Environmental Analysis: Business Environment PDF

**ENVIRONMENTAL ANALYSIS** **THE BUSINESS ENVIRONMENT:** **Environment:** everything over which a firm has no control as an organization. A [business environment] is made up of all those external factors that have a bearing on a firm´s decisions and performance. A firm can´t control those factor,...

**ENVIRONMENTAL ANALYSIS** **THE BUSINESS ENVIRONMENT:** **Environment:** everything over which a firm has no control as an organization. A [business environment] is made up of all those external factors that have a bearing on a firm´s decisions and performance. A firm can´t control those factor, but they may have a significant impact on the success of its strategy. Their analysis allows identifying that influence and decide upon the most appropriate way of responding to them. - [General environment:] external medium surrounding the firm from an overall perspective the socio-economic system within which it operates (situations that equally affect the rest of the competitors) - [Competitive environment:] part of the environment closest to the firm´s everyday operations the industry to which the firm belongs. The more dynamic, complex, diverse and hostile an environment is, the greater the uncertainty the firm has to face (globalization of economy, acceleration of technological change, removal of international trade barriers, changes in societies´ values). A firm´s management has to furnish itself with the best possible information on the nature of the environmental factors affecting it and the manner in which they do so: - **Opportunities:** factors that favor a firm´s operations - **Threats:** factors that constitute a hindrance **ANALYSIS OF THE GENERAL ENVIRONMENT:** Purpose of analyzing the general environment: identify variables that affect the firm´s operations from a dual perspective: - Those related to the general political, economic and social system surrounding the firm - Those linked to a firm´s localization in a specific country, region or geographical area (not all economic areas/systems are equally attractive; public policies; infrastructures; market´s regulatory framework; business culture) METHODS OF ANALYSIS: **THE PORTER DIAMOND:** Each country or nation has their own idiosyncrasies for explaining why some are more competitive than others and why certain industries within each country are more competitive than others. PURPOSE explain how belonging to a specific country and to a certain industry in that country influences the way a firm obtains an advantageous position for competing with firms from other countries. FACTORS WHOSE COMBINED EFFECT INFORMS A COUNTRY´S COMPETITIVENES: - Provision of relevant and specialized production factors - Conditions of domestic demand (if there´s no demand, unless you´re able to distribute your products/services digitally and globally, you need to generate that demand) - Highly competitive similar and auxiliary sectors - Strategy, structure and rivalry of existing firms As the implementation of the strategy will extend over a long period of time, it´s expedient to investigate how external factors (arising from the general and the competitive environment) will manifest themselves in the future. **PROSPECTIVE MEASURES:** For defining factors in a turbulent environment in which changes abound. These methods provide a more global vision of the future - Giving special importance to qualitative and subjective aspects - Assuming that the relationships between variables are dynamic and evolve over time - Accepting that the future depends upon the past and on the decisions made in the present - Adopting a proactive and creative attitude toward the future **SCENARIOS METHOD:** (future environment) [Scenario:] description of the circumstances, conditions or events that may depict the environment at a future moment in time (optimistic, pessimistic and as expected). A scenario is a teaching and learning instrument to understand better the way the future may unfold. Its design requires considering the relevant variables to be incorporated, their interrelation and the ramifications of strategic decisions in order to prepare management to adapt better to the environment´s contingencies (how to answer or deal with those results). \*You try to operate in the margin between those different scenarios. **THE ENVIRONMENT´S STRATEGIC PROFILE:** Used to conduct a diagnosis of the general setting. This profile is created in 2 stages: 1. Draft a list of what we have referred as key factors in the environment (identify the significant variables that should be analyzed) \*The key factors tend to be grouped according to different dimensions 2. Assess the impact those variable have on the firm´s business in order to single out the main opportunities and threats. There´s a prior need to define the boundaries of the analysis from a territorial perspective and according to the relevance of the variables themselves. This selection involves considering the possibility of its occurrence and the size of the impact on the firm if and when it does. VARIABLES TEND TO BE ORGANIZED INTO SEVERAL DIMENSIONS: - **Political and legal dimension:** government stability and policies that public administration follow (taxation, labor legislation, foreign trade, social welfare) - **Economic dimension:** affects the nature and direction of the economic system in which the firm operates and is given by its main economic