Models for Environment Analysis

Contents
The basic models for the analysis of external environment of a business are:
 PESTEL analysis
 Porter’s diamond

The nature of environmental analysis

A business entity cannot exist in isolation from its environment. It inter-relates with its
environment, and its survival and strategic success depend on how well it responds to the
threats and opportunities that the environment presents. An entity’s environment is anything
that is not a part of the entity itself. For a business organisation, the environment includes
customers, potential customers, markets, competitors, suppliers, governments and
potential sources of new employees. It also includes the social, political and economic
environment in which the entity exists and operates.

The term ‘macro-environment’ is used to mean general factors in the business environment
of an entity, rather than specific customers, suppliers and competitors. Environmental
influences on an organisation vary with the size of the organisation, and the industry and
the countries in which it operates. The importance of environmental factors for strategic
management arises because:

 organisations operate within their environment and interact with it

 changes in the environment can be large and significant – and continually
happening future changes can be very difficult to predict.

The purpose of environmental analysis

Environmental analysis is a part of the process of assessing strategic position. In order to
make strategic choices about the future, the management of an entity need to understand:

 the factors in the environment that have a significant effect on the entity and what
it does
 the key drivers of change: these are the factors in the environment that will have
the greatest effect on the entity, and force the entity to change its strategies in
order to survive and succeed
 the difference in impact that key drivers of change in the environment will have on
different industries or different markets, or how changes in the environment might
affect one particular entity more or less than other entities.
It is also important to consider the future impact of factors in the environment. The future
impact might be different from the impact that they have had in the past. Some factors
might grow in significance; others might become less significant.

Environmental analysis is the process of:

 studying the environment in which an entity operates
 identifying significant factors in the environment, particularly those that will be
significant in the future.
The purpose of the analysis is to assess the environment, to analyse the position of an
entity in relation to its environment and to judge how the entity’s strategies should be
developed to take advantage of opportunities and deal with any potential threats. It is a
first step towards formulating a business strategy.

Two models for (external) environmental analysis

In your examination, you might be required to carry out an environmental analysis with
the use of any ‘model’ of your choice. Alternatively you might be asked specifically to
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use PESTEL analysis or Porter’s Diamond.

The PESTEL model is used to identify significant factors in the macro environment of an
entity; while Porter’s Diamond model is used to analyse reasons why entities in particular
countries, or regions within a country, appear to have a significant competitive advantage
over similar entities in the same industry, but operating in other countries or regions.

PESTEL ANALYSIS
Section overview
The nature of PESTEL analysis
Political environment
Economic environment
Social and cultural environment
Technological environment
Ecological influences
Legal environment

The nature of PESTEL analysis

PESTEL analysis is a structured approach to analysing the external environment of an
entity. The influences (current influences and possible future influences) of the
environment on the entity are grouped into categories. For each category of environmental
influence, the main influences are identified.

There are six or seven categories of environmental influence:

P – Political environment
E – Economic environment
S – Social and cultural environment
T – Technological environment
E – Ecological/Environmental environment/influences
L – Legal environment
I – International environment

The purpose of dividing environmental influences into categories is simply to make it

easier to organise the environmental analysis and ensure that some key influences are not
over-looked. It provides a useful framework for analysis.

1. Political environment
The political environment consists of political factors that can have a strong influence on
business entities and other organisations. Investment decisions by companies will be
influenced by factors such as:
 the stability of the political system in particular countries
 the threat of government action to nationalise the industry and seize ownership
from private business
 wars and civil unrest
 the threat of terrorist activity.
 Political considerations are particularly important for business entities operating in
countries with unstable political regimes or dictatorships.

2. Economic environment
The economic environment consists of the economic influences on an entity and the effect
of possible changes in economic factors on future business prospects.

