Chapter Three

External Environmental Analysis

3.1 Introduction
For any organization, the environment consists of the set of external conditions and forces that
have the potential to influence the organization. Understanding the environment that surrounds
an organization is important. There are several reasons for this. First, the environment provides
resources that an organization needs in order to create goods and services. In the seventeenth
century, British poet John Donne famously noted, “no man is an island.” Similarly, it is accurate
to say that no organization is self-sufficient. As the human body must consume oxygen, food,
and water, an organization needs to take in resources such as labor, money, and raw materials
from outside its boundaries.
Second, the environment is a source of opportunities and threats to an organization.
Opportunities are events and trends that create chances to improve an organization’s
performance level. Threats are events and trends that may undermine an organization’s
performance. Executives must also realize that virtually any environmental trend or event is
likely to create opportunities for some organizations and threats for others. This is true even in
extreme cases. In addition to horrible human death and suffering, the March 2011 earthquake and
tsunami in Japan devastated many organizations, ranging from small businesses that were simply
wiped out to corporate giants such as Toyota whose manufacturing capabilities were
undermined. As odd, as it may seem, however, these tragic events also opened up significant
opportunities for other organizations. The rebuilding of infrastructure and dwellings requires
concrete, steel, and other materials. Japanese concrete manufacturers, steelmakers, and
construction companies are likely to be very busy in the years ahead.
Third, the environment shapes the various strategic decisions that executives make as they
attempt to lead their organizations to success. The environment often places important
constraints on an organization’s goals, for example. A firm that set a goal of increasing annual
sales by 50 percent might struggle to achieve this goal during an economic recession or if several
new competitors enter its business. Environmental conditions also need to be taken into account
when examining whether to start doing business in a new country, whether to acquire another
company, and whether to launch an innovative product, to name just a few.

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Characteristics of Environment
Some of the important, and obvious, characteristics are briefly described here.
1. Environment is complex. The environment consists of a number of factors, events,
conditions, and influences arising from different sources. All these do not exist in isolation,
but interact with each other to create entirely new sets of influences. It is difficult to
comprehend at once what factors constitute a given environment. Generally, environment is a
complex phenomenon relatively easier to understand in parts but difficult to grasp in its
totality.
2. Environment is dynamic. The environment is constantly changing in nature. Due to the
many and varied influence operating, there is dynamism in the environment, causing it to
change its shape and character continuously.
3. Environment is multifaceted. What shape and character an environment will assume
depends on the perception of the observer. A particular change in the environment, or a new
development, may be viewed differently by different observers.
4. Environment has a far-reaching impact. An occurrence in the environment now may have
an impact that will stay for long time. The growth and profitability of an organization depend
critically on the environment in which it exists.
3.2 The Nature of External Audit
The purpose of an external audit is to develop a finite list of opportunities that could benefit a
firm and threats that should be minimized. As the term finite suggests, the external audit is not
aimed at developing an exhaustive list of every possible factor that could influence the business;
rather, it is aimed at identifying key variables that offer actionable responses. Firms should be
able to respond either offensively or defensively to the factors by formulating strategies that take
advantage of external opportunities or that minimize the impact of potential threats. Most firms
face external environments that are highly turbulent, complex, and global conditions that make
interpreting them increasingly difficult. To cope with what are often ambiguous and incomplete
environmental data and to increase their understanding of the general environment, firms engage
in a process called external environmental analysis.
Components of the External Environment Analysis
Scanning: Identifying early signals of environmental changes and trends. Scanning entails the
study of all segments in the general environment. Through scanning, firms identify early signals

