

THIS CHAPTER WILL HELP YOU UNDERSTAND:

LO 1 How to recognize the factors in a company’s broad macro-environment that may have strategic significance.

LO 2 How to use analytic tools to diagnose the competitive conditions in a company’s industry.

LO 3 How to map the market positions of key groups of industry rivals.

LO 4 How to determine whether an industry’s outlook presents a company with sufficiently attractive opportunities for growth and profitability.

© Bull’s Eye/Image Zoo/Getty Images

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No matter what it takes, the goal of strategy is to beat the competition.

Kenichi Ohmae—Consultant and author

There is no such thing as weak competition; it grows all the time.

Nabil N. Jamal—Consultant and author

Sometimes by losing a battle you find a new way to win the war.

Donald Trump—President of the United States and

founder of Trump Entertainment Resorts

Every company operates in a broad “macro-environment”  that comprises six principal components: political factors; economic conditions in the firm’s general environment (local, country, regional, worldwide); sociocultural forces; technologi- cal factors; environmental factors (concerning the natural environment); and legal/ regulatory conditions. Each of these components has the potential to affect the firm’s more immediate industry and competitive environment, although some are likely to have a more important effect than others (see Figure 3.2). An analysis of the impact of these factors is often referred to as PESTEL analysis, an acronym that serves as a reminder of the six components involved (political, economic, sociocultural, techno- logical, environmental, legal/regulatory).

THE STRATEGICALLY RELEVANT FACTORS IN THE COMPANY’S MACRO-ENVIRONMENT

LO 1

How to recognize the factors in a company’s broad macro-environment that may have strategic significance.

In order to chart a company’s strategic course wisely, managers must first develop a deep under- standing of the company’s present situation. Two facets of a company’s situation are especially pertinent: (1) its external environment—most nota- bly, the competitive conditions of the industry in which the company operates; and (2) its internal environment—particularly the company’s resources and organizational capabilities.

Insightful diagnosis of a company’s external and internal environments is a prerequisite for managers to succeed in crafting a strategy that is an excellent fit with the company’s situation— the first test of a winning strategy. As depicted in Figure 3.1, strategic thinking begins with an appraisal of the company’s external and internal

environments (as a basis for deciding on a long- term direction and developing a strategic vision), moves toward an evaluation of the most promising alternative strategies and business models, and culminates in choosing a specific strategy.

This chapter presents the concepts and analytic tools for zeroing in on those aspects of a compa- ny’s external environment that should be consid- ered in making strategic choices. Attention centers on the broad environmental context, the specific market arena in which a company operates, the drivers of change, the positions and likely actions of rival companies, and the factors that determine competitive success. In Chapter 4, we explore the methods of evaluating a company’s internal circumstances and competitive capabilities.

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CORE CONCEPT

PESTEL analysis can be used to assess the strategic relevance of the six principal components of the macro-environment: Political, Economic, Social, Technological, Environmental, and Legal/ Regulatory forces.

FIGURE 3.1 From Thinking Strategically about the Company’s Situation to Choosing a Strategy

Identify promising strategic options for the

company

Select the best

strategy and

business model for the

company

Form a strategic vision of where the company needs to

head

Thinking strategically

about a company’s

external environment

Thinking strategically

about a company’s

internal environment

Since macro-economic factors affect different industries in different ways and to different degrees, it is important for managers to determine which of these repre- sent the most strategically relevant factors outside the firm’s industry boundaries. By strategically relevant, we mean important enough to have a bearing on the deci- sions the company ultimately makes about its long-term direction, objectives, strat- egy, and business model. The impact of the outer-ring factors depicted in Figure 3.2 on a company’s choice of strategy can range from big to small. But even if those factors change slowly or are likely to have a low impact on the company’s business situation, they still merit a watchful eye.

For example, the strategic opportunities of cigarette producers to grow their businesses are greatly reduced by antismoking ordinances, the decisions of governments to impose higher cigarette taxes, and the growing cultural stigma attached to smoking. Motor vehicle companies must adapt their strategies to cus- tomer concerns about high gasoline prices and to environmental concerns about carbon emissions. Companies in the food processing, restaurant, sports, and fit- ness industries have to pay special attention to changes in lifestyles, eating habits, leisure-time preferences, and attitudes toward nutrition and fitness in fashioning their strategies. Table 3.1 provides a brief description of the components of the macro-environment and some examples of the industries or business situations that they might affect.

