Analyzing the External Environment of the Firm

1. Why must managers be aware of a firm’s external environment? 2. What is gathering and analyzing competitive intelligence and why is it important for firms to engage in it? 3. Discuss and describe the six elements of the external environment. 4. Select one of these elements and describe some changes relating to it in an industry that interests you. 5. Describe how the five forces can be used to determine the average expected profitability in an industry. 6. What are some of the limitations (or caveats) in using five-forces analysis? 7. Explain how the general environment and industry environment are highly related. How can such interrelationships affect the profitability of a firm or industry? 8. Explain the concept of strategic groups. What are the performance implications?

Summary

Managers must analyze the external environment to minimize or eliminate threats and exploit opportunities. This involves a continuous process of environmental scanning and monitoring as well as obtaining competitive intelligence on present and potential rivals. These activities provide valuable inputs for developing forecasts. In addition, many firms use scenario planning to anticipate and respond to volatile and disruptive environmental changes. We identified two types of environment: the general environment and the competitive environment. The six segments of the general environment are demographic, sociocultural, political/legal, technological, economic, and global. Trends and events occurring in these segments, such as the aging of the population, higher percentages of women in the workplace, governmental legislation, and increasing (or decreasing) interest rates, can have a dramatic effect on your firm. A given trend or event may have a positive impact on some industries and a negative or neutral impact or none at all on others. The competitive environment consists of industry-related factors and has a more direct impact than the general environment. Porter’s five-forces model of industry analysis includes the threat of new entrants, buyer power, supplier power, threat of substitutes, and rivalry among competitors. The intensity of these factors determines, in large part, the average expected level of profitability in an industry. A sound awareness of such factors, both individually and in combination, is beneficial not only for deciding what industries to enter but also for assessing how a firm can improve its competitive position. The limitations of five-forces analysis include its static nature and its inability to acknowledge the role of complementors. Although we discussed the general environment and competitive environment in separate sections, they are quite interdependent. A given environmental trend or event, such as changes in the ethnic composition of a population or a technological innovation, typically has a much greater impact on some industries than on others. The concept of strategic groups is also important to the external environment of a firm. No two organizations are completely different nor are they exactly the same. The question is how to group firms in an industry on the basis of similarities in their resources and strategies. The strategic groups concept is valuable for determining mobility barriers across groups, identifying groups with marginal competitive positions, charting the future directions of firm strategies, and assessing the implications of industry trends for the strategic group as a whole. 1. SWOT analysis is a technique to analyze the internal and external environment of a firm. What are its advantages and disadvantages? 2. Briefly describe the primary and support activities in a firm’s value chain. 3. How can managers create value by establishing important relationships among the value-chain activities both within their firm and between the firm and its customers and suppliers? 4. Briefly explain the four criteria for sustainability of competitive advantages. 5. Under what conditions are employees able to appropriate some of the value that is created by their firm? 6. What are the advantages and disadvantages of conducting a financial ratio analysis of a firm? 7. Summarize the concept of the balanced scorecard. What are its main advantages?

Assessing the Internal Environment of the Firm

In the traditional approaches to assessing a firm’s internal environment, the primary goal of managers would be to determine their firm’s relative strengths and weaknesses. Such is the role of SWOT analysis, wherein managers analyze their firm’s strengths and weaknesses as well as the opportunities and threats in the external environment. In this chapter, we discussed why this may be a good starting point but hardly the best approach to take in performing a sound analysis. There are many limitations to SWOT analysis, including its static perspective, its potential to overemphasize a single dimension of a firm’s strategy, and the likelihood that a firm’s strengths do not necessarily help the firm create value or competitive advantages. We identified two frameworks that serve to complement SWOT analysis in assessing a firm’s internal environment: value-chain analysis and the resource-based view of the firm. In conducting a value-chain analysis, first divide the firm into a series of valuecreating activities. These include primary activities such as inbound logistics, operations, and service as well as support activities such as procurement and human resources management. Then analyze how each activity adds value as well as how interrelationships among value activities in the firm and among the firm and its customers and suppliers add value. Thus, instead of merely determining a firm’s strengths and weaknesses per se, you analyze them in the overall context of the firm and its relationships with customers and suppliers, the value system. The resource-based view of the firm considers the firm as a bundle of resources: tangible resources, intangible resources, and organizational capabilities. Competitive advantages that are sustainable over time generally arise from the creation of bundles of resources and capabilities. For advantages to be sustainable, four criteria must be satisfied: value, rarity, difficulty in imitation, and difficulty in substitution. Such an evaluation requires a sound knowledge of the competitive context in which the firm exists. The owners of a business may not capture all of the value created by the firm. The appropriation of value created by a firm between the owners and employees is determined by four factors: employee bargaining power, replacement cost, employee exit costs, and manager bargaining power. An internal analysis of the firm would not be complete unless you evaluate its performance and make the appropriate comparisons. Determining a firm’s performance requires an analysis of its financial situation as well as a review of how well it is satisfying a broad range of stakeholders, including customers, employees, and stockholders. We discussed the concept of the balanced scorecard, in which four perspectives must be addressed: customer, internal business, innovation and learning, and financial. Central to the balanced scorecard is the idea that the interests of various stakeholders can be interrelated. We provide examples of how indicators of employee satisfaction lead to higher levels of customer satisfaction, which in turn lead to higher levels of financial performance. Thus, improving a firm’s performance does not need to involve making trade-offs among different stakeholders. Assessing the firm’s performance is also more useful if it is evaluated in terms of how it changes over time, compares with industry norms, and compares with key competitors.