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of potential changes in the general environment and detect changes that are already under way.
When scanning, the firm often deals with ambiguous, incomplete, or unconnected data and
information. Environmental scanning is critically important for firms competing in highly
volatile environments .In addition, scanning activities must be aligned with the organizational
context; a scanning system designed for a volatile environment is inappropriate for a firm in a
stable environment.
Monitoring: Detecting meaning through ongoing observations of environmental changes and
trends. When monitoring, analysts observe environmental changes to see if an important trend is
emerging from among those spotted by scanning. Critical to successful monitoring is the firm’s
ability to detect meaning in different environmental events and trends. By monitoring trends,
firms can be prepared to introduce new goods and services at the appropriate time to take
advantage of the opportunities identified trends provides. Effective monitoring requires the firm
to identify important stakeholders. Because the importance of different stakeholders can vary
over a firm’s life cycle, careful attention must be given to the firm’s needs and its stakeholder
groups across time. Scanning and monitoring is particularly important when a firm competes in
an industry with high technological uncertainty. Scanning and monitoring not only can provide
the firm with information; they also serve as a means of importing new knowledge about markets
and about how to successfully commercialize new technologies that the firm has developed.
Forecasting: Developing projections of anticipated outcomes based on monitored changes and
trends. Scanning and monitoring is concerned with events and trends in the general environment
at a point in time. When forecasting, analysts develop feasible projections of what might happen,
and how quickly, as a result of the changes and trends detected through scanning and monitoring.
Assessing: Determining the timing and importance of environmental changes and trends for
firms’ strategies and their management. The objective of assessing is to determine the timing and
significance of the effects of environmental changes and trends in the strategic management of
the firm. Through scanning, monitoring, and forecasting, analysts are able to understand the
general environment. Going a step further, the intent of the assessment is to specify the
implications of that understanding for the organization. Without assessment, the firm is left with
data that may be interesting but are of unknown competitive relevance.

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3.3 The Process of Performing an External Audit
The process of performing an external audit must involve as many managers and employees as
possible. As emphasized in earlier chapter, involvement in the strategic-management process can
lead to understanding and commitment from organizational members. Individuals appreciate
having the opportunity to contribute ideas and to gain a better understanding of their firms’
industry, competitors, and markets. To perform an external audit companies may follow the
following steps
1. Gather competitive intelligence and information: a company gathers competitive
intelligence and information about economic, social, cultural, demographic, environmental,
political, governmental, legal, and technological trends. Individuals can be asked to monitor
various sources of information, such as key magazines, trade journals, and newspapers.
These persons can submit periodic scanning reports to a committee of managers charged with
performing the external audit. This approach provides a continuous stream of timely strategic
information and involves many individuals in the external-audit process. Internet provides
another source for gathering strategic information, as do corporate, university, and public
libraries. Suppliers, distributors, salespersons, customers, and competitors represent other
sources of vital information.
2. Assimilation and evaluation: Once information is gathered, it should be assimilated and
evaluated. A meeting or series of meetings of managers is needed to collectively identify the
most important opportunities and threats facing the firm. These key external factors should
be listed on flip charts or a chalkboard. A prioritized list of these factors could be obtained by
requesting that all managers rank the factors identified, from the most important
opportunity/threat to the least important opportunity/threat. These key external factors can
vary over time and by industry. These key external factors should be (a) important to
achieving long-term and annual objectives, (b) measurable, (c) applicable to all competing
firms, and (d) hierarchical in the sense that some will pertain to the overall company and
others will be more narrowly focused on functional or divisional areas.
3. Communicate and distribute key external factors: A final list of the most important key
external factors should be communicated and distributed widely in the organization. Both
opportunities and threats can be key external factors.

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3.4 Analysis of Key External Factors
An integrated understanding of the external and internal environments is essential for firms to
understand the present and predict the future. Firm’s external environment is divided into three
major areas: the general, industry, and competitor environments. An important objective of
studying the external environment is identifying opportunities and threats.
Figure 3.1Three Major Areas External Environment

Economic

Sociocultural

Industry Environment
Threat of New Entrants
Power of Suppliers
Power of Buyers Legal
Product Substitutes
Intensity of Rivalry
Competitor Environment

