Chapter 4

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CHAPTER 4

The Internal Environmental Assessment


4.1 The nature of Internal Audit

All organizations have strengths and weaknesses in the functional areas of business; no
enterprise is equally strong or weak in all areas. Internal strengths/weaknesses, coupled with
external opportunities/threats and a clear statement of mission, provide the basis for establishing
objectives and strategies. Objectives and strategies are established with the intention of
capitalizing upon internal strengths and overcoming weaknesses.
Key Internal Forces
It is not possible in a strategic-management to review in depth all the material presented in
courses such as marketing, finance, accounting, management, management information systems,
and production/operations. There are many subareas within these functions, such as customer
service, warranties, advertising, packaging, and pricing under marketing. For different types of
organizations, such as hospitals, universities, and government agencies, the functional business
areas, of course, differ. Within large organizations, each division has certain strengths and
weaknesses. A firm’s strengths that cannot be easily matched or imitated by competitors are
called distinctive competencies. Building competitive advantages involves taking advantage of
distinctive competencies. Strategies are designed in part to improve on a firm’s weaknesses,
turning them into strengths and maybe even into distinctive competencies.
4.2 The Process of Performing an Internal Audit
The process of performing an internal audit closely parallels the process of performing an
external audit. Representative Managers and employees from throughout the firm need to be
involved in determining a firm’s strengths and weaknesses. The internal audit requires gathering
and assimilating information about the firm’s management, marketing, finance/accounting,
production/operations, research and development (R&D), and management information systems
operations.
Compared to the external audit, the process of performing an internal audit provides more
opportunity for participants to understand how their jobs, departments, and divisions fit into the
whole organization. This is a great benefit because managers and employees perform better when
they understand how their work affects other areas and activities of the firm.

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For example, when marketing and manufacturing managers jointly discuss issues related to
internal strengths and weaknesses, they gain a better appreciation of the issues, problems,
concerns, and needs of all the functional areas. In organizations that do not use strategic
management, marketing, finance, and manufacturing managers often do not interact with each
other in significant ways. Performing an internal audit thus is an excellent vehicle or forum for
improving the process of communication in the organization. Communication may be the most
important word in management.
4.3 The relationship among functional areas of a business
Management
The functions of management consist of five basic activities: Planning, Organizing, Motivating,
Staffing, and Controlling.
Planning consists of all those managerial activities related to preparing for the future. Specific
tasks include forecasting, establishing objectives, devising strategies, developing policies, and
setting goals. It is more important during strategy formulation.
Organizing includes all those managerial activities that result in a structure of task and authority
relationships. Specific areas include organizational design, job specialization, job descriptions,
job specifications, span of control, unity of command, coordination, job design, and job analysis.
It is more important during strategy implementation.
Motivating involves efforts directed toward shaping human behavior. Specific topics include
leadership, communication, work groups, behavior modification, delegation of authority, job
enrichment, job satisfaction, needs fulfillment, organizational change, employee morale, and
managerial morale. It is more important during strategy implementation.
Staffing activities are centered on personnel or human resource management. Included are wage
and salary administration, employee benefits, interviewing, hiring, firing, training, management
development, employee safety, affirmative action, equal employment opportunity, union
relations, career development, personnel research, discipline policies, grievance procedures, and
public relations. It is more important during strategy implementation.
Controlling refers to all those managerial activities directed toward ensuring that actual results
are consistent with planned results. Key areas of concern include quality control, financial
control, sales control, inventory control, expense control, analysis of variances, rewards, and
sanctions. It is more important during strategy evaluation.

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Controlling consists of five basic steps:
1. Determining areas of control
2. Establishing performance standards
3. Measuring individual and organizational performance
4. Comparing actual performance to planned performance standards
5. Taking corrective actions
Management Audit Checklist questions
The following checklist of questions can help determine specific strengths and weaknesses in the
functional area of business. An answer of no to any question could indicate a potential weakness,
although the strategic significance and implications of negative answers, of course, will vary by
organization, industry, and severity of the weakness. Positive or yes answers to the checklist
questions suggest potential areas of strength.
1. Does the firm use strategic-management concepts?
2. Are company objectives and goals measurable and well communicated?
3. Do managers at all hierarchical levels plan effectively?
4. Do managers delegate authority well?
5. Is the organization’s structure appropriate?
6. Are job descriptions and job specifications clear?
7. Is employee morale high?
8. Are employee turnover and absenteeism low?
9. Are organizational reward and control mechanisms effective?

Marketing
Marketing can be described as the process of defining, anticipating, creating, and fulfilling
customers’ needs and wants for products and services. There are seven basic functions
ofmarketing: (1) customer analysis, (2) selling products/services, (3) product and service
planning, (4) pricing, (5) distribution, (6) marketing research, and (7) opportunity analysis.
Understanding these functions helps strategists identify and evaluate marketing strengths and
weaknesses.
Marketing Audit Checklist Questions
The following questions about marketing must be examined in strategic planning:
1. Are markets segmented effectively?