Factors in the economic environment include:

 the rate of growth in the economy and per capita GDP;
 the rate of inflation;
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  the level of interest rates, and whether interest rates may go up or fall;
 foreign exchange rates, and whether particular currencies are likely to get weaker
or stronger;
 unemployment levels and the availability of skilled or unskilled workers;
 government tax rates and government subsidies to industry;
 the existence or non-existence of free trade between countries, and whether trade
barriers may be removed; and
 the existence of trading blocs of countries, such as the European Community (EC)
and Economic Community of West African States (ECOWAS).

Economic factors could affect a decision by a company about where to invest. Tax
incentives, the availability of skilled labour, a good transport infrastructure, a stable
currency, energy (and its impact on the cost of production) and other factors can all
influence strategic choices.

3. Social and cultural environment

An entity is affected by social and cultural influences in the countries or regions in which
it operates, and by social customs and attitudes. Some influences are more significant
than others.

Factors in the social and cultural environment include the following:

 The values, attitudes and beliefs of customers, employees and the general public;
 Patterns of work and leisure, such as the length of the working week and popular
 views about what to do during leisure time;
 The ethnic structure of society;
 The influence of religion and religious attitudes in society; and
 The relative proportions of different age groups in society.

4. Technological environment
The technological environment consists of the science and technology available to an
organisation (and its competitors), and changes and developments in science and
technology. Some aspects of technology and technological change affect virtually all
organisations. Developments in IT and computer technology, including the Internet, are the
most obvious example. Business entities that do not respond to changes in IT and
computerisation risk losing their share of the market to competitors. However,
technological change might also affect particular industries. Scientific developments in
food and drugs, for example, are having a continual impact on companies in these
industries.

For strategic planning, companies need to be aware of current technological changes and
the possible nature of changes in the future. Technology could have an important
influence, for example, on investment decisions in research and development, and
investment in new technology.

5. Ecological/Environmental Influences
The ecological or environmental environment consists of the influences of factors relating
to atmospheric pollution and related regulations. For business entities in some industries,
environmental factors have an important influence on strategic planning and decision-
making. They are particularly important for industries that are:
subject to strict environmental legislation, or the risk of stricter legislation in the future
(for example, legislation to cut levels of atmospheric pollution);
faced with the risk that their sources of raw materials will be used up (for example,
parts of the fishing industry and timber production industry); and
at the leading edge of technological research, such as producers of genetically modified
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foods.
For example, oil companies operating in the Niger Delta area of Nigeria have been forced
to deal with oil pollution due to increasing hostility from the host communities. Major oil
companies are investing in the development of energy from renewable energy sources,
such as the sea, wind and sun.

6 Legal environment
The legal environment consists of the laws and regulations affecting an entity, and the
possibility of major new laws or regulations in the future. Laws and regulations vary
between different countries, although international regulation is accepted in certain areas
of commercial activity, such as banking. Strategic decisions by an entity might be
affected by legal considerations. For example:
an international company might locate some operations, for tax reasons, in a country
with a favourable tax system;
decisions to relocate operations from one country to another could be affected by the
differences in employment law in the two countries, or by new employment legislation;
and
in many industries, companies are faced with environmental legislation or health and
safety legislation, affecting the ways in which they operate, as well as the design of the
products they make and sell.

7 International environment
International or global environment consists of all the factors that operate at the
transnational, cross-cultural and cross-the-border level which have an impact on the
business of an entity. Some of the important factors and influences operating in the
international environment include the following:
Globalisation
Global economic forces
Global financial system, etc

Limitations of PESTEL analysis

PESTEL analysis is a useful framework for identifying environmental influences on an
entity. However, there are limitations to the technique.

It is easier to use PESTEL analysis to identify environmental influences in the past and
present. It is not so easy to identify the environmental influences that will have the biggest
influence in the future.

It is a method of identifying environmental influences, by providing a framework for

analysis. It does not provide an assessment of environmental influences. It is used for
qualitative analysis, but not for quantification. A manager using PESTEL analysis might
need to use his (subjective) judgement to decide which environmental factors are more
important than others.