Environmental
Political

Technological

I. General external factors

The general environment is composed of dimensions in the broader society that influence an
industry and the firms within it. It aim is to identifying opportunities and threats. An opportunity
is a condition in the general environment that, if exploited, helps a company achieves strategic
competitiveness. Firms cannot directly control the general environment’s segments and elements.
Accordingly, successful companies gather the information required to understand each segment
and its implications for the selection and implementation of the appropriate strategies.
Segments of the general environment
The general environment is composed of segments that are external to the firm. Although the
degree of impact varies, these environmental segments affect each industry and its firms. The
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challenge to the firm is to scan, monitor, forecast, and assess those elements in each segment that
are of the greatest importance. These efforts should result in recognition of environmental
changes, trends, opportunities, and threats. PESTEL analysis is one important tool that
executives can rely on to organizes factors within the general environment and to identify how
these factors influence industries and the firms. PESTEL is an anagram, meaning it is a word that
created by using parts of other words. In particular, PESTEL reflects the names of the six
segments of the general environment: (1) political, (2) economic, (3) social, (4) technological,
(5) environmental, and (6) legal.
1. Political segment
The political segment centers on the role of governments in shaping business. This segment
includes elements such as tax policies, changes in trade restrictions and tariffs, the stability of
governments and immigration policy. Immigration policy is an aspect of the political segment of
the general environment that offers important implications for many different organizations.
2. The Economic Segment
The health of a nation’s economy affects individual firms and industries. Because of this,
companies study the economic environment to identify changes, trends, and their strategic
implications .The economic environment refers to the nature and direction of the economy in
which a firm competes or may compete. Because nations are interconnected as a result of the
global economy, firms must scan, monitor, forecast, and assess the health of economies outside
their host nation. For example, many nations throughout the world are affected by the U.S.
economy. The economic segment centers on the economic conditions within which organizations
operate. It includes elements such as: interest rates, inflation rates, gross domestic product,
unemployment rates, levels of disposable income, trade deficits or surpluses, monetary policies ,
fiscal policies the general growth or decline of the economy. Rising unemployment discouraged
consumers from purchasing expensive, nonessential goods such as automobiles and television
sets. Bank failures during the economic crisis led to a dramatic tightening of credit markets. This
dealt a huge blow to homebuilders, for example, who saw demand for new houses plummet
because mortgages were extremely difficult to obtain.
3. Socio-cultural segment
The socio-cultural environment consists of factors related to human relationship within a society;
the development, forms and functions of such a relationship; and the learnt and shared behavior

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of groups of human beings, which have a bearing on the business of an organization. Some of the
important elements are demographic characteristics includes population size, ethnic mix, age
structure, income distribution, geographic distribution. Socio-cultural attitudes and values: social
customs, beliefs, rituals and practices, changing lifestyle patterns and materialism; women in the
workforce, concerns about the environment, workforce diversity , shifts in work and career
preferences, attitudes about the quality and shifts in preferences regarding product and service
characteristics
4. Technological segment
The technological environment consists of those factors that are related to the knowledge applied
and the materials and machines used in the production of goods and services, which have an
impact on the business of an organization. The Internet has changed the nature of opportunities
and threats by altering the life cycles of products, increasing the speed of distribution, creating
new products and services, erasing limitations of traditional geographic markets, and changing
the historical trade-off between production standardization and flexibility. The Internet has
lowered entry barriers and redefined the relationship between industries and various suppliers,
creditors, customers, and competitors. The technological segment centers on improvements in
products and services that are provided by science. Relevant factors include changes in the rate
of new product development, increases in automation, product innovations, focus of private and
government, applications of knowledge, advancements in service industry delivery.
5. Environmental segment
The environmental segment involves the physical conditions within which organizations operate.
It includes factors such as: natural disasters, pollution levels, weather patterns, climate change.
The threat of pollution, for example, has forced municipalities to treat water supplies with
chemicals. These chemicals increase the safety of the water but detract from its taste. This has
created opportunities for businesses that provide better-tasting water. Rather than consume cheap
but bad-tasting tap water, many consumers purchase bottled water. Changes in temperature can
affect many industries including farming, tourism and insurance. With major climate changes,
occurring due to global warming and with greater environmental awareness this external factor is
becoming a significant issue for firms to consider. The growing desire to protect the environment
is having an impact on many industries such as the travel and transportation industries (for
example, more taxes being placed on air travel and the success of hybrid cars) and the general

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move towards more environmentally friendly products and processes is affecting demand
patterns and creating business opportunities.

6. Legal segment
These are related to the legal environment in which firms operate. The legal segment centers on
how the legal issues influence business activity. Business Organizations prefer to operate in a
country where there is a sound legal system. Examples of important legal factors include
employment laws; health and safety regulations, discrimination laws, antitrust laws. Intellectual
property rights are a particularly daunting aspect of the legal segment for many organizations.
When a studio such as Adica produces a movie, a software firm such as Adobe revises a
program, or a video game company such as Activision devises a new game, these firms are
creating intellectual property. Such firms attempt to make profits by selling copies of their
movies, programs, and games to individuals. Piracy of intellectual property—a process wherein
illegal copies are made and sold by others—poses a serious threat to such profits. Law
enforcement agencies and courts in many countries, including the United States, provide
organizations with the necessary legal mechanisms to protect their intellectual property from
piracy.
The introduction of age discrimination and disability discrimination legislation, an increase in
the minimum wage and greater requirements for firms to recycle are examples of relatively
recent laws that affect an organization’s actions. Legal changes can affect a firm's costs (e.g. if
new systems and procedures have to be developed) and demand (e.g. if the law affects the
likelihood of customers buying the good or using the service).
II. Industry analysis
Wayne Calloway said: “Nothing focuses the mind better than the constant sight of a competitor
that wants to wipe you off the map.” An industry is a group of firms producing products that are
close substitutes such as soft drinks or financial services. Industry analysis (popularized by
Michael Porter) refers to an in-depth examination of key factors within a corporation’s task
environment. In the course of competition, these firms influence one another.

