STRATEGIC MANAGEMENT

Understanding the External Environment for Businesses

What is a Business’ External Environment?

The External Environment in business encompasses external factors and influences that impact business
operations. It includes elements beyond a company’s control, requiring effective responses to ensure business
continuity. Some examples of external factors include competitive structure, competitive position, dynamics.
These external forces can influence internal processes, objectives, and strategies.

Factors of External Environment & their relevance

1. Market Size & Growth: Accurately evaluating market size is essential for businesses as it determines
investor interest, strategic planning, and long-term profitability. When businesses have a clear idea of
the potential of their market, investors are more willing to support them. Additionally, a clear
understanding of market sizes & growth helps develop well-informed plans that are in-line with market
dynamics.

2. Competition Landscape: The main purpose of competitor analysis is to identify the strengths &
weaknesses of competitors, as well as the opportunities and threats they represent for the company. It
also benchmarks operational & financial performance against the competition to determine best
practices.

3. Technological Advancements: Technological innovations have the potential to disrupt an industry.

Introduction of newer products often renders a business’ offering obsolete, or failure to adapt to
upcoming technologies can inevitably lead to a business losing its competitive edge.

4. Regulatory Environment: Staying informed about regulatory changes enables businesses to adapt
strategically, innovate, and capitalize on new market opportunities, all of which contribute to long-term
success and sustainability. Regulations around sourcing, entry of foreign players, distribution models,
etc can often cause a business to alter their strategies.

5. Economic & Political Factors: Economic and political factors critically impact business operations.
Economic shifts like inflation and interest rates affect demand and costs, while political changes can
alter regulations and market dynamics. Businesses must stay alert to these factors to adapt quickly,
ensuring stability and capitalizing on emerging opportunities for growth.

Market Sizing & Growth

o Market Size: The market size of an industry refers to the total demand generated within the particular
industry all over a specific period, measured annually.

- It is an indicator of the industry's overall economic impact and can also be calculated by
summing up the sales or revenue figures of all the businesses operating within that market.
 - Market size helps businesses and analysts understand the industry's scope, evaluate potential
for growth, and make strategic decisions such as market entry or investment.

- Understanding the demand build-up of an industry is critical for a business when deciding new
strategic product offerings, or introduction of new SBUs. It helps by outlining the opportunity in
specific segments, geographies, channels, etc that a business can play in.

- It is also used to gauge market share, which is the percentage of the total market size that a
particular company or product holds.

Market Share % = (Total Revenue of a company / Total value of demand generated in an industry)
x 100

o Growth: The growth of an industry refers to the increase in its market size or value over time, typically
measured by the rise in sales, revenue, or output. It can be expressed as a percentage rate and is often
assessed annually.

- Industry growth is influenced by various factors, including technological advancements,

consumer demand, regulatory changes, and macroeconomic conditions. Understanding the
underlying factors of growth / degrowth of an industry is crucial when it comes to framing
business strategies.

- Positive growth indicates a thriving industry with expanding business opportunities, while
negative growth may signal a contraction or challenges within the industry.

- Understanding industry growth helps businesses, investors, and policymakers make informed
decisions regarding investments, resource allocation, and strategic planning.

- Growth is typically measured through a metric called CAGR (Compounded Annual Growth Rate).
It is a measure used to calculate the mean annual growth rate of an industry over a specified time
period longer than one year. CAGR is used over YoY (year-on-year) growth rates because it
smooths out the rate of growth over time, providing a clearer picture of the long-term trend by
assuming the value grows at a steady rate compounded annually.

CAGR % (Compounded Annual Growth Rate) = (Terminal Value / Starting Value) ^ (1/n) – 1

For example, the chart shows market sizes & growth

rates of the smart phone industry in India. It was valued
at 28 USD Bn in FY18, reached 45 USD Bn in FY24 & is
projected to grow at a rate of 7.8% till FY19, forming a 63
USD Bn market.

Competitive Landscape
The purpose of a competitor analysis is to understand your competitors’ strengths and weaknesses in
comparison to your own and to find a gap in the market.
A competitor analysis is important because:

o It will help a business recognise how to enhance a business strategy to be in-line with the industry.

o It will outline how a business can out-do its competitors in the identified areas to keep customer
attention.

o Resulting in a competitive edge over others in the particular industry.