PORTER’S DIAMOND
Porter’s Diamond model is used to analyse reasons why entities in particular countries, or
regions within a country, appear to have a significant competitive advantage over similar
entities in the same industry, but operating in other countries or regions. The emphasis in
Porter’s Diamond is National competitive advantage.

The four elements in Porter’s Diamond are:

Favourable factor conditions

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 Related and supporting industries
Demand conditions in the home market
Firm strategy, structure and rivalry

The Concept of National competitive advantage

Business entities in some countries appear to enjoy a competitive advantage over
businesses in other countries in particular industries. For example, the US and Japan
appear to enjoy an advantage in global markets for IT and communications products and
services; Switzerland and the US enjoy an advantage in pharmaceuticals, the UK appears
to have some advantage in investment banking, and so on. This competitive advantage is
often concentrated in a particular region of a country. Traditional economic theory states
that a country ‘inherits’ a comparative advantage over other countries in particular
industries because of the natural resources that it enjoys. Natural resources include not
only land and mineral deposits, but also the labour force and size of the population.

However, Michael Porter challenged the traditional theory of comparative national

advantage in his book The Competitive Advantage of Nations. He put forward a different
theory of national competitive advantage, known as Porter’s Diamond.

The strategic significance of national competitive advantage

Porter argued that the national domestic market plays an important role in creating
competitive advantage for companies on a global scale. Companies operating in a strong
domestic market can develop competitive strengths. They can then build on the strength of
their ‘home base’ to extend their business operations into other countries, where their
competitive advantage will also apply and help them towards success.

The four elements in Porter’s Diamond

Porter argued that a country could create factors that give its firms (business entities) a
comparative competitive advantage over firms in the same industry in other countries.
Comparative competitive advantage for a country (or region) means that business entities
in the country (or region) can compete successfully and effectively against business
entities in the same industry but operating in another country (or region). When a country
enjoys a comparative competitive advantage in a particular industry, there will be a
concentration of businesses in the country operating in the industry or in supporting
industries.

Porter’s Diamond model provides an analysis of the factors that give a country or region
a comparative competitive advantage. Porter argued that a key to national or regional
supremacy in a particular industry is the ability to innovate. Firms and industries must
innovate to remain successful: a country must encourage innovation in order to retain a
national comparative advantage.
Porter used a diamond shape to present the factors that create comparative competitive
advantage for a country over other countries. There are four inter-related elements, viz:
 Favourable factor conditions
 Related and supporting industries
 Demand conditions in the home market
 Firm strategy, structure and rivalry.
These four elements can be presented in a diagram in a diamond shape, as follows:

Insert diagram here

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1. Favourable factor conditions
‘Factors’ are the economic factors of production – land, labour, capital (equipment) and
raw materials. ‘Factor conditions’ are conditions in a market with regard to one or more of
these factors of production. Some factor conditions in a national market might be
favourable for companies operating in a particular industry, and give them a strong
national competitive advantage. Factor conditions in a country can be divided into two
categories:
 basic factors; and
 advanced factors.

Basic factors
Basic factors are factors of production that exist naturally in the country. These might be:
 large amounts of suitable land, such as land for agriculture;
 large quantities of natural materials, such as timber, fresh water, and mineral
 resources such as oil and metals; and
 a favourable climate.
For example, the basic factor conditions of climate and suitable soil help to explain why
countries such as France and Australia are successful at wine-making.

Advanced factors
Advanced factors are factors that are ‘created’ and developed over time. Unlike basic
factors, they are not ‘inherited’ and do not exist naturally. A country might be successful
at developing particular factors that make it easier for companies to compete more
successfully.

Examples of advanced factors are:

 Labour skills and knowledge. These might be general skills, such as a highly
educated workforce with excellent skills in language and mathematics. They
might also be skills in a particular industry or type of work. For example, a
country might have a working population with high levels of technical skill in
computer software writing, or nuclear physics;
 Technological resources. A country might benefit, for example, from the existence
of scientific research centres; and
 Infrastructure. A country might benefit from excellent transport networks and
telecommunications networks.

