Chapter Two

Internal & External

Environment Analysis

1
 2.1: The External
Environment Analysis

2
 The Nature of an External Audit
 The purpose of an external audit is to
develop a finite list of opportunities that could
benefit a firm & threats that should be
avoided.

Firms should be able to respond either

offensively or defensively to the factors by
formulating strategies that take advantage of 3
 Key External Forces

External forces can be divided into five broad

categories:

PESTEC:

P= Political, Governmental & Legal forces;

EC= Economic forces;

S= Social, Cultural & Demographic

EN= Natural Environment forces;

T= Technological forces; and

C= Competitive forces. 4
Relationships Between Key External
Forces and an Organization
SUPLIERS
CUSTOMERS
DISTRIBUTORS
CREDITORS
EMPLOYEES AN
COMMUNITIES ORGANISATI
MANAGERS ON’S
STACK HOLDERS OPPORTUNIT
PESTEC LABOUR UNIONS
IES AND
GOVERNMENTS
COMPETITORS THREATS
PRODUCTS
SERVICES
MARKETS
 External forces affect the types of products to
be developed, the nature of positioning and
market segmentation strategies, the type of
services to be offered, and the choice of
businesses to acquire or sell. External forces
directly affect suppliers, buyers, distributors,
and consumers.
 Identifying and evaluating external
opportunities and threats enables
6
 The Process of Performing an
External Audit
 The process of performing an external audit must
involve as many managers and employees as possible.
 To perform an external audit, a company first must

gather competitive intelligence and information about

PESTE trends.
 Individuals can be asked to monitor various sources of

information, such as key magazines, trade journals, and

newspapers. These individuals can submit periodic
scanning reports to a committee of managers charged
with performing the external audit. 7
 Cont.
…...
 The Internet provides another source for gathering
strategic information, as do corporate, university,
and public libraries.
 Suppliers, distributors, salespersons, customers, and
competitors represent the other sources of vital
information. 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.
8
 Economic Forces
Key Economic Variables to Be
Monitored
 Availability of credit
 Level of disposable income
 Propensity of people to spend
 Interest rates
 Inflation rates
 GDP trend
 Consumption patterns
 Unemployment trends
 Workers’ productivity levels and other 9
 Social, Cultural, Demographic, and
Natural
Environment (SCDEN) Forces
 SCDEN changes have a major impact

virtually on all products, services,

markets, and customers.
 Small, large, for-profit, and non-profit
organizations in all industries are being
staggered and challenged by the
opportunities and threats arising from
changes in SCDEN variables. 10
 Key SCDEN Variables

 Number of marriages, number of

divorces
 Number of births, number of deaths

 Attitudes toward business

 Lifestyles, life expectancy rates

 Per-capita income
 Attitudes toward work 11
 Political, Governmental, and Legal (PGL)
Forces

 Federal, state, local, and foreign governments are

major regulators, deregulators, subsidizers, employers,
and customers of organizations.
 PGL factors, therefore, can represent the key
opportunities or threats for both small and large
organizations.
 For industries and firms that depend heavily on
government contracts or subsidies, political forecasts
can be the most important part of an external audit.
 Changes in patent laws, antitrust legislation, tax rates,
12
 …Some PGL Variables
 Government regulations or deregulations

 Changes in tax laws, special tariffs

 Political action committees

 Number, severity, and location of

government protests
 Changes in patent laws, environmental

protection laws
 Legislation on equal employment 13
 Technological Forces
 Technological changes and discoveries are having a
dramatic impact on organizations.
 The Internet has changed the very nature of
opportunities and threats by altering the life cycles of
products, increasing the speed of distribution, creating
new products and services, removing limitations of
traditional geographic markets. This trend reflects the
growing importance of information technology (IT) in
strategic management.
 Technological forces represent major opportunities and
threats that must be considered in formulating strategies.
14
 ….Cont.