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Figure 3.2 The Porter’s “Five-Force” competition Model: - A key Analytical Tool

Typically, industries include a rich mix of competitive strategies that companies use in pursuing
strategic competitiveness and above-average returns. In part, these strategies are chosen because
of the influence of an industry’s characteristics. According to porter the intensity of industry
competition and an industry’s profit potential are functions of five forces of competition: the
threats posed by new entrants, the power of suppliers, and the power of buyers, product
substitutes, and the intensity of rivalry among competitors.
1. The Threat of New Entrants to the Industry
A new entrant into industry represents a competitive threat to existing firms. It adds new
production capacity and potential to erode the market share of the existing industry. New
entrants into the industry are potential competitors. Potential competitors are organizations that
currently are not competing in an industry but have the capability to do so if they choose.
Existing (established) organizations try to discourage potential competitors from entering, since
the more organizations enter an industry, the more difficult it becomes for established
organizations to hold their share of the market and to generate success. Thus, a high risk of entry
by potential competitors represents a threat to the profitability of established organizations. On
the other hand, if the risk of new entry is low, established organizations could take advantage of

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this opportunity to raise prices and earn greater returns. The strength of the competitive forces of
potential rivals is largely a function of the height of barriers to entry. The concept of barriers to
entry implies that there are significant costs in joining an industry.
The greater the costs that potential competitors must bear, the greater are the barriers to entry.
High entry barriers keep potential competitors out of an industry even when industry returns are
high. Barriers to entry are unique industry characteristics that define the industry. Barriers reduce
the rate of entry of new firms, thus maintaining a level of profits for those already in the industry.
From a strategic perspective, barriers can be created or exploited to enhance a firm's competitive
advantage. The principal sources of barriers to entry are:
 Economies of scale: Economies of scale are derived from incremental efficiency
improvements through experience, as a firm gets larger. Therefore, as the quantity of a
product produced during a given period increases the cost of manufacturing each unit
declines. Economies of scale can be developed in most business functions, such as
marketing, manufacturing, research and development, and purchasing. Increasing economies
of scale enhances a firm’s flexibility.
 Product Differentiation: Over time, customers may come to believe that a firm’s product is
unique. This belief can result from the firm’s service to the customer, effective advertising
campaigns, or being the first to market a good or service. Companies such as Coca-Cola,
Pepsi Cola, and the world’s automobile manufacturers spend a great deal of money on
advertising to convince potential customers of their products’ distinctiveness. Customers
valuing a product’s uniqueness tend to become loyal to both the product and the company
producing it. Typically, new entrants must allocate many resources over time to overcome
existing customer loyalties. To combat the perception of uniqueness, new entrants frequently
offer products at lower prices. This decision, however, may result in lower profits or even
losses.
 Capital Requirements: Competing in a new industry requires a firm to have resources to
invest. In addition to physical facilities, capital is needed for inventories, marketing activities,
and other critical business functions. Even when competing in a new industry is attractive,
the capital required for successful market entry may not be available to pursue an apparent
market opportunity.