2. Related and supporting industries

A country’s industry is made more competitive, compared to other countries, when there is
strong competition and innovation in related and supporting industries. When supporting
industries are highly competitive, costs are reduced and innovation occurs continually.
Some of the benefits of lower costs and innovation in a supporting industry (or related
industry) are passed on to business entities in industries that the supporting industry serves.
For example, many industries in the US have benefited from the competitiveness and
innovation of IT firms in Silicon Valley. In Singapore, companies have achieved national
competitive advantage in both port services and shipping repairs: port services benefit
from the presence of a strong shipping repair industry, and the shipping repair industry
benefits from the existence of excellent port facilities.

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Porter argued that the competitive benefits of an innovative supporting industry (or
related industry) are greater when firms in the supporting industry are themselves strong
competitors in global markets. In many industries, innovation depends on research and
development. Another feature of national competitive advantage may therefore be the
existence of companies with strong R&D departments, and universities that have research
departments with specialists in the industry.

3. Demand conditions in the home market

Porter argued that strong demand in local markets, particularly when this demand is
sophisticated and discerning, can help to make local firms more competitive in global
markets.
When local demand is strong, local firms will give more attention than their foreign
competitors to the needs of the local customers. This will help to make local firms more
innovative and competitive. When local firms sell their products in global markets, the
innovation and competitiveness created in local markets will help them to succeed
internationally. Innovation in local markets will help local firms to anticipate changes in
global demand.

As an example, it might be argued that strong local demand for wine, and sophisticated
local customers, has helped France to maintain its strong competitive position in the
global markets for wine. It has also been argued that in the Japanese market for
consumer electrical and
electronic goods, customers have very high expectations about the quality of products.
Companies are therefore forced to produce products to very high quality standards to
satisfy demand in the Japanese market. This creates a competitive advantage for
Japanese producers in foreign markets.

4. Firm strategy, structure and rivalry

Porter suggested that other factors that create national competitive advantage are the
strategy of firms and their owners, the organisation structure of firms and the rivalry
between local firms in the industry. Firms and their owners might have different ideas
about investment strategy. For example, in the US, investors and the management of
companies often have a short-term outlook, and expect returns on their investment within a
relatively short time. In other countries, investors might expect to invest for longer, to
obtain the benefits of long-term returns. This might help to explain, for example, why the
US does well in computer industries and Switzerland excels in pharmaceuticals. In some
countries, the management structure in larger companies is formal and hierarchical. In
other countries, many companies are family-run businesses. This might give companies in
some countries a competitive advantage in some
industries, but not others.

Note that a country is likely to retain a competitive advantage in industries whose key
employees have jobs that give the individual a high status in society. For example, the UK
has some comparative strength in investment banking: jobs as investment bankers have a
high status in UK society. Rivalry between local firms is also an important factor in
maintaining national or
regional competitive advantage. This is because rivalry forces producers to innovate, and
to keep on looking for ways of meeting customer needs better than their competitors. It has
been suggested for example that the international success of beer producing companies in
the Netherlands and Belgium is attributable to keen competition between producers in
those countries. Similarly, the success of pharmaceutical companies in Switzerland may
be attributable to the rivalry between Swiss firms in the industry.

THE ROLE OF GOVERNMENT IN CREATING COMPETITIVE ADVANTAGE

Porter argued that the four elements in the diamond are all important for creating
national competitive advantage, because they create the conditions that result in
competitive advantage: the availability of suitable resources and skills information that
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firms can use to decide how to invest the resources and skills that are available to them
goals of individuals and companies pressure on companies to innovate and invest.

Governments can help to create suitable conditions for national competitive advantage.
They can create an education and training system that develops appropriate labour skills
and knowledge.
They can help companies to raise their performance levels by enforcing strict
product standards.
They can create early demand for new and advanced products by purchasing the
products themselves.
They can stimulate rivalry between local firms by enforcing strict anti-trust
legislation.