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2. Is the organization positioned well among competitors?
3. Has the firm’s market share been increasing?
4. Are present channels of distribution reliable and cost effective?
5. Does the firm have an effective sales organization?
6. Does the firm conduct market research?
7. Are product quality and customer service good?
8. Are the firm’s products and services priced appropriately?
9. Does the firm have an effective promotion, advertising, and publicity strategy?
10. Are marketing, planning, and budgeting effective?
11. Do the firm’s marketing managers have adequate experience and training?
12. Is the firm’s Internet presence excellent as compared to rivals?
Finance/Accounting
Financial condition is often considered the single best measure of a firm’s competitive position
and overall attractiveness to investors. Determining an organization’s financial strengths and
weaknesses is essential to effectively formulating strategies.
A firm’s liquidity, leverage, working capital, profitability, asset utilization, cash flow, and equity
can eliminate some strategies as being feasible alternatives. Financial factors often alter existing
strategies and change implementation plans.
Finance/Accounting Functions
According to James Van Horne, the functions of finance/accounting comprise three decisions:
the Investment decision, the Financing decision, and the Dividend decision. Financial ratio
analysis is the most widely used method for determining an organization’s strengths and
weaknesses in the investment, financing, and dividend areas.
Financial ratio analysis must go beyond the actual calculation and interpretation of ratios. The
analysis should be conducted on three separate fronts:
1. How has each ratio changed over time? This information provides a means of evaluating
historical trends. It is important to note whether each ratio has been historically increasing,
decreasing, or nearly constant. For example, a 10 percent profit margin could be bad if the trend
has been down 20 percent each of the last three years. But a 10 percent profit margin could be
excellent if the trend has been up, up, up.

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2. How does each ratio compare to industry norms? A firm’s inventory turnover ratio may
appear impressive at first glance but may pale when compared to industry standards or norms.
Industries can differ dramatically on certain ratios. For example grocery companies, such as
Kroger, have a high inventory turnover whereas automobile dealerships have a lower turnover.
Therefore, comparison of a firm’s ratios within its particular industry can be essential in
determining strength/weakness.
3. How does each ratio compare with key competitors? Oftentimes competition is more intense
between several competitors in a given industry or location than across all rival firms in the
industry. When this is true, financial ratio analysis should include comparison to those key
competitors. For example, if a firm’s profitability ratio is trending up over time and compares
favorably to the industry average, but it is trending down relative to its leading competitor, there
may be reason for concern.
Financial ratio analysis is not without some limitations. First of all, financial ratios are based on
accounting data, and firms differ in their treatment of such items as depreciation, inventory
valuation, research and development expenditures, pension plan costs, mergers, and taxes. Also,
seasonal factors can influence comparative ratios.
Therefore, conformity to industry composite ratios does not establish with certainty that a firm is
performing normally or that it is well managed. Likewise, departures from industry averages do
not always indicate that a firm is doing especially well or badly. For example, a high inventory
turnover ratio could indicate efficient inventory management and a strong working capital
position, but it also could indicate a serious inventory shortage and a weak working capital
position.
It is important to recognize that a firm’s financial condition depends not only on the functions of
finance, but also on many other factors that include (1) management, marketing, management
production/operations, research and development, and management information systems
decisions; (2) actions by competitors, suppliers, distributors, creditors, customers, and
shareholders; and (3) economic, social, cultural, demographic, environmental, political,
governmental, legal, and technological trends.
Finance/Accounting Audit checklist of questions
The following finance/accounting questions, like the similar questions about marketingand
management earlier, should be examined:

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1. Where is the firm financially strong and weak as indicated by financial ratio analyses?
2. Can the firm raise needed short-term capital?
3. Can the firm raise needed long-term capital through debt and/or equity?
4. Does the firm have sufficient working capital?
5. Are capital budgeting procedures effective?
6. Are dividend payout policies reasonable?
7. Does the firm have good relations with its investors and stockholders?
8. Are the firm’s financial managers experienced and well trained?
9. Is the firm’s debt situation excellent?
Production/Operations
The production/operations function of a business consists of all those activities that transform
inputs into goods and services. Production/operations management deals with inputs,
transformations, and outputs that vary across industries and markets. A manufacturing operation
transforms or converts inputs such as raw materials, labor, capital, machines, and facilities into
finished goods and services. Roger Schroeder suggested that production/operations management
comprises five functions or decision areas: process, capacity, inventory, workforce, and quality.
Production/Operations audit checklist questions
Questions such as the following should be examined:
1. Are supplies of raw materials, parts, and subassemblies reliable and reasonable?
2. Are facilities, equipment, machinery, and offices in good condition?
3. Are inventory-control policies and procedures effective?
4. Are quality-control policies and procedures effective?
5. Are facilities, resources, and markets strategically located?
6. Does the firm have technological competencies?
Research and Development
The fifth major area of internal operations that should be examined for specific strengths and
weaknesses is research and development (R&D). Many firms today conduct no R&D, and yet
many other companies depend on successful R&D activities for survival. Firms pursuing a
product development strategy especially need to have a strong R&D orientation.
Organizations invest in R&D because they believe that such an investment will lead to a superior
product or service and will give them competitive advantages.