indicators (macroeconomic variables: trends in GDP, interest rates, rate of inflation, unemployment) - **Demographic dimension:** main changes in the population´s structure (population pyramid, life expectancy, birth rate, ethnic diversity, migration) - **Socio-cultural dimension:** beliefs, values, attitudes and life-styles of the people who make up society and the (cultural, ecological, demographic, religious, educational, ethnic) conditions of the social system as a whole - **Technological dimension:** scientific and technological framework that defines the state of a system (R&D policy, information technologies, technological changes, technology transfer) - **Ecological dimension:** aspects that affect sustainability (availability of natural resources, renewable energies, climate change, recycling, waste management) When variables are defined, then there´s a rating of the behavior of each of the key factors on a [Likert scale] from 1 to 5; or very negative (VN) -- negative (N), neutral or indifferent (I) -- positive (P) -- very positive (VP). It can be used to observe and readily identify opportunities (scores toward the right) and threats (scores toward the left). Different managers or analysts might reach different conclusions (the rating is provided in a subjective manner depending on the perceive of the variables) the involvement of several people in the process might reinforce this perception if there´s convergence, or generate a different positioning regarding the same situation if there´s divergence. - Not all the variables on the general environment have a significant impact on a specific industry or firm the relevant factors have to be identified in each individual case - Similar characteristics of the general environment may have different effects in different industries - The impact the general environment has may vary significantly even among firms in the same industry **INDUSTRIAL DISTRICTS:** Numerous group of similar firms and institutions connected by the same economic activity and located in a specific geographical environment. A district includes those firms belonging to the main industry identifying it and those institutions/businesses related to it. TYPES OF AGENTS: - **Businesses dedicated to the same activity** which provide end products and services. It may sometimes involve a single large corporation that makes up the district. - **Different types of institutions** (public and private) which provide specialized technical support and information (universities, research centers, standards agencies, training centers, business associations, financial institutions, government agencies) - **Businesses located upstream and downstream of the main or focus product** suppliers of raw material, components, machinery and specialized services, or distribution companies and client businesses - **Business in related industries**, which provide products that supplement the main product Considering a district´s components, its boundaries will rarely coincide with the traditional classifications of economic sectors, as they include institutional agents and relationships between different industries. Its analysis is related to the general environment as the aim is to define the role that a firm´s location plays in its competitiveness. FACTORS THAT FAVOR A FIRM´S COMPETITIVENESS: - **Increase in productivity:** given the easy access to certain specialist resources in the district (suppliers, qualified labor, information, infrastructures, communications networks) made possible by geographical proximity. \*Having a bigger productivity you are able to test faster - **Boost for innovation:** given their closeness to research centers or due to their actual internal interrelations, the companies belonging to a district tend to perceive new customer needs and new trends in technology more quickly than their isolated competitors. Internal competitive pressure forces them to distinguish themselves in a more creative manner, increasing the onus on them to innovate. - **New start-ups:** the district favors the incorporation or entry of new companies that will join it to make it stronger and more competitive. - The entry barriers are lower, as they can gain easier access to the specialist human and material resources they require - The financing for setting up new businesses tends to be cheaper, as the risk premium required by financial institutions is lower because of the greater number of potential clients and the prior experiences of other existing companies. Industrial districts are a combination of competition and cooperation: - They generate direct rivalry between companies that compete with one another in the same type of business - They generate symbiotic relationships that are advantageous to all concerned because they are located in a common environment and because of the complementarities emerging between them **ANALYSIS OF THE COMPETITIVE ENVIRONMENT:** **DEFINING THE COMPETITIVE ENVIRONMENT:** Who are our business competitors? What are the boundaries of the industry I am competing with? The answer to these questions is not always obvious and it´s especially relevant because: - It delimits the arena that needs to be analyzed in order to identify opportunities, threats and key factors of success. - A poor definition of the competitive arena may mean the analysis omits firms from other industries or sector that may compete directly for some customers - It may compromise the definition of the most appropriate competitive strategy because it doesn´t consider all the agents involved. The answer to the above questions is related to the type of business the firm pursues the industrial sector in which it´s located. **Industry:** a group of companies offering products or services that are close substitutes for each other. Therefore, rivals are those firms that provide substitute products. This substitute nature may be measured by 2 criteria: (when products can be substituted for purchasers and producers alike) A. **Technological criterion:** (applied from the standpoint of supply) defines an industry as the sum of firms that use similar operating processes or raw materials in the manufacture of one or more products (degree to which these operating processes are interchangeable) B. **Market criterion:** (applied from the demand side) picks out the sum of firms manufacturing products that are closely interchangeable from the perspective of catering for customer´s needs. \*There are cases in which the degree of substitution differs substantially for one or the other. Besides the traditional concept of industrial sector, there´s a need to define others closely related to it. Following [Abell´s] approach, the competitive environment may be defined on the basis of 3 dimensions: - *Groups of customers served:* target consumers of products or services - *Functions the products or services cover for said customers:* closely related to the needs met - *Technology used (*how the product is supplied*):* the manner in which a function is covered CONCEPTS TO IDENTIFY AND DELIMIT THE COMPETITIVE ENVIRONMENT: - **INDUSTRY:** series of firms that, based on a specific technology, seek to attend to all their customer groups and cover all possible functions. This concept would delimit the industrial sector on the supply side.  - **A FIRM´S BUSINESS:** the specific selection each firm makes of the functions and customer groups it wishes to cater for. An industry may contain numerous firms. Each one of them decides, according to the technology chosen, to cater for one or more types of customer groups and cover one or more functions or needs. Also, a firm might dedicate itself to different businesses belonging to different industries. - **MARKET:** the industrial sector from the demand side. It includes the sum of companies that cover the same function for the same group of customers, irrespective of the industry in which they operate (the technology they use)  Defining the competitive environment is a key issue for strategic analysis (competitors, customer, suppliers). The concept of market is closer to the definition of competitive environment, as it includes competitors and customers. If it includes suppliers, then it would provide the competitive environment the firm needs to analyze. \*From a customer´s perspective, [replaceability] (products or services that cover the same basic need) is the key to defining a firm´s competitive environment. Once we have decided upon the concept of market, all that remains is to identify a firm´s competitors: - If an industry caters solely for one specific function for one particular group of customers and all the companies in that industry define their businesses in a highly similar way regarding the 3 basic dimensions, it won´t be difficult to identify the firm´s competitive environment (all rivals come from the same industry and cover the same set of functions for the same groups of customers) - Sometimes, companies from the same industry define their businesses differently. Many industries can be divided up into smaller competitive scopes through the identification of segments. - Companies from different industries seek to cover the same functions for the same customer groups (using different technological alternatives). Then, firms compete only in those activities in which they coincide because of the function covered and because of their target customer group **heterogeneous competitive environment** \*Companies in the same industry that aren´t direct rivals because they cover different functions for different customer groups (2 airlines that service different routes). \*Direct competitors that come from different industries (passenger transport between 2 cities airlines, railway companies, coach firms, customer´s own cars) the concept of industry on the supply side is irrelevant from a strategic perspective (it doesn´t help to identify competitors). Defining the competitive environment and identifying the main competitors constitute a difficult yet crucial issue for the outside analysis that requires prudence and, on occasions, imagination. These should be defined by managers based on the objective data available and on their own judgement depending on the purpose of each analysis and its context. \*There´s a need to establish certain boundaries that include the main rivals, distant competitors, potential ones or substitutes the definition of the boundaries not too broadly or too narrowly. **ANALYSIS OF THE INDUSTRY´S STRUCTURE:** The aim of analyzing the industry´s structure is to highlight the **opportunities and threats** it poses for a firm and which determine its capacity for returning profits, which constitutes the industry´s attractiveness **how do firms compete in the industry?