An analysis of the competitive landscape is often carried out by peer benchmarking. Although there can be
various types of benchmarking that proves insightful for a business, the two most important buckets for
benchmarking include:

o Financial Benchmarking: Refers to an in-depth evaluation of key financial metrics like revenue, revenue
CAGR, gross margin, EBITDA margins, RoCE%, etc. Specific financials at times indicate the strengths &
weaknesses of a business. For example, while comparing common sizes of key cost line items, a
competitor reflects a lower-than-average COGS. This would indicate an efficient sourcing &
procurement strategy.

- RoCE (Return on Capital Employed) is often used ratios like PAT (Profit After Tax) or PBT (Profit
Before Tax) because RoCE provides a more comprehensive measure of a company's profitability
and efficiency in using its capital. RoCE is calculated before tax, which makes it a tax-neutral
metric, allowing for better operational comparisons across different tax jurisdictions. It takes into
account both equity and debt, offering a clearer picture of how effectively a firm is generating
returns on all of its invested capital. This makes ROCE a valuable tool for both management
decision-making and for investors assessing long-term investment potential, as it focuses on
sustainable earnings rather than short-term profitability that can be influenced by tax rates and
policies.

RoCE % = EBIT / Capital Employed

EBIT (Earnings Before Interest & Tax) = Revenue – Operating Expenses

Capital Employed = Total Assets – Current Liabilities

o Operational Benchmarking: Operational benchmarking of competitors is crucial for strategy because

it provides insights into industry standards and reveals performance gaps, enabling a company to
identify areas for improvement. By understanding how competitors operate and excel, a company can
adopt best practices, innovate, and allocate resources effectively to enhance its competitive advantage.
This benchmarking informs strategic planning, aids in risk management, and ultimately contributes to
better customer satisfaction and market positioning. It's a tool that drives continuous improvement and
helps companies adapt to the dynamic business environment.

- Operational benchmarking includes comparing manufacturing capabilities (number of plants,

locations of the plants, capacities, etc), channel strength (number of distributors, retailers, B2B
clients, etc), pricing comparison, focus on R&D, customer engagement programs, etc. These are
specific to an industry & can be tailored to reflect key insights.

Technological Advancements
Keeping up with technological advancements in product offerings is vital for businesses to remain competitive
and meet evolving customer expectations. As technology progresses, it creates opportunities for innovation,
efficiency, and new market development.
For example, the automotive industry has seen a significant shift with the introduction of electric vehicles (EVs).
Traditional automakers who have embraced this technology, such as General Motors with their commitment to
an all-electric future, are positioning themselves as leaders in sustainability and innovation. By integrating
cutting-edge technology into their products, companies can offer enhanced features, improved performance,
and better user experiences, which can lead to increased market share and customer loyalty. Those who fail to
adapt risk becoming obsolete as consumer preferences shift towards more technologically advanced options
that offer greater convenience, connectivity, and environmental benefits.

Failure to adapt to emerging technologies can have detrimental effects on a business, leading to a loss of
competitive edge and market relevance. Companies that ignore technological trends may find their products
and services becoming outdated, resulting in decreased demand and customer attrition.

For instance, Kodak's reluctance to pivot towards digital photography, despite having developed the first digital
camera, led to a significant decline in its market position as competitors embraced the new technology. This
resistance to change can also stifle innovation, hinder operational efficiency, and increase costs, making it
difficult to compete with more agile and technologically adept firms. Ultimately, neglecting technological
advancements can lead to a company's diminished brand perception, reduced profitability, and in some cases,
complete obsolescence.

Regulatory Environment
Understanding the regulatory environment is crucial for business strategies, especially concerning product
offerings and foreign entry and exit barriers.

For instance, the Reserve Bank of India (RBI) and the Securities and Exchange Board of India (SEBI) impose strict
regulations on financial products and services, influencing how banks and fintech companies operate. The
recent Personal Data Protection Bill, inspired by the GDPR, is set to impact how companies collect, process,
and store consumer data, affecting product development and marketing strategies.

Foreign companies looking to enter the Indian market face regulations such as the Foreign Direct Investment
(FDI) policy, which outlines sector-specific caps and conditions. For example, in the retail sector, there are
restrictions on FDI in multi-brand retail, which have implications for foreign retail giants seeking to establish a
presence in India. Additionally, the Make in India initiative encourages foreign companies to manufacture locally
by offering incentives, but also imposes certain requirements and standards that must be met.