As company managers scan the external environment, they must be alert for potentially important outer-ring developments, assess their impact and influence,

and adapt the company’s direction and strategy as needed. However, the factors in a company’s environment having the biggest strategy-shaping impact typically pertain to the company’s immediate industry and competitive environment. Consequently, it is on a company’s industry and competitive environment that we concentrate the bulk of our attention in this chapter.

CORE CONCEPT

The macro-environment encompasses the broad environmental context in which a company’s industry is situated.

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FIGURE 3.2 The Components of a Company’s Macro-Environment

Political Factors

MACRO-E NVIRONMENT

Economic Conditions

Legal/ Regulatory

Factors

Environmental Forces

Technological Factors

Sociocultural Forces

COMPANY

Substitute Products

Suppliers

Rival Firms

New Entrants

Buyers

Im me

diat e Ind

ustry and Competitive Environment

Thinking strategically about a company’s industry and competitive environment entails using some well-validated concepts and analytic tools. These include the five forces framework, the value net, driving forces, strategic groups, competitor analysis, and key success factors. Proper use of these analytic tools can provide managers with the understanding needed to craft a strategy that fits the company’s situation within their industry environment. The remainder of this chapter is devoted to describing how managers can use these tools to inform and improve their strategic choices.

ASSESSING THE COMPANY’S INDUSTRY AND COMPETITIVE ENVIRONMENT

LO 2

How to use analytic tools to diagnose the competitive conditions in a company’s industry.

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Component Description

Political factors Pertinent political factors include matters such as tax policy, fiscal policy, tariffs, the political climate, and the strength of institutions such as the federal banking system. Some political policies affect certain types of industries more than others. An example is energy policy, which clearly affects energy producers and heavy users of energy more than other types of businesses.

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. 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, benefit when general economic conditions weaken, as consumers become more price-conscious.

Sociocultural forces

Sociocultural forces include the societal values, attitudes, cultural influences, and lifestyles that impact demand for particular goods and services, as well as demographic factors such as the population size, growth rate, and age distribution. 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. The demographic effect of people living longer is having a huge impact on the health care, nursing homes, travel, hospitality, and entertainment industries.

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, nanotechnology, and solar energy technology. They include institutions involved in creating new knowledge and controlling the use of technology, such as R&D consortia, university- sponsored technology incubators, patent and copyright laws, and government control over the Internet. Technological change can encourage the birth of new industries, such as the connected wearable devices, and disrupt others, such as the recording industry.

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 insurance, 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 consumer laws, labor laws, antitrust laws, and occupational health and safety regulation. Some factors, such as financial services regulation, 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 The Six Components of the Macro-Environment

The character and strength of the competitive forces operating in an industry are never the same from one industry to another. The most powerful and widely used tool for diagnosing the principal competitive pressures in a market is the five forces frame- work.1 This framework, depicted in Figure 3.3, holds that competitive pressures on

THE FIVE FORCES FRAMEWORK

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companies within an industry come from five sources. These include (1) competition from rival sellers, (2) competition from potential new entrants to the industry, (3) competition from producers of substitute products, (4) supplier bargaining power, and (5) customer bargaining power.

Using the five forces model to determine the nature and strength of competitive pressures in a given industry involves three steps:

∙ Step 1: For each of the five forces, identify the different parties involved, along with the specific factors that bring about competitive pressures.

FIGURE 3. 3 The Five Forces Model of Competition: A Key Analytic Tool

Buyers

Competitive pressures stemming

from supplier bargaining

power

Competitive pressures coming from other firms in

the industry

Competitive pressures coming from the threat of entry of new rivals

Competitive pressures stemming from buyer bargaining

power

Potential New Entrants

Firms in Other Industries O�ering Substitute Products

Rivalry among Competing

Sellers

Competitive pressures coming from the producers of substitute

products

Suppliers

Sources: Adapted from M. E. Porter, “How Competitive Forces Shape Strategy,” Harvard Business Review 57, no. 2 (1979), pp. 137–145; M. E. Porter, “The Five Competitive Forces That Shape Strategy,” Harvard Business Review 86, no. 1 (2008), pp. 80–86.

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∙ Step 2: Evaluate how strong the pressures stemming from each of the five forces are (strong, moderate, or weak).

∙ Step 3: Determine whether the five forces, overall, are supportive of high industry profitability.