** through prices: \- High prices (high margin) and low volume \- Low prices and high volume \- Price-quality \*The industry´s structure conditions the firm´s behavior and profitability. In an industry in a state of perfect competition, there are very few options available to a firm, being restricted to the application of the market price, with no capacity for influencing supply and demand. Those industries in a state of imperfect competition have possibilities with higher earnings (if the firm is capable of properly exploit opportunities and tackle threats) analytical model involving imperfect markets in which it´s possible to outperform one´s competitors. From this perspective: - Opportunities will be factors that reduce competition and allow above average earnings - Threats will involve aspects that may increase the level of competition, leading companies in the sector to a more tempered performance The greater the opportunities and the fewer the threats, the more attractive the industry will be the higher the expectations on returns. FIVE-FORCES MODEL OF INDUSTRY COMPETITION: Methodology used for investigating opportunities and threats. According to [Porter]: an industry´s level of attractiveness is informed by the action of 5 basic competitive forces, which define the possibility of recording a better performance, provided threats are tackled and opportunities taken. 1. **[THE INTENSITY OF RIVALRY AMONG ESTABLISHED COMPETITORS: ]** Behavior of competitors in the industry at a given moment. A study is made of the industry´s basic characteristics that define the general framework for competitors, and of the possible actions and reactions of established companies that may alter the intensity of this rivalry. As the intensity of the competition increases, the possibility of higher returns is reduced and the industry´s attractiveness diminishes. The intensity of this rivalry is the outcome of a series of structural factors: - [Numerous or equally balanced competitors:] as the number of established competitors increases (with greater balance between them), the intensity of the competition will increase. It´s associated with the industry´s degree of concentration (how each competitor´s market share is distributed) industries may be **concentrated or fragmented** (intensity of competition lower in the former) - [Industry´s growth rate] (emerging, growing, maturing and declining industries): as the industry´s growth rate slows, the intensity of the competition increases. As an industry enters the stages of maturity or decline, the intensity of competition increases (turnover stagnates or falls and competitors are required to be more aggressive to capture new customers or sustain their current ones) - [Mobility barriers:] obstacles or hindrances that stop firms moving from one segment to another within the same industry. The presence of these barriers restricts the competition to those firms included in each segment, so its intensity for the industry as a whole diminishes. - [Exit barriers:] factors that impede or hinder the departure from an industry. Their presence forces firms to continue competing in order to survive intensity of competition increases. - Specialized **assets** that are difficult to reuse outside the industry - **Fixed exit costs** (severance pay or liquidation of stock) - **Strategic interrelationships** between some businesses and other that require sustaining all of them - **Emotional** or psychological barriers - **Social** (industrial action, demonstrations, product boycotts) **or political restraints** (legislation, political pressure) which make it difficult to terminate the business. - [Companies cost structure:] the greater weight of fixed costs over variable ones drives firms to operate at full capacity in order to reduce their average costs increase the output of products and force their sale on the market increasing the intensity of competition. - [Product differentiation:] as an industry records a higher level of product differentiation, the intensity of competition diminishes (customers show loyalty to differentiated products) - [Switching supplier costs:] the expense a customer has to incur when switching suppliers. Their existence reduces the intensity of competition it hinders the customer´s choice and protects the supplier from an aggressive approach by competitors - [Installed operating capacity:] an excess of installed operating capacity in the industry leads to an imbalance between supply and demand. This forces firms in the sector to be more aggressive in their competitive approach in order to provide an outlet for their production outputs. - [Competitor diversity:] when rivals differ as regard strategies, national origins, personality, relations with their parent companies, objectives, size and ways of competing competition becomes more intense due to the difficulty in establishing rules of the game that are generally accepted or in predicting competitor´s behavior. - [Strategic interests:] as more firms become interested at the same time in an industry´s success, competition intensifies, as they will be willing to undertake all kinds of actions to achieve their aim. 2. **[THE THREAT OF NEW ENTRANTS: ]** **Potential entrants:** new firms wishing to enter an industry. The more attractive an industry is, the more potential rivals there will be. An industry´s level of attractiveness will diminish if potential competitors manage to enter it and compete on similar terms to current competitors (otherwise it will increase). The possibility