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Research and development expenditures are directed at developing new products before
competitors do, at improving product quality, or at improving manufacturing processes to reduce
costs.
Internal and External R&D
Cost distributions among R&D activities vary by company and industry, but total R&D costs
generally do not exceed manufacturing and marketing start-up costs. Four approaches to
determining R&D budget allocations commonly are used: (1) financing as many project
proposals as possible, (2) using a percentage-of-sales method, (3) budgeting about the same
amount that competitors spend for R&D, or (4) deciding how many successful new products are
needed and working backward to estimate the required R&D investment.
R&D in organizations can take two basic forms: (1) internal R&D, in which an organization
operates its own R&D department, and/or (2) contract R&D, in which a firm hires independent
researchers or independent agencies to develop specific products. Many companies use both
approaches to develop new products. A widely used approach for obtaining outside R&D
assistance is to pursue a joint venture with another firm. R&D strengths (capabilities) and
weaknesses (limitations) play a major role in strategy formulation and strategy implementation.
Research and Development audit checklist questions
Questions such as the following should be asked in performing an R&D audit:
1. Does the firm have R&D facilities? Are they adequate?
2. If outside R&D firms are used, are they cost-effective?
3. Are the organization’s R&D personnel well qualified?
4. Are R&D resources allocated effectively?
5. Are management information and computer systems adequate?
6. Is communication between R&D and other organizational units effective?
7. Are present products technologically competitive?
Management Information Systems
Information ties all business functions together and provides the basis for all managerial
decisions. It is the cornerstone of all organizations. Information represents a major source of
competitive management advantage or disadvantage. Assessing a firm’s internal strengths and
weaknesses in information systems is a critical dimension of performing an internal audit.
Information is the lifeblood of the company.

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A management information system’s purpose is to improve the performance of an enterprise by
improving the quality of managerial decisions. An effective information system thus collects,
codes, stores, synthesizes, and presents information in such a manner that it answers important
operating and strategic questions. The heart of an information system is a database containing the
kinds of records and data important to managers.
A management information system receives raw material from both the external and internal
evaluation of an organization. It gathers data about marketing, finance, production, and personnel
matters internally, and social, cultural, demographic, environmental, economic, political,
governmental, legal, technological, and competitive factors externally. Data are integrated in
ways needed to support managerial decision making.
Management Information Systems audit checklist questions
Questions such as the following should be asked when conducting this audit:
1. Do all managers in the firm use the information system to make decisions?
2. Is there a chief information officer or director of information systems position in the firm?
3. Are data in the information system updated regularly?
4. Do managers from all functional areas of the firm contribute input to the information system?
5. Are there effective passwords for entry into the firm’s information system?
6. Are strategists of the firm familiar with the information systems of rival firms?
7. Is the information system user-friendly?
8. Do all users of the information system understand the competitive advantages that information
can provide firms?
9. Are computer training workshops provided for users of the information system?
10. Is the firm’s information system continually being improved in content and user-friendliness?
Strategic management in the whole organization
As far as the whole organization is concerned, each functional area has its own strategic
management. Strategic management penetrates into different functional areas and helps the
whole organization to enhance its own competitive advantages. The application of the unique
strategic management leads the organization to the final success. Accordingly, it is essential for
an organization to choose proper strategies in each functional area in order to form a corporate
strategic plan.

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Strategic management in marketing
Marketing is the first department in the whole organization. It is about finding customers’ needs
and wants. It is very crucial to use effective marketing strategy with regard to a certain
organization. Theodore Levitt said if the growth of a certain industry is threatened, slowed, or
stopped is not because the market is saturated. It is because there has been a failure of
management. For example, the need of the railroad declined. That did not mean the need was
filled by others (cars, airplanes, buses, etc.). The main reason why the need in such area declined
was that they let others take customers away from themselves. They were railroad oriented
instead of transportation-oriented; they were product-oriented instead of customer-oriented.
According to above-mentioned instance, it can be safely concluded customer-oriented
management is a sort of effective strategic management in marketing which can keep the
industry growing, even if there is no obvious opportunities.
Strategic management in operations management
Strategic management in operations management is very essential in an organization as well. For
example, Tesco, a successful supermarket in the UK, the layout for the whole site reflects a lot of
strategic thinking’s. They place the meat after the vegetable on shelves, because people in the
UK often do the cooking by using vegetable and meat together. In addition, they always put the
profitable goods on the middle shelves where customers can reach quite easily. Therefore, to
choose proper strategic management in operations management can help the organization lead to
success more easily.
Strategic management in finance
As far as the whole organization is concerned, to think strategically is significant for the growth
of an organization. As for finance, the capital is a very essential element of a certain
organization. Hence, it is a good idea to issue ordinary shares to raise the capital in order to think
for the future.
Strategic management in HRM
The recruitment of employees is crucial to an organization as well. The staff with skills and
abilities can provide customers with satisfactory products and services. The recruitment of
employees also helps the organization achieve its strategic goals efficiently, because recruitment
process selects appropriate applicants to work together in order to realize the objectives towards
the strategic direction of an organization.