Competitive Pressures Created by the Rivalry among Competing Sellers The strongest of the five competitive forces is often the rivalry for buyer patronage among competing sellers of a product or service. The intensity of rivalry among competing sellers within an industry depends on a number of identifiable factors. Figure 3.4 summarizes these factors, identifying those that intensify or weaken rivalry among direct competitors in an industry. A brief explanation of why these factors affect the degree of rivalry is in order:

FIGURE 3.4 Factors Affecting the Strength of Rivalry

Suppliers

Rivalry among Competing Sellers

Rivalry increases and becomes a stronger force when:

Rivalry decreases and becomes a weaker force under the opposite conditions.

Substitutes

New Entrants

Buyers

• Buyer demand is growing slowly. • Buyer costs to switch brands are low. • The products of industry members are commodities or else weakly di�erentiated. • The firms in the industry have excess production capacity and/or inventory. • The firms in the industry have high fixed costs or high storage costs. • Competitors are numerous or are of roughly equal size and competitive strength. • Rivals have diverse objectives, strategies, and/or countries of origin. • Rivals have emotional stakes in the business or face high exit barriers.

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∙ Rivalry increases when buyer demand is growing slowly or declining. Rapidly expanding buyer demand produces enough new business for all industry members to grow without having to draw customers away from rival enterprises. But in markets where buyer demand is slow-growing or shrinking, companies eager to gain more business are likely to engage in aggressive price discounting, sales pro- motions, and other tactics to increase their sales volumes at the expense of rivals, sometimes to the point of igniting a fierce battle for market share.

∙ Rivalry increases as it becomes less costly for buyers to switch brands. The less costly it is for buyers to switch their purchases from one seller to another, the easier it is for sellers to steal customers away from rivals. When the cost of switch- ing brands is higher, buyers are less prone to brand switching and sellers have protection from rivalrous moves. Switching costs include not only monetary costs but also the time, inconvenience, and psychological costs involved in switching brands. For example, retailers may not switch to the brands of rival manufacturers because they are hesitant to sever long-standing supplier relationships or incur the additional expense of retraining employees, accessing technical support, or testing the quality and reliability of the new brand.

∙ Rivalry increases as the products of rival sellers become less strongly differentiated. When the offerings of rivals are identical or weakly differentiated, buyers have less reason to be brand-loyal—a condition that makes it easier for rivals to convince buy- ers to switch to their offerings. Moreover, when the products of different sellers are virtually identical, shoppers will choose on the basis of price, which can result in fierce price competition among sellers. On the other hand, strongly differentiated product offerings among rivals breed high brand loyalty on the part of buyers who view the attributes of certain brands as more appealing or better suited to their needs.

∙ Rivalry is more intense when industry members have too much inventory or significant amounts of idle production capacity, especially if the industry’s product entails high fixed costs or high storage costs. Whenever a market has excess supply (overproduction relative to demand), rivalry intensifies as sellers cut prices in a des- perate effort to cope with the unsold inventory. A similar effect occurs when a prod- uct is perishable or seasonal, since firms often engage in aggressive price cutting to ensure that everything is sold. Likewise, whenever fixed costs account for a large fraction of total cost so that unit costs are significantly lower at full capacity, firms come under significant pressure to cut prices whenever they are operating below full capacity. Unused capacity imposes a significant cost-increasing penalty because there are fewer units over which to spread fixed costs. The pressure of high fixed or high storage costs can push rival firms into offering price concessions, special discounts, and rebates and employing other volume-boosting competitive tactics.

∙ Rivalry intensifies as the number of competitors increases and they become more equal in size and capability. When there are many competitors in a market, com- panies eager to increase their meager market share often engage in price-cutting activities to drive sales, leading to intense rivalry. When there are only a few com- petitors, companies are more wary of how their rivals may react to their attempts to take market share away from them. Fear of retaliation and a descent into a damaging price war leads to restrained competitive moves. Moreover, when rivals are of comparable size and competitive strength, they can usually compete on a fairly equal footing—an evenly matched contest tends to be fiercer than a contest in which one or more industry members have commanding market shares and substantially greater resources than their much smaller rivals.

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∙ Rivalry becomes more intense as the diversity of competitors increases in terms of long-term directions, objectives, strategies, and countries of origin. A diverse group of sellers often contains one or more mavericks willing to try novel or rule- breaking market approaches, thus generating a more volatile and less predictable competitive environment. Globally competitive markets are often more rivalrous, especially when aggressors have lower costs and are intent on gaining a strong foothold in new country markets.

∙ Rivalry is stronger when high exit barriers keep unprofitable firms from leaving the industry. In industries where the assets cannot easily be sold or transferred to other uses, where workers are entitled to job protection, or where owners are com- mitted to remaining in business for personal reasons, failing firms tend to hold on longer than they might otherwise—even when they are bleeding red ink. Deep price discounting of this sort can destabilize an otherwise attractive industry.