that new competitors will enter and start competing depends on: a. [ENTRY BARRIERS:] factors that hinder the entry into the industry of new firms, normally through the higher costs incurred (decrease in financial expectations of possible new competitors). The presence of entry barriers reins in the appearance of new entrants, protecting those firms already installed and sustaining their financial expectations. Industries with entry barriers have higher average returns and they uphold its attractiveness over time. \*If an industry is profitable but doesn´t have entry barriers, many companies will install in it drawn by the higher returns intensity of competition increases. - **Absolute entry barriers:** very difficult or impossible to overcome, regardless of the resources the firm may have (requirement of a government license for operating) - **Relative entry barriers:** can be overcome depending on the firm´s resources and capabilities. They are linked to the additional costs that potential competitors have to assume to enter the industry. INDUSTRY´S MAIN ENTRY BARRIERS - Economies of scale and scope that current competitors enjoy - Cost advantages (patented product technology, favorable access to raw materials, location advantages, the learning/experience curve) - Product differentiation in favor or established firms - Start-up capital needs - Costs for customers of switching from current firms to new entrants - Access to distribution channels (restricted for new competitors or available at a higher cost) - Government policy that favor established companies (subsidies, restrictions on licenses, ecological/safety legislation) The barriers´ effectiveness depends on the resources and capabilities the new entrants have. Firms with high competencies may easily overcome these barriers and pose a real threat to those already established in the industry. b. [REACTION OF ESTABLISHED COMPETITORS:] as current competitors are able to react strongly, new entrants tend to be dissuaded. The conditions that signal a likelihood of **reprisals** are an industry´s track record in this matter (price wars, blanket advertising campaigns, special offers or emotional or localist aspects) with the aim of established companies being to dissuade the new entrant through their major resources for defending themselves (surplus liquidity, surplus operating capacity) or advantages in distribution channels. 3. **[THREAT OF SUBSTITUTE PRODUCTS: ]** **Substitute products:** those that fulfil the same customer needs as those already provided by the industry, regardless of the industry producing them. As an industry finds substitute products, its level of attractiveness will diminish (also its expectations of profitability). The existence of substitute products forces established firms to convince their customers of the advantages of consuming their products in terms of quality, price, characteristics, fulfilment of needs, ease of use... as opposed to those produced by other industries. THREAT OF SUBSTITUTE PRODUCTS DEPENDS ON: - The extent to which the substitute products provide a better quality-price ratio for customers better fulfilment of customer´s needs and lower prices - The costs of switching to the alternative products are low - The substitute products are produced by high-return industries that can sacrifice part of their profits and reduce their prices On certain occasions, the industry´s specific pricing levels sets the threshold above which alternative products may become economically viable. By contrast, when substitute products are tendered at lower prices, the companies in the industry are forced to lower their own reducing their profit margins (unless they can find new ways of reducing their costs) 4. **[BARGAINING POWER OF SUPPLIERS AND CUSTOMERS: ]** The ability to impose conditions on their transactions with firms in the industry (discounts, deferred payment, quality requirements, delivery times, returns, complaints). When suppliers or customers have a high negotiating power, they put pressure on prices or costs and seek to capture part of the value added generated in the industry, reducing its profitability. The greater the bargaining power, the lesser the industry´s attractiveness. The bargaining power of suppliers and customer is not the same across the board, just as it´s not for the different firms in the industry. There are factors that have an influence on that bargaining power, favoring on or other agents. The factors explaining the bargaining power of suppliers and customers are similar and are linked to the general supplier-customer relationship they will be analyzed jointly, noting when they favor a supplier´s position and when they favor a customer´s one. \*The firms in an industry act as customers as regards their suppliers and, in turn, as suppliers to their customers. FACTORS WITH AN IMPACT ON THE BARGAINING POWER: - Degree of concentration in relation to the industry - Volume of transactions arranged with firms in the industry - Degree of importance of the purchases made in relation to a customer´s costs - Degree of differentiation of the products or services subject to the transaction - Customer´s level of profits in relation to the supplier - Real threat of forward or backward vertical integration - Importance of the product or service sold for the quality of the buyer´s products or services - Whether or not the product may be stockpiled - Level of information