 Technological advancements can dramatically affect organizations’

products, services, markets, suppliers, distributors, competitors,

customers, manufacturing processes, marketing practices, and
competitive position.
 Technological advancements can create new markets, result in a
proliferation of new and improved products, change the relative
competitive cost positions in an industry, and render existing
products and services obsolete.
 Not all sectors of the economy are affected equally by
technological developments.
 The communications, electronics, aeronautics, and pharmaceutical
industries are much more volatile than the textile, forestry, and
15
metals industries.
 Competitive Forces
 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. 16
 Competitive Intelligence Programs

 is a systematic and ethical process for

gathering and analyzing information about the
competitor’s activities and general business
trends to further a business’s own goals.
 Major competitors’ weaknesses can represent
external opportunities; major competitors’
strengths may represent the key threats.

17
 Key Questions About Competitors

 What are the major competitors’ strengths?

 What are the major competitors’ weaknesses?

 What are the major competitors’ objectives and

strategies?
 How will the major competitors most likely
respond to current PESTEC trends affecting our
industry?
 How vulnerable are the major competitors to
our alternative company’s strategies? 18
 Cont.…...

 How vulnerable are our alternative

strategies to successful counterattack by
our major competitors?
 How are our products or services positioned

relative to major competitors?

 To what extent are new firms entering and

old firms leaving this industry?

 To what extent could substitute products or
19
 Competitive Analysis:
Porter’s Five-Forces Model

 Porter’s Five-Forces Model of competitive

analysis is a widely used approach for
developing strategies in many industries.
 The intensity of competition among firms varies
widely across industries.
 According to Porter, the nature of
competitiveness in a given industry can be
viewed as a composite of five forces: 20
 The Five-Forces Model of Competition

Potential development of
.

substitute products

Rivalry among
Bargaining power of competing Bargaining power
suppliers firms of consumers

Potential entry of new

competitors

21
 Rivalry Among Competing Firms
 Rivalry among competing firms is usually the
most powerful of the five competitive forces.
 The strategies pursued by one firm can be
successful only to the extent that they
provide competitive advantage over the
strategies pursued by rival firms.
 Changes in strategy by one firm may be met
with retaliatory countermoves, such as
lowering prices, enhancing quality, adding 22
 Conditions That Cause High
Rivalry Among Competing Firms
 High number of competing firms

 Similar size of firms competing

 When consumers can easily switch among brands

 When barriers to leave the market are high

 When barriers to enter the market are low

 When the product is perishable

 When rivals have excess inventory

 When rivals sell similar products/services 23

 Potential Entry of New Competitors

 Whenever new firms can easily enter a

particular industry, the intensity of

competitiveness among firms

increases.

 Barriers to entry include:

the need to gain economies of scale

quickly, 24
 Cont.…...
 strong brand preferences,

 large capital requirements,

 lack of adequate distribution channels,

 government regulatory policies, tariffs,

 lack of access to raw materials,

 possession of patents, undesirable

locations,

 counterattack by entrenched firms, and 25

 Cont.…...

 Despite numerous barriers to entry, new firms

sometimes enter industries with higher-quality
products, lower prices, and substantial
marketing resources.
 The strategist’s job, therefore, is to identify
potential new firms entering the market, to
monitor the new rival firms’ strategies, to
counterattack as needed, and to capitalize on
existing strengths and opportunities.
26
 Potential Development of
Substitute Products

 In many industries, firms are in close competition

with producers of substitute products in other
industries.
 Competitive pressures arising from substitute
products increase as the relative price of
substitute products declines and as consumers’
switching costs decrease.
27
 Bargaining Power of Suppliers

 The bargaining power of suppliers affects the

intensity of competition in an industry,
especially; when there are only a few good
substitute raw materials ; when the cost of
switching to raw materials is costly.
 Firms may pursue a backward integration
strategy to gain control or ownership of
suppliers. This strategy is especially effective
28
when suppliers are unreliable, too costly, or
 Bargaining Power of Consumers

 When customers are concentrated or large or buy in

volume, their bargaining power represents a major

force affecting the intensity of competition in an

industry.