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Working together
To achieve the goal of the whole organization needs the cooperation of the four main functional
areas. Via analyzing the market, applying effective strategies of each functional area and coming
to an agreement of a corporate strategic plan by all these functional areas, the organization put
the plan which is thinking for the future into implementation at last.
4.4 Value Chain Analysis (VCA)
According to Porter, the business of a firm can best be described as a value chain, in which total
revenues minus total costs of all activities undertaken to develop and market a product or service
yields value. All firms in a given industry have a similar value chain, which includes activities
such as obtaining raw materials, designing products, building manufacturing facilities,
developing cooperative agreements, and providing customer service. A firm will be profitable as
long as total revenues exceed the total costs incurred in creating and delivering the product or
service. Firms should strive to understand not only their own value chain operations but also
their competitors’, suppliers’, and distributors’ value chains.
Value chain analysis (VCA) refers to the process whereby a firm determines the costs associated
with organizational activities from purchasing raw materials to manufacturing product(s) to
marketing those products.
Benchmarking
Benchmarking is an analytical tool used to determine whether a firm’s value chain activities are
competitive compared to rivals and thus conducive to winning in the marketplace. Benchmarking
entails measuring costs of value chain activities across an industry to determine “best practices”
among competing firms for the purpose of duplicating or improving upon those best practices.
Benchmarking enables a firm to take action to improve its competitiveness by identifying (and
improving upon) value chain activities where rival firms have comparative advantages in cost,
service, reputation, or operation.
The hardest part of benchmarking can be gaining access to other firms’ value chain activities
with associated costs. Typical sources of benchmarking information, however, include published
reports, trade publications, suppliers, distributors, customers, partners, creditors, shareholders,
lobbyists, and willing rival firms. Some rival firms share benchmarking data.

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4.5. The Internal Factor Evaluation (IFE) Matrix
A summary step in conducting an internal strategic-management audit is to construct an Internal
Factor Evaluation (IFE) Matrix. This strategy-formulation tool summarizes and evaluates the
major strengths and weaknesses in the functional areas of a business, and it also provides a basis
for identifying and evaluating relationships among those areas. Intuitive judgments are required
in developing an IFE Matrix, so the appearance of a scientific approach should not be interpreted
to mean this is an all-powerful technique. A thorough understanding of the factors included is
more important than the actual numbers. Similar to the EFE Matrix and Competitive Profile
Matrix described in Chapter 3, an IFE Matrix can be developed in five steps:
1. List key internal factors as identified in the internal-audit process. Use a total of from 10 to 20
internal factors, including both strengths and weaknesses. List strengths first and then
weaknesses.
2. Assign a weight that ranges from 0.0 (not important) to 1.0 (all-important) to each factor. The
weight assigned to a given factor indicates the relative importance of the factor to being
successful in the firm’s industry. Regardless of whether a key factor is an internal strength or
weakness, factors considered to have the greatest effect on organizational performance should be
assigned the highest weights. The sum of all weights must equal 1.0.
3. Assign a 1-to-4 rating to each factor to indicate whether that factor represents a major
weakness (rating = 1), a minor weakness (rating = 2), a minor strength (rating = 3), or a major
strength (rating = 4). Note that strengths must receive a 3 or 4 rating and weaknesses must
receive a 1 or 2 rating. Ratings are thus company-based, whereas the weights in step 2 are
industry-based.
4. Multiply each factor’s weight by its rating to determine a weighted score for each variable.
5. Sum the weighted scores for each variable to determine the total weighted score for the
organization. Regardless of how many factors are included in an IFE Matrix, the total weighted
Score can range from a low of 1.0 to a high of 4.0, with the average score being 2.5.
Total weighted scores well below 2.5 characterize organizations that are weak internally,
whereas scores significantly above 2.5 indicate a strong internal position. Like the EFE Matrix,
an IFE Matrix should include from 10 to 20 key factors. The number of factors has no effect
upon the range of total weighted scores because the weights always sum to 1.0.

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