of one of the parties as regards the other one  **LIMITATIONS AND EXTENSIONS OF THE FIVE-FORCES MODEL:** Not all the forces carry the same weight and not all the factors with a bearing on each force have the same importance. One needs to recognize the critical factors with a decisive impact on an industry´s attractiveness. - **Relative importance of the industry´s structure:** the five-forces model gives too much importance to an industry´s structure when explaining a firm´s performance. If an industry´s degree of attractiveness were to be the main determinant of a firm´s performance, its strategy would simply involve choosing the right industry and understanding the competitive forces better than its rivals. Competitive forces are the same for all the firms operating in the same competitive environment they all have the same performance opportunities. In reality, firms in the same industry record very different performances (difference in their resources and capabilities) - **Boundary agents:** besides suppliers and customers, firms have dealings with other stakeholders ([boundary agents]public authorities, consumer organizations, ecologists or similar groups) whose actions may limit an industry´s attractiveness. - **Complementary products:** in many industries there are complementary products that in conjunction with the industry´s own ones can increase an industry´s level of attractiveness. A product complements another when a customer values it more when it´s sold or used in conjunction with the complementary one that when it´s sold on its own. - **Industry dynamics:** the model doesn´t consider the changes that may occur and which introduce new conditions on the nature of competition and on the expectations for future performance. Changes in an industry may stem from: - Factors external to established competitors (those arising from the general environment) - Internal factors, due to the strategic actions of the established firms themselves (brand policies, innovations, product differentiation, alliances) - **Hypercompetitive industries:** in which the pace of change is fast and more intense. The industry becomes more complex and dynamic the uncertainty associated with the competitive environment increases exponentially and the industry evolves in an unstable and unpredictable manner. \*Industries related to information technologies could be included, as well as internet-related businesses. The problem with these industries is that their structure is constantly changing, their competitors´ bases are constantly evolving, and doing it so in an unpredictable manner the usefulness of the five-forces model is diminished. **INDUSTRY SEGMENTATION: STRATEGIC GROUPS** **Industry segmentation:** process, which completes an industry-level competitive analysis, that involves identifying segments (smaller competitive areas in which the dynamics of the competition is structured in a particular way) Traditional way of performing segmentation demand variables characteristics of products (quality, price, physical size, presentation) or customers (geographical areas, distribution channel, life-style, population types). \*Each one of these segments may be applied the same analytical instruments as the industry for estimating their degree of attractiveness. Other way of dividing an industry into smaller competitive environments **strategic groups:** group of firms in an industry following the same or a similar strategy along the strategic dimensions (broad product line, geographical scope, product quality, pricing policy, cost structure, technology, customer care, after-sales service). The analysis of strategic groups may help to understand the dynamics of the competition between direct rivals better than when it´s performed for the industry as a whole. Through the selection of 2 significant dimensions, the groups could be shown on a **map of strategic groups.** It reveals the homogeneity of the dimensions chosen for the firms included in each one of the groups. This maps let firms included in each group know who their most direct rivals are, as in addition to being in the same industry, they compete in the same way. In turn, it permits isolating oneself from all the other competitors, for although they are in the same industry, they compete in a different way. \*Diameter of the circle collective involvement in the market of the firms pertaining to each strategic group. Each group has its own degree of attractiveness as it will have a different set of opportunities and threats, and different expectations in terms of performance. It needs to be considered whether a firm may move from one strategic group to another, and at what cost ([permeability of groups]). This will depend on the existence of mobility barriers (entering a new strategic group or leaving the group) that will make it difficult for firms in one group to change their way of competing across the strategic dimensions. When an industry with strategic groups is devoid of mobility and exit barriers, firms may easily move from groups performing less well to ones performing better, balancing out the competitive opportunities of all the firms increasing the intensity of the rivalry in the industry as a whole. Otherwise, the firms in a group may be protected from the competition of other firms, which although operating in the same industry don´t compete in the same way because they are in a different strategic group.