Exit barriers are also present, such as those seen in the Vodafone tax case, where retrospective taxation laws
led to a prolonged legal battle over the company's tax liabilities in India. Such regulatory challenges can deter
foreign investment and influence the decision-making process for companies considering entering or exiting the
Indian market.

Overall, a deep understanding of India's regulatory landscape is essential for businesses to navigate the
complexities of compliance, market entry, and product offerings, ensuring sustainable operations and growth
within the country.

Economic & Political Factors

Navigating economic and political factors is critical for businesses, as these can significantly influence market
dynamics and strategic decision-making. Economically, factors like inflation rates, interest rates set by the
Reserve Bank of India, and the GDP growth rate can affect consumer purchasing power and business
investment. For example, during periods of high inflation, consumers may reduce spending on non-essential
goods, impacting companies in sectors like luxury goods or discretionary services.

Politically, stability and policy direction play a vital role in shaping the business environment. A stable
government can lead to consistent economic policies, fostering a favourable climate for investment and growth.
However, political uncertainty or changes in government can result in policy shifts that may affect business
operations. For instance, the introduction of the Goods and Services Tax (GST) represented a significant
overhaul of the tax system, affecting pricing, supply chain logistics, and compliance requirements for
businesses.

Moreover, political relations between India and other countries can affect international trade policies, impacting
import-export businesses and those reliant on global supply chains. The recent border tensions between India
and China led to increased scrutiny and restrictions on Chinese investments and apps, affecting companies in
the technology and telecommunications sectors.

In summary, economic and political factors in India can have profound implications for business strategies,
operational costs, and market opportunities. Companies that stay informed and agile in the face of such
changes are better positioned to mitigate risks and capitalize on the opportunities that arise from India's
dynamic economic and political landscape.

Porter’s 5 Forces
Michael Porter’s insights started a revolution in the strategy field and continue to shape business practice and
academic thinking today. A Five Forces analysis can help companies assess industry attractiveness, how trends
will affect industry competition, which industries a company should compete in—and how companies can
position themselves for success.

Why use Porter’s Five Forces model at all? The answer lies in the unique insights it provides. By examining each
force, you gain a holistic understanding of your business environment. This understanding empowers you to:

- Identify opportunities: Discover untapped market niches and customer segments.

- Mitigate risks: Anticipate and proactively address potential threats to a business.

- Craft tailored strategies: Develop strategies that are not only effective but also finely tuned to the
nuances of the market.

In essence, the job of the strategist is to understand and cope with competition. Often, however, managers
define competition too narrowly, as if it occurred only among today’s direct competitors. Yet competition for
profits goes beyond established industry rivals to include four other competitive forces as well: customers,
suppliers, potential entrants, and substitute products. The extended rivalry that results from all five forces
defines an industry’s structure and shapes the nature of competitive interaction within an industry. As different
from one another as industries might appear on the surface, the underlying drivers of profitability are the same.
The global auto industry, for instance, appears to have nothing in common with the worldwide market for art
masterpieces or the heavily regulated health-care delivery industry in Europe. But to understand industry
competition and profitability in each of those three cases, one must analyze the industry’s underlying structure
in terms of the five forces.

If the forces are intense, as they are in such industries as airlines, textiles, and hotels, almost no company earns
attractive returns on investment. If the forces are benign, as they are in industries such as software, soft drinks,
and toiletries, many companies are profitable. Industry structure drives competition and profitability, not
whether an industry produces a product or service, is emerging or mature, high tech or low tech, regulated or
unregulated. While a myriad of factors can affect industry profitability in the short run—including the weather
and the business cycle—industry structure, manifested in the competitive forces, sets industry profitability in
the medium and long run. The point of industry analysis is not to declare the industry attractive or unattractive
but to understand the underpinnings of competition and the root causes of profitability

An analysis of all five competitive forces gives a comprehensive view of the factors affecting industry profitability.
On understanding each force, one can formulate a strategy that will allow a company to better cope with
competitive forces and increase profit potential.

1. Threat of New Entrants

When an industry starts becoming profitable, it will attract new entrants. If the barriers to entry are low, new
entrants can easily capture market share and threaten profitability.

New entrants undercut prices and offer valuable alternatives to what an industry currently provides.