Criticisms of Porter’s Diamond

There are some weaknesses in Porter’s Diamond theory. In particular:
 It is more relevant to companies in advanced economies than to companies in
countries with developing economies; and
 The diamond model does not consider the role of the multinational company, which
locates production operations in different countries across the world.

Using Porter’s Diamond

In your examination, you might be required to use Porter’s Diamond theory to explain the
global success of companies in a particular country. To do this, you would need to
consider the four factors in the Diamond, together with the influence of government.

Example: London
The success of London as a global financial centre can be explained using Porter’s
Diamond.

Favourable factor conditions

In the UK, investment bankers have a high social status. This helps to attract highly-
talented individuals into the industry from other countries as well as the UK.

There is a highly-skilled workforce in investment banking and also related industries.

London benefits from its membership of the European Union.
London is in a favourable time zone in Europe, between the time zones of the Far East
and the
US (especially New York).
English is the ‘language’ of international banking, and London benefits from being in an
English-
speaking country.

Related and supporting industries

London’s financial companies benefit from the existence of strong related and
supporting
industries, such as accounting firms, law firms and IT firms.

Demand conditions in the home market

Investment institutions such as pension funds and insurance companies are major
customers
of financial services firms in the UK. They have very high expectations of the quality of
service
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 they should receive.

Firm strategy, structure and rivalry

Banks in the London market benefit from strong rivalry between firms that helps to
maintain
standards of service at a high level. London also benefits from high standards of
corporate
behaviour/corporate governance, but a regulatory regime that is not too oppressive.
The UK
government seeks to encourage the success of the UK financial services industry.

Competitive forces
Contents
 Competition and markets
 Industry competition:
 Five Forces model
 Life cycle model
 Boston Consulting Group matrix (BCG matrix)

Strategic analysis
Analyse the external business environments and examine the opportunities and threats
that could arise from events or potential events at the global, national, industry or
competitive levels.

Analyse the position of a business in terms of its competitive strategy, plans and current
markets, drawing conclusions and giving simple recommendations on the chosen plans.
Note: Models for analysis include SWOT, Porter’s Five Forces, Life Cycle, BCG Matrix

Strategic choice
Evaluate the appropriateness of a chosen strategy that supports business objectives,
considering constraints, conflicts and other issues based on a given scenario. The
following models and tools may be employed in carrying out the evaluation:
 Five forces model,
 Life-cycle model and
 Boston Consulting Group (BCG) model

Exam context
Having considered the external environment in the previous section we now switch the
focus to the internal environment. In this chapter you will see how business strategists
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think about their market and competitors using the Five Forces model. You will also see
how businesses look at their own product offerings using lifecycle and BCG analyses. The
section closes by showing how the external and competitor analyses are brought together
using SWOT analysis as a means for identifying opportunities and threats (i.e. the “OT” of
SWOT).

1 COMPETITION AND MARKETS

Section overview
Customers, consumers and markets
Industries and sectors
Convergence

1.1 Customers, consumers and markets

A market is a place where buying and selling takes place between vendors (sellers) and
customers (buyers). A market can be defined in different ways. It can be defined by the
products or services that are sold, such as the fashion clothes market, the banking market
or the market for air travel. It can be defined by the customers or potential customers for
products or services, such as the consumer market or the ‘youth market’. Customer
markets might also be defined by geographical area, such as the North American market
or European market. Markets can be global or localised.
A customer is the person or entity that purchases a good or service. A consumer is the
person or entity that uses (consumes) the good or service that has been purchased.
Subsequently, customers and consumers need not necessarily be the same person (or
entity). For example, someone who buys an ice cream to eat themselves is both the
customer and consumer. However, when a parent buys an ice cream for their child, the
parent is the customer whereas the child is the consumer. An important aspect of business
strategy for companies is concerned with selling goods or services successfully to
targeted markets. (These strategies are ‘product-market strategies’).
A similar concept of ‘markets’ and ‘customers’ can also be applied to the provision of
public services, such as state-owned schools and hospitals. For example, there are
‘markets’ for education services in which customers are pupils (or their parents).