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 Switching Costs: Switching costs are the one-time costs customers incur when they buy
from a different supplier. In some cases, switching costs are low, such as when the consumer
switches to a different soft drink. Switching costs can vary as a function of time. For
example, a decision made by manufacturers to produce a new, innovative product creates
high switching costs for the final consumer. Customer loyalty programs, such as airlines’
frequent flier miles, are intended to increase the customer’s switching costs. If switching
costs are high, a new entrant must offer either a substantially lower price or a much better
product to attract buyers. Usually, the more established the relationship between parties, the
greater is the cost incurred to switch to an alternative offering.
 Access to Distribution Channels: Over time, industry participants typically develop
effective means of distributing products. Once a relationship with its distributors has been
developed, a firm will nurture it to create switching costs for the distributors. Access to
distribution channels can be a strong entry barrier for new entrants, particularly in consumer
nondurable goods industries (for example, in grocery stores where shelf space is limited) and
in international markets. New entrants have to persuade distributors to carry their products,
either in addition to or in place of those currently distributed. Price breaks and cooperative
advertising allowances may be used for this purpose; however, those practices reduce the
new entrant’s profit potential.
 Government Policy. Through licensing and permit requirements, governments can also
control entry into an industry. Liquor retailing, radio and TV broadcasting, banking, and
trucking are examples of industries in which government decisions and actions affect entry
possibilities. In addition, governments often restrict entry into some industries because of the
need to provide quality service or the need to protect jobs. Some of the most publicized
government actions are those involving antitrust
 Retaliation by established producer: Firms seeking to enter an industry also anticipate the
reactions of firms in the industry. An expectation of swift and vigorous competitive
responses reduces the likelihood of entry. Vigorous retaliation can be expected when the
existing firm has a major stake in the industry (for example, it has fixed assets with few, if
any, alternative uses), when it has substantial resources, and when industry growth is slow or
constrained. For example, any firm attempting to enter the auto industry at the current time
can expect significant retaliation from existing competitors due to the overcapacity.

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2. Rivalry among Established/Existing Firms
It describes the intensity of rivalry among competitors or established organizations within in the
industry. Because an industry’s firms are mutually dependent, actions taken by one company
usually invite competitive responses. In many industries, firms actively compete against one
another. Competitive rivalry intensifies when a firm is challenged by a competitor’s actions or
when a company recognizes an opportunity to improve its market position. Some industries
appear “sleepy” because of a low level of rivalry among competitors. On the other hand, some
industries are characterized by a high level of competitive activity (example, the brewing
industry has many competitors who battle fiercely with each other over market share). If this
competitive force is weak, organizations have an opportunity to raise prices and earn grater
profits. However, if it is strong, significant price competition, including price wars, may result
from the intense rivalry. Price competition limits profitability by reducing the margins that can
be earned on sales. Generally, the factors that tend to precipitate intense rivalries in an industry
are:
Numerous or equally balanced competitors: Intense rivalries are common in industries with
many companies. With multiple competitors, it is common for a few firms to believe that they
can act without eliciting a response. However, evidence suggests that other firms generally are
aware of competitors’ actions, often choosing to respond to them. At the other extreme,
industries with only a few firms of equivalent size and power also tend to have strong rivalries.
The large and often similar-sized resource bases of these firms permit vigorous actions and
responses.
Rate of industry growth: When a market is growing, firms try to effectively use resources to
serve an expanding customer base. Growing markets reduce the pressure to take customers from
competitors. However, rivalry in no-growth or slow-growth markets becomes more intense as
firms battle to increase their market shares by attracting competitors’ customers.
Lack of differentiation or low switching costs: When buyers find a differentiated product that
satisfies their needs, they frequently purchase the product loyally over time. Industries with
many companies that have successfully differentiated their products have less rivalry, resulting
in lower competition for individual firms. Firms that develop and sustain a differentiated product
that cannot be easily imitated by competitors often earn higher returns. However, when buyers
view products as commodities (that is, as products with few differentiated features or

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capabilities), rivalry intensifies. In these instances, buyers’ purchasing decisions are based
primarily on price and, to a lesser degree, service.
The effect of switching costs is identical to the effect of differentiated products. The lower the
buyers’ switch costs, the easier it is for competitors to attract buyers through pricing and service
offerings. High switching costs at least partially insulate the firm from rivals’ efforts to attract
customers. Interestingly, the switching costs such as pilot and mechanic training—are high in
aircraft purchases, yet the rivalry between Boeing and Airbus remains intense because the stakes
for both are extremely high.