The previous factors, taken as whole, determine whether the rivalry in an industry is relatively strong, moderate, or weak. When rivalry is strong, the battle for mar- ket share is generally so vigorous that the profit margins of most industry members are squeezed to bare-bones levels. When rivalry is moderate, a more normal state, the maneuvering among industry members, while lively and healthy, still allows most industry members to earn acceptable profits. When rivalry is weak, most companies in the industry are relatively well satisfied with their sales growth and market shares and rarely undertake offensives to steal customers away from one another. Weak rivalry means that there is no downward pressure on industry profitability due to this particu- lar competitive force.

The Choice of Competitive Weapons Competitive battles among rival sellers can assume many forms that extend well beyond lively price competition. For example, competitors may resort to such market- ing tactics as special sales promotions, heavy advertising, rebates, or low-interest-rate financing to drum up additional sales. Rivals may race one another to differentiate their products by offering better performance features or higher quality or improved customer service or a wider product selection. They may also compete through the rapid introduction of next-generation products, the frequent introduction of new or improved products, and efforts to build stronger dealer networks, establish positions in foreign markets, or otherwise expand distribution capabilities and market pres- ence. Table 3.2 displays the competitive weapons that firms often employ in battling rivals, along with their primary effects with respect to price (P), cost (C), and value (V)—the elements of an effective business model and the value-price-cost framework, discussed in Chapter 1.

Competitive Pressures Associated with the Threat of New Entrants New entrants into an industry threaten the position of rival firms since they will compete fiercely for market share, add to the number of industry rivals, and add to the industry’s production capacity in the process. But even the threat of new entry puts added competitive pressure on current industry members and thus functions as an important competitive force. This is because credible threat of entry often prompts industry members to lower their prices and initiate defensive actions in an attempt

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Types of Competitive Weapons Primary Effects

Discounting prices, holding clearance sales

Lowers price (P), increases total sales volume and market share, lowers profits if price cuts are not offset by large increases in sales volume

Offering coupons, advertising items on sale

Increases sales volume and total revenues, lowers price (P), increases unit costs (C ), may lower profit margins per unit sold (P − C )

Advertising product or service characteristics, using ads to enhance a company’s image

Boosts buyer demand, increases product differentiation and perceived value (V ), increases total sales volume and market share, but may increase unit costs (C) and lower profit margins per unit sold

Innovating to improve product performance and quality

Increases product differentiation and value (V ), boosts buyer demand, boosts total sales volume, likely to increase unit costs (C)

Introducing new or improved features, increasing the number of styles to provide greater product selection

Increases product differentiation and value (V ), strengthens buyer demand, boosts total sales volume and market share, likely to increase unit costs (C)

Increasing customization of product or service

Increases product differentiation and value (V ), increases buyer switching costs, boosts total sales volume, often increases unit costs (C)

Building a bigger, better dealer network

Broadens access to buyers, boosts total sales volume and market share, may increase unit costs (C)

Improving warranties, offering low- interest financing

Increases product differentiation and value (V), increases unit costs (C), increases buyer switching costs, boosts total sales volume and market share

TABLE 3.2 Common “Weapons” for Competing with Rivals

to deter new entrants. Just how serious the threat of entry is in a particular market depends on two classes of factors: (1) the expected reaction of incumbent firms to new entry and (2) what are known as barriers to entry. The threat of entry is low in industries where incumbent firms are likely to retaliate against new entrants with sharp price discounting and other moves designed to make entry unprofitable (due to the expectation of such retaliation). The threat of entry is also low when entry barriers are high (due to such barriers). Entry barriers are high under the following conditions:2

∙ There are sizable economies of scale in production, distribution, advertising, or other activities. When incumbent companies enjoy cost advantages associated with large-scale operations, outsiders must either enter on a large scale (a costly and perhaps risky move) or accept a cost disadvantage and consequently lower profitability.

∙ Incumbents have other hard to replicate cost advantages over new entrants. Aside from enjoying economies of scale, industry incumbents can have cost advantages that stem from the possession of patents or proprietary technology,

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exclusive partnerships with the best and cheapest suppliers, favorable locations, and low fixed costs (because they have older facilities that have been mostly depreciated). Learning-based cost savings can also accrue from experience in performing certain activities such as manufacturing or new product develop- ment or inventory management. The extent of such savings can be measured with learning/experience curves. The steeper the learning/experience curve, the bigger t

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