THE EXTERNAL ENVIRONMENT

Two of the primary determinants of

organizational performance are the industry
environment in which a company competes
and the country (or countries) in which it is
located. Both of these factors are aspects of
the company’s external environment.
In order to succeed a company must either fit its
strategy to the industry environment in which
it operates, or be able to reshape the industry
environment to its advantage through its
chosen strategies.
THE FIVE FORCES MODEL
The task facing managers is to analyze
competitive forces in an industry environment
in order to identify the opportunities and
threats confronting a company. Michael E.
Porter of the Harvard School of Business
Administration has developed a framework
that helps managers in this analysis. Porter’s
frame- work, known as the five forces model
focuses on five forces that shape competition
within an industry:
  The risk of new entry by potential
competitors,
 The degree of rivalry among established com­
panies within an industry,
 The bargaining power of buyers,
 The bargaining power of suppliers, and
 The closeness of substitutes to an industry's
products. 
Within Porter's framework, a strong competitive
force can be regarded as a threat since it
depresses profits. A weak competitive force
can be viewed as an opportunity, for it allows
a company to earn greater profits.
Because of industry evolution, the strength of
the five forces may change through time.
In such circumstances, the task facing strategic
managers is to recognize opportunities and
threats as they arise and to formulate
appropriate strategic responses.
 The risk of new entry by potential competitors
Established companies try to discourage potential
competitors from entering, since the more
companies enter an industry, the more difficult it
becomes for established companies to hold their
share of the market and to generate profits.
Thus a high risk of entry by potential competitors
represents a threat to the profitability of
established companies. On the other hand, if the
risk of new entry is low, established companies
can take advantage of this opportunity to raise
prices and earn greater returns.
Barrier to Entry
The concept of barriers to entry implies that
there are significant costs to 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.
Following are the sources of barrier to entry:
Brand Loyalty: Brand loyalty is buyers' preference
for the products of established companies.
A company can create brand loyalty through
-continuous advertising of brand and company
names,
-patent protection of products,
-product innovation,
-an emphasis on high product quality, and good
after-sales service.
Significant brand loyalty makes it difficult for new
entrants to take market share away from
established companies.
Absolute Cost Advantages: Lower absolute costs
give established companies an advantage that
is difficult for potential competitors to match.
Absolute cost advantages can arise from
superior production techniques.
These techniques can be due to
-past experience, patents, or secret processes;
-control of particular inputs required for
production, such as labor, materials,
equipment, or management skills; or
-access to cheaper funds because existing
companies represent lower risks than
potential companies.
Economies of Scale: Economies of scale are the
cost advantages associated with large
company size. Sources of scale economies
include
-cost reductions gained through mass-producing
a standardized output,
-discounts on bulk purchases of raw-material
inputs and component parts,
-the spreading of fixed costs over a large
volume, and
-scale economies in advertising.
 Rivalry among established companies
The second of Porter's five competitive forces is
the extent of rivalry among established
companies within an industry.
If this competitive force is weak, companies
have an opportunity to raise prices and earn
greater profits. But if it is strong, significant
price competition, including price wars, may
result from the intense rivalry.
The extent of rivalry among established
companies within an industry is largely a
function of three factors:

(1)Industry competitive structure,

(2)Demand conditions, and
(3)The height of exit barriers in the industry.
1. Competitive Structure: Competitive structure
refers to the number and size distribution of
companies in an industry. Different
competitive structures have different
implications for rivalry.
Structures vary from fragmented to
consolidated.
A fragmented industry contains a large number
of small or medium-sized companies, none of
which is in a position to dominate the
industry.
A consolidated industry is dominated by a
small number of large companies or, in
extreme cases, by just one company (a
monopoly).
Fragmented industries range from agriculture,
video rental, and health clubs, to real estate
brokerage and suntanning parlors.
Consolidated industries include aerospace,
automobiles, and phar­maceuticals.
Many fragmented industries are characterized
by low entry barriers and commodity-type
products that are hard to differentiate. The
combination of these traits rends to result in
boom-and-bust cycles.
Low entry barriers imply that whenever demand
is strong and profits are high there will be a
flood of new entrants hoping to cash in on the
boom.
Often the flood of new entrants into a booming
fragmented industry creates excess capacity.
Once excess capacity develops, companies start
to cut prices in order to utilize their spare
capacity.
The result is a price war, which depresses
industry profits, forces some companies out of
business, and deters potential new entrants.
A fragmented industry structure constitutes a
threat rather than an opportunity. Most
booms will be relatively short-lived because of
the ease of new entry and will be followed by
price wars and bankruptcies.
The nature and intensity of competition for
consolidated industries are much more
difficult to predict.