High Exit Barriers: Sometimes companies continue competing in an industry even though the
returns on their invested capital are low or negative. Firms making this choice likely face high
exit barriers, which include economic, strategic, and emotional factors causing companies to
remain in an industry when the profitability of doing so is questionable. Exit barriers are
especially high in the airline industry.
Common exit barriers are:
 Specialized assets (assets with values linked to a particular business or location).
 Fixed costs of exit (such as labor agreements).
 Strategic interrelationships (relationships of mutual dependence, such as those between one
business and other parts of a company’s operations, including shared facilities and access to
financial markets).
 Emotional barriers (aversion to economically justified business decisions because of fear for
one’s own career, loyalty to employees, and so forth).
 Government and social restrictions (these restrictions often are based on government
concerns for job losses and regional economic effects).
3. The Bargaining Power of Buyers
Firms seek to maximize the return on their invested capital. Alternatively, buyers (customers of
an industry or a firm) want to buy products at the lowest possible price the point at which the
industry earns the lowest acceptable rate of return on its invested capital. The bargaining power
of buyers refers to the ability of buyers to bargain down prices charged by companies in the
industry or to raise the costs of companies in the industry by demanding better product quality
and service. To reduce their price, buyers bargain for higher quality, greater levels of service,

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and lower prices. These outcomes are achieved by encouraging competitive battles among the
industry’s firms. Customers (buyer groups) are powerful when:
 They purchase a large portion of an industry’s total output.
 The sales of the product being purchased account for a significant portion of the seller’s
annual revenues.
 They could switch to another product at little, if any, cost.
 The industry’s products are undifferentiated or standardized, and the buyers pose a
credible threat if they were to integrate backward into the sellers’ industry.
 The sellers’ product is not critical in one way or another to the buyer. If it is critical to the
quality, price, appeal, etc,, of an industrial buyer group’s finished product, for example,
then the sellers will have power over the buyers.
 When buyers can threaten to enter the industry and produce the product themselves and
thus supply their own needs, also a tactic for forcing down industry prices.
 When the supply industry depends on the buyers for a large percentage of its total orders.
Armed with greater amounts of information about the manufacturer’s costs and the power of the
Internet as a shopping and distribution alternative, consumers appear to be increasing their
bargaining power in many industries. One reason for this shift is that individual buyers incur
virtually zero switching costs when they decide to purchase from one manufacturer rather than
another or from one dealer as opposed to a second or third one.
4. The Bargaining Power of Suppliers
The fourth of Porter’s five competitive forces is the bargaining power of suppliers the
organizations that provide inputs into the industry, such as materials, services, and labor (which
may be individuals, organizations such as labor unions, or companies that supply contract labor).
The bargaining power of suppliers refers to the ability of suppliers to raise input prices, or to
raise the costs of the industry in other ways for example, by providing poor quality inputs or poor
service. Powerful suppliers squeeze profits out of an industry by raising the costs of companies
in the industry. Thus, powerful suppliers are a threat. Alternatively, if suppliers are weak,
companies in the industry have the opportunity to force down input prices and demand higher-
quality inputs (e.g., more productive labor). Suppliers are most powerful in the following
situations:

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 The product that suppliers sell has few substitutes and is vital to the companies in an
industry.
 The profitability of suppliers is not significantly affected by the purchases of companies in a
particular industry, in other words, when the industry is not an important customer to the
suppliers.
 Companies in an industry would experience significant switching costs if they moved to the
product of a different supplier because a particular supplier’s products are unique or
different. In such cases, the company depends on a particular supplier and cannot play
suppliers off against each other to reduce price.
 Suppliers can threaten to enter their customers’ industry and use their inputs to produce
products that would compete directly with those of companies already in the industry.
 Companies in the industry cannot threaten to enter their suppliers’ industry and make their
own inputs as a tactic for lowering the price of inputs.
 Suppliers’ product is differentiated
5. The Threat of Substitute Products
Substitutes are offerings that differ from the goods and services provided by the competitors in
an industry but that fill similar needs to what the industry offer. How strong of a threat
substitutes are depends on how effective substitutes are in serving an industry’s customers. For
example, companies in the coffee industry compete indirectly with those in the tea and soft drink
industries because all three serve customer needs for nonalcoholic drinks. The existence of close
substitutes is a strong competitive threat because this limits the price that companies in one
industry can charge for their product, and thus industry profitability. If the price of coffee rises
too much relative to that of tea or soft drinks, coffee drinkers may switch to those substitutes.
If an industry’s products have few close substitutes, so that substitutes are a weak competitive
force, then, other things being equal, companies in the industry have the opportunity to raise
prices and earn additional profits. For example, there is no close substitute for microprocessors,
which gives companies like Intel and AMD the ability to charge higher. In general, product
substitutes present a strong threat to a firm when customers face few, if any, switching costs and
when the substitute product’s price is lower or its quality and performance capabilities are equal
to or greater than those of the competing product.
III. Competitive Forces/Competitor’s analysis