A practical example of a new entry and high threat to existing players is Apple’s entrance into the music
distribution industry with the iPod. Apple entered into a new market, stole market share from existing players,
and completely changed the way we consume music and audio content today.

On the other hand, if barriers to entry are high, it’s much harder for new entrants to threaten an industry’s
profitability.

According to Porter, there are 7 main sources influencing the height of entry barriers:

- Supply-side economies of scale: High production volumes and low costs per unit force new entrants
to start large or face cost disadvantages.

- Network effect: Buyers are willing to pay more as the number of users grows. Customer brand loyalty
and preference for a larger network limit new entrants. Having a strong brand identity can be a big
advantage.

- Switching costs: Higher costs for customers to switch suppliers raise the entry barrier.

- Capital requirement: High starting capital costs are needed for new entrants. However, if industry
returns are high, investors might provide the needed capital.

- Unfair advantage: Industry leaders have advantages from hard-to-copy resources like patents,
exclusive raw materials, strong brands, or favorable locations.

- Unequal access to distribution channels: New competitors might struggle to enter existing channels.
Alternatives include bypassing traditional channels or creating new ones, like low-cost airlines selling
tickets on their own websites.

- Government policies: Policies can influence entry barriers by either raising them through licensing
requirements or lowering them through subsidies.

Questions that are usually used during analysis:

- How expensive and time-consuming would it be for a new competitor or startup to enter your market?
 - Is there strong customer loyalty in the industry? Would it be hard for a new competitor to attract
customers?

- Are there additional barriers to entry (e.g. regulation, intellectual property, access to distribution
channels)?

- What’s the industry structure? How strictly is it regulated?

- Is the key technology protected?

2. Bargaining Power of Suppliers

Suppliers offer an industry the needed inputs to operate (e.g. components, materials, and services). When the
bargaining power of suppliers is high, there’s a strong chance suppliers could set higher prices for those inputs
or reduce quality without retaliation.

If there are a number of suppliers to choose from, their bargaining power is likely low, so there likely isn’t a
problem in switching suppliers if needed.

For example, let's take a look at the automotive industry.

Volkswagen Group's suppliers have limited bargaining power due to VW's global presence with suppliers
scattered around the globe. Volkswagen also has at least 1 or 2 backup suppliers for each part and can shift
demand between them.

On the contrary, many automotive suppliers manufacture only a specific part and are heavily dependent on the
industry. These automotive industry dynamics put Volkswagen in a superior position while its suppliers have
relatively low bargaining power.

If multiple supplier options aren’t opted for, there are no substitutes, or switching costs are high, the supplier
bargaining power increases, and the business strategy will have to be reworked. Companies facing fewer
suppliers or relying solely on one supplier often find themselves at a disadvantage in negotiations.

Questions you can use during analysis:

- Who are your key suppliers?

- How many competent suppliers can your company choose from?

- How many alternative suppliers are available?

- How difficult or costly would it be to switch suppliers?

3. Bargaining Power of Buyers

In Porter's Five Forces model, buyers are the customers. At the expense of industry profitability, strong buyer
power can lower prices, pit rivals against each other, and demand higher quality or service.

The power of customers is higher when they are few in number and have many sellers to choose from. Beyond
this, if a large portion of a seller’s revenue is determined by a handful of buyers, those buyers will have more
power.

Buyer switching costs should also be considered when determining their bargaining power.

In the fashion world, brands like Zara or H&M deal with a lot of bargaining power from shoppers who have tons
of choices, from fast-fashion giants to boutique stores. With so many options, consumers can push for better
prices, higher quality, and even more sustainable practices. This puts a lot of pressure on brands to keep up and
constantly improve their products.
Questions you can use during analysis:

- How many buyers are in your industry compared to sellers?

- Do a few buyers make up most of your revenue?

- What size are your orders?

- How easy is it for buyers to switch sellers?

4. Threat of Substitute Products or Services

All firms within an industry face competition from other industries offering substitute products or services. For
instance, a messaging app can replace email, just as an airline's website can supplant travel agents by providing
its own ticket booking system.

When buyers can meet their needs with an alternative product or service from a different industry, it limits how
high an industry can set its prices. The more appealing the substitute, the stricter the cap industry's profits. The
threat of substitution is high if numerous substitutes can serve a similar function as the offered product or
service product or service. Conversely, if only a few substitutes exist, the threat is low.