Industries and sectors

An industry consists of companies which produce similar goods and services. For
example, there is an aerospace industry, an automobile manufacturing industry, a
construction industry, a travel industry, a leisure industry, an insurance industry, and so
on. Within an industry, there may be different segments. An industry segment is a
separately-identifiable part of a larger industry. For example, the automobile industry
can be divided into segments for the construction of automobiles and the manufacture of
parts. Similarly, the insurance industry has several sectors,
including general insurance, life assurance and pensions. Companies need to make
strategic decisions about: the industry and industrial segment (or segments) they intend to
operate in, and the market or markets in which they will sell their goods or services.

A distinction should be made between products and markets. Companies in different

industries might sell their goods or services to the same market. For example, small
building companies compete with retailers of do-it yourself tools and other products.
Laundry services compete with manufacturers of domestic washing machines.

Companies in the same industry might not compete because they operate in different
markets. For example, a ferry company operating passenger services between the UK
and France is in the same industry as a ferry company operating passenger services
between the Greek islands, but they operate in different markets.

In their analysis of strategic position, management need to recognise which industries and
segments they operate in, and also which markets they are selling to. They also need to
recognise changing conditions in industries, segments and markets, in order to decide what
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their product-market strategies should be in the future.

Generic types of industry

The strategic position of a company depends to some extent on the type of industry it is
operating in. Porter suggested that there are five generic types of industry as follows:

Fragmented industries. In a fragmented industry, firms are small and sell to a small
portion of
the total market. Examples are dry cleaning services, hairdressing services, and shoe
repairs.

Emerging industries. These are industries that have only just started to develop, and are
likely
to become much bigger and much more significant in the future. An example is the space
travel
industry.
Mature industries. These are industries where products have reached the mature phase
of
their life cycle. (The product life cycle is described later.) Examples are automobile
manufacture
and soft drinks manufacture.
Declining industries. These are industries that are going into decline: total sales are
falling and the number of competitors in the market is also falling. An example is coal
mining in Europe.

Global industries. Some industries operate on a global scale, such as the microprocessor
industry and the professional football industry.

Convergence
Occasionally, two or more industries or industrial segments converge, and become part of
the same industry, with the same customer markets. When convergence happens, or might
happen in the future, this can have a major impact on business strategy.

Example: Communications services

In the past, there were three separate communications industries providing services to
consumer households.
Television broadcasters (such as the BBC and ITV) delivered terrestrial television
services to
households.
Telephone service companies delivered voice communications to households through
the
telephone network.
More recently, data communications have been provided to households through
internet
service providers.
A separate mobile telephone industry also developed.

These industries or industrial segments are now converging into a single industry, serving
the same customers. Voice, data and entertainment services can be delivered over the
same network. They can also be delivered to mobile telephones as well as to households.
As a consequence, these industries have undergone, and continue to undergo, major
strategic changes.
Technology is continuing to develop. It is now possible to download high quality TV

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pictures over the internet. Customers are able to receive voice, data and entertainment
services through the same hardware, anywhere and at any time.

New products and new services will emerge and markets for these products will grow
– examples are on-demand TV programmes, video conferencing, and narrowcasting
(delivering programmes to a targeted audience). Direct advertising services will also be
affected.

Inevitably, some companies will be ‘winners’ and some will be ‘losers’. The companies
that survive in the converging industries will be those that are most successful with their
strategic management.

Demand-led and supply-led convergence

Convergence can be either demand-led or supply-led. With demand-led convergence, the
pressure for industry convergence comes from customers. Customers begin to think of two
or more products as interchangeable or closely complementary. With supply-led
convergence suppliers see a link between different industries and decide to bridge the
gap between the industries. The convergence of the entertainment, voice communication
and data communication industries, discussed in the previous example, is probably supply
-led, because suppliers became aware of the technological possibilities before consumers
became aware of the convenience.