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An important part of an external audit is identifying rival firms and determining their strengths,
weaknesses, capabilities, opportunities, threats, objectives, and strategies. Collecting and
evaluating information on competitors is essential for successful strategy formulation.
Identifying major competitors is not always easy because many firms have divisions that
compete in different industries. Many multidivisional firms do not provide sales and profit
information on a divisional basis for competitive reasons. In addition, privately held firms do not
publish any financial or marketing information.
Seven characteristics describe the most competitive companies:
1. Strive to continually increase market share.
2. Use the vision/mission as a guide for all decisions.
3. Realize that the old adage “if it’s not broke, don’t fix it” has been replaced by “whether it’s
broke or not, fix it;” in other words, continually strive to improve everything about the firm
4. Continually adapt, innovate, and improve – especially when the firm is successful.
5. Strive to grow through acquisition whenever possible
6. Hire and retain the best employees and managers possible
7. Strive to stay cost-competitive on a global basis
Competitor analysis focuses on each company against which a firm directly competes. For
example, Coca cola and Pepsi cola, Mesobo Cement, Muger cement and Derba cement, and
Boeing and Airbus should be keenly interested in understanding each other’s objectives,
strategies, assumptions, and capabilities. Furthermore, intense rivalry creates a strong need to
understand competitors. In a competitor analysis, the firm seeks to understand
 What drives the competitor, as shown by its future objectives
 What the competitor is doing and can do, as revealed by its current strategy.
 What the competitor believes about the industry, as shown by its assumptions.
 What competitor’s capabilities are, as shown by its strengths and weaknesses
Information about these four dimensions helps the firm prepare an anticipated response profile
for each competitor. The results of an effective competitor analysis help a firm understand,
interpret, and predict its competitors’ actions and responses. Understanding the actions of
competitors clearly contributes to the firm’s ability to compete successfully within the industry.
Critical to an effective competitor analysis is gathering data and information that can help the
firm understand its competitors’ intentions and the strategic implications resulting from them.

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Useful data and information combine to form competitor intelligence: the set of data and
information the firm gathers to better understand and better anticipate competitors’ objectives,
strategies, assumptions, and capabilities. The more information and knowledge a firm can obtain
about its competitors, the more likely it is that it can formulate and implement effective
strategies. Major competitors’ weaknesses can represent external opportunities; major
competitors’ strengths may represent key threats.
3.5 Sources of external information
A wealth of strategic information is available to organizations from both published and
unpublished sources. Unpublished sources include customer surveys, market research, speeches
at professional and shareholders’ meetings, television programs, interviews, and conversations
with stakeholders. Published sources of strategic information include periodicals, journals,
reports, government documents, abstracts, books, directories, newspapers, and manuals. The
Internet has made it easier for firms to gather, assimilate, and evaluate information.
3.6 Forecasting tools and techniques
Forecasts are educated assumptions about future trends and events. Forecasting is a complex
activity because of factors such as technological innovation, cultural changes, new products,
improved services, stronger competitors, and shifts in government priorities, changing social
values, unstable economic conditions, and unforeseen events.
People eat expecting to be satisfied and nourished in the future. People sleep assuming that in the
future they will feel rested. They invest energy, money, and time because they believe their
efforts will be rewarded in the future. The truth is we all make implicit forecasts throughout our
daily lives. The question, therefore, is not whether we should forecast but rather how we can best
forecast to enable us to move beyond our ordinarily unarticulated assumptions about the future.
Can we obtain information and then make educated assumptions (forecasts) to better guide our
current decisions to achieve a more desirable future state of affairs?
No forecast is perfect, and some forecasts are even wildly inaccurate. This fact accents the need
for strategists to devote sufficient time and effort to study the underlying bases for published
forecasts and to develop internal forecasts of their own. Key external opportunities and threats
can be effectively identified only through good forecasts. Accurate forecasts can provide major
competitive advantages for organizations. Forecasting tools can be broadly categorized into two
groups: quantitative techniques and qualitative techniques.