Take the beverage industry, for example. The rise of health drinks is a big threat to traditional sodas. More and
more consumers are looking for healthier options, which is creating a growing market for drinks with nutritional
benefits, less sugar, and natural ingredients. This change in consumer preferences is shaking up the dominance
of traditional sodas and pushing companies to innovate and adapt.

Questions you can use during analysis:

- How many substitute products/services exist in your industry?

- How functionally similar are they to yours?

- What sets your products/services apart from these substitutes?

- Are these substitutes affordable?

- What is the cost for buyers to switch to a substitute? Is it low or high?

- Can you introduce a new product/service to compete with a market leader? If so, what is it?

5. Competitive Rivalry

Although rivals face the same industry forces as you, competitive rivalry is often the largest determinant of an
attractive industry because it is influenced by the four previous forces. To capture market share, rivals will
compete on price, quality, service, marketing spend, and more.

An industry can usually be categorised based on the basis its competitive rivalry as two:

- Fragmented: A fragmented industry is one where numerous small or medium-sized companies operate
and no single entity has a significant market share or dominance. This leads to high competition, with
firms often competing on price, quality, service, and innovation. Barriers to entry are typically low,
allowing for new participants to enter the market easily. The lack of dominant players means that control
over pricing and industry standards is dispersed, often resulting in a wide variety of products and services
being available to consumers.

- Concentrated: A concentrated industry is one where a small number of companies hold a large market
share, resulting in limited competition. This concentration often leads to a few dominant players exerting
significant control over pricing, product offerings, and market strategy. High barriers to entry, such as
 substantial capital requirements or stringent regulations, typically characterize such industries, making
it difficult for new competitors to enter the market. This concentration can lead to monopolistic or
oligopolistic market structures, where the leading firms can influence the industry's direction and
dynamics to a considerable extent.

Intense competition arises when buyers have numerous alternatives, there is little product or service
differentiation, and industry growth is slowing. In such a competitive environment, buyers can initiate bidding
wars, reducing profits.

When differentiation between rivals is minimal, product or service may be seen as a commodity, and buyers will
make decisions based solely on price. If industry growth is decelerating, existing firms will fiercely compete to
maintain their market share.

For example, McDonald's and Burger King are in constant competition to outdo each other. They invest heavily
in marketing campaigns, innovative product development, and customer engagement strategies. Whether it’s
launching new menu items, offering limited-time deals, or using tech to improve customer service, these giants
are always on the hunt to keep their competitive edge.

Questions you can use during analysis:

- What is the number of existing competitors in your industry?

- Who is your biggest competitor?

- What makes your product/service different from others?

- Are there any barriers preventing customers from switching providers? If so, what are they?

- Is your industry shrinking or growing?

PESTLE Analysis
A PESTLE analysis is a management framework and diagnostic tool. The outcome of the analysis will help you
to understand factors external to your organisation which can impact upon strategy and influence business
decisions.

PESTLE is an acronym for:

P= Political
E = Economic
S = Social
T = Technology
L = Legal
E = Environmental

o Political: When looking at Political factors one will need to take into account the respective countries’
government policies and political stability. Other factors will include tax implications, industry
regulations and global trade agreements and restrictions.
o Economic: Economic factors will include exchange rates, economic growth or decline, globalisation,
inflation, interest rates and the cost of living, labour costs and consumer spending.
o Social: Social factors look at trends such as lifestyle factors, cultural norms and expectations such as
career attitudes and work-life balance. It also concerns itself with consumer tastes and buying habits
as well as population demographics.
o Technology: Technology has grown exponentially. How a business responding to technological
innovation in products and services? Other technological advancements will impact on data storage,
 disruptive technologies such as smartphones, social networking, automation robotics and the
increasing shift towards AI artificial intelligence?
o Legal: Shifts in the Legal landscape are constantly changing especially here in the UK. Employment
labour law and employment tribunal decisions impact upon working practices continuously. It is also
important to keep up to date with all changes in legislation and of course Health and safety regulations.
o Environmental: Does a business have a direct impact on the environment? Political sanctions now
govern carbon emissions and a move towards sustainable resources such as wind turbines and
recycling. This area also covers CSR corporate social responsibility and ethical sourcing of goods and
services which in turn has a direct impact on procurement and your businesses supply chain
management.

Next steps: Once you are clear on the main overarching factors included in a PESTLE analysis the next challenge
is to relate this in real terms into the industry sector you work in.