Business-Level Strategy

1. Explain why the concept of competitive advantage is central to the study of strategic management. 2. Briefly describe the three generic strategies: overall cost leadership, How and why firms outperform each other goes to the heart of strategic differentiation, and focus. management. In this chapter, we identified three generic strategies and discussed 3. Explain the relationship between the three generic strategies and the five how firms are that determine the average profitability within an industry. forces able not only to attain advantages over competitors, but also to sustain What advantages over ways in which some advantagesabecome long-lasting 4. such are some of the time. Why do a firm can attain successful turnaround while others are quickly imitated by competitors? strategy? 5. Describe some of the pitfalls associated with each of the three generic strategies. The three generic strategies—overall cost leadership, differentiation, and focus—form the 6. Can this chapter. We began by providing aof overall cost leadership and core of firms combine the generic strategies brief description of each generic differentiation? Why or why and strategy (or competitive advantage)not? furnished examples of firms that have successfully implemented these strategies. Successful generic strategies invariably enhance a firm’s position vis-à-vis the fiveconceptof thatimportant factor inthat we 7. Explain why the industry life cycle forces is an industry—a point stressed and illustrated with business-level strategy. we pointed out, there are pitfalls determining a firm’s examples. However, as to each of the generic strategies. Thus, the sustainability of a firm’s advantage is always challenged because of imitation or substitution by new or existing rivals. Such competitor moves erode a firm’s advantage over time. We also discussed the viability of combining (or integrating) overall cost leadership and differentiation generic strategies. If successful, such integration can enable a firm to enjoy superior performance and improve its competitive position. However, this is challenging, and managers must be aware of the potential downside risks associated with such an initiative. The concept of the industry life cycle is a critical contingency that managers must take into account in striving to create and sustain competitive advantages. We identified the four stages of the industry life cycle—introduction, growth, maturity, and decline—and suggested how these stages can play a role in decisions that managers must make at the business level. These include overall strategies as well as the relative emphasis on functional areas and value-creating activities. When a firm’s performance severely erodes, turnaround strategies are needed to reverse its situation and enhance its competitive position. We have discussed three approaches— asset cost surgery, selective product and market pruning, and piecemeal productivity improvements.

Summary

Corporate-Level Strategy Summary Review Questions

A key challengehow managers can create value for their firm through diversification 1. Discuss of today’s managers is to create "synergy" when engaging in diversification activities. As we discussed in this chapter, corporate managers do not, efforts. in general, have a very of the track record in creating value in such endeavorsachieve 2. What are some good reasons that many diversification efforts fail to when it comes to mergers and acquisitions. Among the factors that serve to erode desired outcomes? shareholder values are paying an excessive premium for the target firm, failing to 3. How can companies benefit from related diversification? Unrelated integrate the activities What are some of the businesses into the corporate family, diversification? of the newly acquired key concepts that can explain such and undertaking diversification initiatives that are too easily imitated by the success? competition. are some of the important ways in which a firm can restructure a 4. What business? 5. Discusstwo major types of corporate-level strategy: related and unrelated We addressed some of the various means that firms can use to diversify. What are the pros and cons associated with the of these? diversification. With related diversification eachcorporation strives to enter into areas in which key resources and capabilities of the corporation can be shared or leveraged. Synergies come from horizontal relationshipsengage in business units. 6. Discuss some of the actions that managers may between to erode Cost savings and enhanced revenues can be derived from two major sources. First, shareholder value. economies of scope can be achieved from the leveraging of core competencies and the sharing of activities. Second, market power can be attained from greater, or pooled, negotiating power and from vertical integration. When firms undergo unrelated diversification they enter product markets that are dissimilar to their present businesses. Thus, there is generally little opportunity to either leverage core competencies or share activities across business units. Here, synergies are created from vertical relationships between the corporate office and the individual business units. With unrelated diversification, the primary ways to create value are corporate restructuring and parenting, as well as the use of portfolio analysis techniques. Corporations have three primary means of diversifying their product markets. These are mergers and acquisitions, joint ventures/strategic alliances, and internal development. There are key trade-offs associated with each of these. For example, mergers and acquisitions are typically the quickest means to enter new markets and provide the corporation with a high level of control over the acquired business. However, with the expensive premiums that often need to be paid to the shareholders of the target firm and the challenges associated with integrating acquisitions, they can also be quite expensive. Strategic alliances between two or more firms, on the other hand, may be a means of reducing risk since they involve the sharing and combining of resources. But such joint initiatives also provide a firm with less control (than it would have with an acquisition) since governance is shared between two independent entities. Also, there is a limit to the potential "upside" for each partner because returns must be shared as well. Finally, with internal development, a firm is able to capture all of the value from its initiatives (as opposed to sharing it with a merger or alliance partner). However, diversification by means of internal development can be very time-consuming—a disadvantage that becomes even more important in fast-paced competitive environments. Traditional tools such as net present value (NPV) analysis are not always very helpful in making resource allocation decisions under uncertainty. Real options analysis (ROA) is increasingly used to make better quality decisions in such situations. Finally, some managerial behaviors may serve to erode shareholder returns. Among these are "growth for growth’s sake," egotism, and antitakeover tactics. As we discussed, some of these issues—particularly antitakeover tactics—raise ethical considerations because the managers of the firm are not acting in the best interests of the shareholders.

Summary

Summary Review Questions

1. What are some of the advantages and disadvantages associated with a firm’s expansion into international markets? 2. What are the four factors described in Porter’s diamond of national advantage? How do the four factors explain why some industries in a given country are more successful than others? 3. Explain the two opposing forces—cost reduction and adaptation to local markets—that firms must deal with when they go global. 4. There are four basic strategies—international, global, multidomestic, and transitional. What are the advantages and disadvantages associated with each? 5. Describe the basic entry strategies that firms have available when they enter international markets. What are the relative advantages and disadvantages of each?

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