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1. Qualitative methods: These methods rely essentially on the judgment of experts to translate
qualitative information into quantitative estimates. Examples in these groups are:
 Expert opinion method: this method calls for the pooling of views of group of experts on
expected future sales and combining them into a sales estimate. The major advantage of this
method is the pooling of expertise knowledge in the forecasting process. However, the
accuracy of the forecast will depend on the care and experience of the people providing the
inputs. The reliability of this technique is questionable.
 Delphi method: this method involves converting the views of a group of experts, who do not
interact face-to-face, into a forecast through an iterative process; it is used for eliciting the
opinions of a group of experts with the help of a mail survey. The processes may include the
following steps:
 A group of experts is sent a questionnaire by mail and asked to express their view
 The response received from the experts are summarized without disclosing the
identity of the experts, and sent back to the experts, along with a questionnaire meant
to probe further the reasons for extreme views expressed in the first round
 The process may be continued for one or more rounds until a reasonable agreement
emerges in the view of the experts.
 Brainstorming: is a non-quantitative approach that requires simply the presence of
people with some knowledge of the situation to be predicted. The basic ground rule is to
propose ideas without first mentally screening them. No criticism is allowed. “Wild”
ideas are encouraged. Ideas should build on previous ideas until a consensus is reached.
This is a good technique to use with operating managers who have more faith in “gut
feel” than in more quantitative number-crunching techniques
2. Quantitative methods: uses a formal mathematical method for forecasting. Quantitative
forecasts are most appropriate when historical data are available and when the relationships
among key variables are expected to remain the same in the future. We can classify as time
series analysis and causal forecasting methods.

Time series analysis: some of the examples are; Last Period Demand (LPD): Last Period
Demand method simply forecasts for the next period taking the actual demand that occurred in
the previous period. Arithmetic Mean (Average): Arithmetic mean method calculates the average
of all past actual demand of materials to arrive at a forecast. Moving Average: When demand for

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a product is neither growing nor declining rapidly, and if it does not have seasonal
characteristics, a moving average can be useful in removing the random fluctuations for
forecasting. Moving averages are more convenient to use past data to predict the future. These
methods calculate the next period's forecast by averaging the actual demand, depending on the
predetermined time period, the old states of demand become out of calculation. For example, if
we want to forecast June with a five month moving average, we can take the average of January,
February, March, April and May. When June passes, the forecast for July would be the average
of February, March, April, May and June.
Causal Forecasting Methods: Causal forecasting methods develop a cause and effect model
between demand and other variables. For example, the demand for Pepsi cola may be related to
population. Data can be collected on these variables and an analysis conducted to determine the
validity of the proposed model. Regression and correlation techniques are means of describing
association between two or more such variables. The regression method is a forecasting model
that establishes a relationship between a dependent variable and one or more independent
variables. Knowledge of this relationship helps to forecast the value of the dependent variable Y,
from the value of the independent variable X. The dependent variable is the variable to be
predicted while the independent variable is the one used for prediction. Simple regression uses
only one independent variable. If the data are a time series, the independent variable is the time
period, and the dependent variable is usually sales or demand for materials.

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 DEMAND

The starting point for the management of inventory is customer demand. Inventory
exists to meet customer demand. Customers can be inside the organization such as
a machine operator waiting for a part or partially completed product to work on.
Customers can also be outside the organization. In either case, an essential
determinant of effective inventory management is an accurate forecast of demand.
For this reason the topic of forecasting and inventory management are directly
interrelated. In general, the demand of items in inventory is either dependent or
independent.
Dependent demand: items are typically component parts or materials used in the
process of producing a final product. If an automobile company planes to produce
1000 new cars, then it will need 5000 wheels and tires (including spare parts). The
demand for wheel is dependant up on the production of cars-the demand of one
item depends up on the demand of another item.
Independent demand: independent demand items are final or finished products
that are not a function of or dependent up on internal production activity.
Independent demand is usually external and thus is beyond the direct control of the
organization.

DEMAND FORECASTING TECHNIQUES

1. Time series method –are statistical techniques that use historical demand data
to predict future demand. Time series method assumes that what has occurred in
the past will continue to occur in the future. As the name time series suggests,
these methods relate the forecast to only one factor –time. They include the
moving average, exponential smoothing, and linear trend line. These methods
assume that identifiable historical patterns or trends for demand over time will
repeat themselves.
A). Moving Average: the simple moving average method uses several demand
values during the recent past to develop forecast. This trends to dampen, or
smooth out, the random increase and decrease of a forecast that uses only one
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