 Rivalry firms may offer extended warranties or special

services to gain customer loyalty whenever the

bargaining power of consumers is substantial. The

bargaining power of consumers can be the most

important force affecting competitive advantage. 29

 Cont.
…...
 Consumers gain increasing bargaining power

under the following circumstances:

1. If they can inexpensively switch to

competing brands or substitutes

2. If they are particularly important to the

seller.

3. If sellers are struggling in the face of

falling consumer demand

30
 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

31
 Cont.…...

 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.
32
 2.2: The Internal
Environment Analysis

33
 The Nature of an 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.
34
 Key Internal Forces

 It is not possible in a strategic-management

text to review in depth all the material
presented in courses such as marketing,
finance, accounting, management,
management information systems, and
production;
 There are many sub areas within these
functions, for example; customer service,
warranties, advertising, packaging, and
35
 Cont.
…...
 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.
36
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
functional areas:
 Management, Marketing,
37
 Management Functins
 The functions of management consist
of five basic activities.
planning,
organizing,
Staffing
motivating, and
controlling.
38
 Management Audit Checklist of
Questions
 The following checklist of questions can help determine

specific strengths and weaknesses in the functional area

of business.

 A negative or no answers to any question could

indicate a potential weaknesses, although the

strategic significance & implications of negative

answers, of course, will vary by organization, industry,

and severity of the weakness.

 Positive or yes answers to the checklist questions

39
suggest potential areas of strength.
 Cont.
1. Does the firm use strategic-management
…...
concepts?
2. Are company objectives & goals measurable
& 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? 40
 Marketing Functions
 There are seven basic functions of
marketing:
1. customer analysis,
2. selling products/services,
3. product and service planning,
4. pricing,
5. distribution,
6. marketing research, and 41
 Marketing Audit Checklist of Questions

 The following questions about marketing must

be examined in strategic planning:

1. Are markets segmented effectively?

2. Is the organization well positioned among
competitors?
3. Has the firm’s market share been
increasing?
4. Are present channels of distribution 42
 Cont.…...
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

43
 Finance/Accounting Functions
 Financial condition is often considered as
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,
44
 Finance/Accounting Audit
Checklist
 The finance/accounting questions that
should be examined are:
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 45
 Cont.…...

5. Are capital budgeting procedures

effective?
6. Are dividend payout policies reasonable?
7. Does the firm have good relations with
its investors & stockholders?
8. Are the firm’s financial managers
experienced and well trained?
9. Is the firm’s debt situation excellent?
46
 Production/Operations Functions

 The production/operations function of a business

consists of all those activities that transform

inputs into outputs (goods and services).
 A manufacturing operation transforms or converts

inputs such as raw materials, labor, capital,

machines, and facilities into finished goods and
services.
47
 Production/Operations Audit
Checklist of Questions
 The questions that should be examined
include :
1. Are supplies of raw materials, parts, &
subassemblies reliable & reasonable?
2. Are facilities, equipment, machinery, and
offices in good condition?
3. Are inventory-control policies and
procedures effective? 48
 Research and Development Functions

 The fifth major area of internal

operations that should be examined for
specific strengths and weaknesses is
research and development (R&D).
 Firms pursuing a product development
strategy especially need to have a
strong R&D orientation. 49
 Research and Development Audit
Checklist of Questions
 Questions such as the following should be asked
with regard to 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?
50
4. Are R&D resources allocated effectively?
 Management Information Systems
Functions
 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. 51
 MIS Audit Checklist of Questions
 Questions to be asked when conducting
the MIS audit:
1. Do all managers in the firm use the
information system to make decisions?
2. Is there a Chief Information Officer (CIO)
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? 52
 Cont.
…...

6. Are strategists of the firm familiar with the

information systems (IS) of rival firms?
7. Is the IS user-friendly?
8. Do all users of the IS 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 IS continually being improved
in content and user-friendliness?
Compiled by: Lemma N. 53
St