The one certainty about consolidated industries

is that the companies are interdependent—
that is, the competitive actions of one
company directly affect the profitability of
others in the industry.
In a consolidated industry, the competitive
action of one company directly affects the
market share of its rivals, forcing a response
from them.

The consequence of such competitive

interdependence can be a dangerous
competitive spiral, with rival companies trying
to undercut each other's prices, pushing
industry profits down in the process.
The interdependence of companies in
consolidated industries and the possibility of a
price war constitute a major threat.

Companies often seek to reduce this threat by

following the price-lead set by a dominant
company in the industry.
2. Demand Conditions: Growing demand tends
to moderate competition by providing greater
room for expansion.
When demand is growing, companies can
increase revenues without taking market
share away from other companies. Thus
growing demand gives a company a major
opportunity to expand operations.
Conversely, declining demand results in more
competition as companies fight to maintain
revenues and market share.

When demand is declining, a company can

attain growth only by taking market share
away from other companies.

Thus declining demand constitutes a major

threat, for it increases the extent of rivalry
between established companies.
3. Exit Barriers: Exit barriers are a serious
competitive threat when industry demand is
declining.
Exit barriers are economic, strategic, and
emotional factors that keep companies
competing in an industry even when returns
are low.
If exit barriers are high, companies can become
locked into an unfavorable industry.
Common exit barriers include the following:
• Investments in plant and equipment that
have no alternative uses and cannot be sold
off. If the company wishes to leave the
industry, it has to write off the book value of
these assets.
• High fixed costs of exit, such as severance
pay to workers who are being made
redundant.
• Emotional attachments to an industry, as
when a company is unwilling to exit from its
original industry for sentimental reasons.
• Strategic relationships between business
units. For example, within a multi-industry
company, a low-return business unit may
provide vital inputs for a high-return
business unit based in another industry. Thus
the company may be unwilling to exit from
the low-return business.

• Economic dependence on the industry, as

when a company is not diversified and so
relies on the industry for its income.
 The Bargaining Power of Buyers
Buyers can be viewed as a competitive threat
when they force down prices or when they
demand higher quality and better service
(which increase operating costs).
Alternatively, weak buyers give a company the
opportunity to raise prices and earn greater
returns.
According to Porter, buyers are most powerful
in the following circumstances:
• When the supply industry is composed of
many small companies and the buyers are
few in number and large. These
circumstances allow the buyers to dominate
supply companies.
• When the buyers purchase in large
quantities. In such circumstances, buyers can
use their purchasing power as leverage to
bargain for price reductions.
• When the supply industry depends on the
buyers for a large percentage of its total
orders.
• When the buyers can switch orders between
supply companies at a low cost, thereby
playing off companies against each other to
force down prices.
• When it is economically feasible for the
buyers to purchase the input from several
companies at once.
• When the buyers can use the threat to
supply their own needs through vertical
integration as a device for forcing down
prices.
 The Bargaining Power of Suppliers
Suppliers can be viewed as a threat when they
are able to force up the price that a company
must pay for input or reduce the quality of
goods supplied, thereby depressing the
company's profitability. Alternatively, weak
suppliers give a company the opportunity to
force down prices and demand higher quality.

According to Porter, suppliers are most

powerful in the following circumstances:
• When the product that suppliers sell has few
substitutes and is important to the company.
• When the company's industry is not an
important customer to the suppliers. In such
instances, the suppliers' health does not depend
on the company's industry, and suppliers have
little incentive to reduce prices or improve
quality.
• When suppliers' respective products are
differentiated to such an extent that it is costly
for a company to switch from one supplier to
another. In such cases, the company depends on
its suppliers and cannot play them off against
each other.
• When, to raise prices, suppliers can use the
threat of vertically integrating forward into
the industry and competing directly with the
company.

• When buying companies cannot use the

threat of vertically integrating back­ward and
supplying their own needs as a means to
reduce input prices.
 The Threat of Substitute Products
The existence of close substitutes presents a
strong competitive threat, limiting the price a
company can charge and thus its profitability.
However, if a company's products have few
close substitutes (that is, if substitutes are a
weak competitive force), then, other things
being equal, the company has the opportunity
to raise prices and earn additional profits.