INDUSTRY COMPETITION: FIVE FORCES MODEL

Section overview
Competition analysis: The Five Forces
Threat from potential entrants
Threat from substitute products
Bargaining power of suppliers
Bargaining power of customers
Competitive rivalry

Using the Five Forces model

2.1 Competition analysis
The Five-forces model is basically used for competition analysis. Analysing competition
is an important part of strategic position analysis. It is also important to assess the
strength of competition in a market, and try to understand what makes the competition
weak or strong. A company should also monitor each of its major competitors, because in
order to obtain a competitive advantage, it is essential to know about what competitors
are doing. Porter’s Five Forces model provides a framework for analysing the strength of
competition in a market. It is not a model for analysing individual competitors, or even
what differentiates the performance of different firms in the same market. In other words,
it is not used to assess why some firms perform better than others.

Profitability and competition

In addition, the Five Forces model can be used to explain why some industries are more
profitable than others, so that companies operating in one industry are able to make
bigger profits than companies operating in another industry. Profitability is affected by
the strength of competition: the stronger the competition, the lower the profits.

Note: Porter argued that two factors affect the profitability of a company. These are:
i. industry structure and competition in the industry, and also

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 ii. sustainable competitive advantage

The Five Forces

Michael Porter (‘Competitive Strategy’) identified five factors or ‘forces’ that determine
the strength and nature of competition in an industry or market. These are:
1. threats from potential entrants
2. threats from substitute products or services
3. the bargaining power of suppliers
4. the bargaining power of customers
5. competitive rivalry within the industry or market.

The Five Forces model is set out in the diagram below:

Insert diagram

When competition in an industry or market is strong, firms must supply their products or
services at a competitive price, and cannot charge excessive prices and make
‘supernormal’ profits. If they do not charge the lowest prices, firms must compete by
offering products that provide extra value to customers, such as higher quality or faster
delivery. When any of the five forces are strong, competition in the market is likely to be
strong and profitability will therefore be low. Analysing the five forces in a market might
therefore help strategic managers to choose the markets and industries for their firm to
operate in.

1. Threat from potential (new) entrants

One of the Five Forces is the threat that new competitors will enter the market and add to
the competition. New entrants might be attracted by the high profits earned by existing
competitors into the market, or by the potential for making high profits. When they enter
the market, new entrants will try to establish a share of the market that is large enough to
be profitable. One way of gaining market share would be to compete on price and charge
lower prices than existing competitors.

The significance of this threat depends on how easy or how difficult it would be for new
competitors to enter the market. In some markets, the cost of entering a new market can be
high, with new entrants having to invest in assets and establish production facilities and
distribution facilities. In other markets, the cost of entering the market can be fairly low.
13
The costs and practical difficulties of entering a market are called ‘barriers to entry’.

When barriers to entry are low. If new entrants are able to come into the market without
much difficulty, firms already in the market are likely to keep prices low and to meet
customer needs as effectively as possible. As a result, competition in the market will be
strong and there will be no opportunities for high profit margins.

When barriers to entry are high. When it is difficult for new competitors to enter a market,
existing competitors are under less pressure to cut their costs and sell their products at
low prices.
A number of factors might help to create high barriers to entry:

Economies of scale. Economies of scale are reductions in average costs that are achieved
by producing and selling an item in larger quantities. In an industry where economies of
scale are large, and the biggest firms can achieve substantially lower costs than smaller
producers, it is much more difficult for a new firm to enter the market. This is because it
will not be big enough at first to achieve the economies of scale, and its average costs
will therefore be higher than those of the existing large-scale producers.

Capital investment requirements. If a new entrant to the market will have to make a large
investment in assets, this will act as a barrier to entry, and deter firms from entering the
market when they do not want the investment risk.

Access to distribution channels. In some markets, there are only a limited number of
distribution outlets or distribution channels. If a new entrant will have difficulty in gaining
access to any of these distribution channels, the barriers to entry will be high.

Time to become established. In industries where customers attach great importance to

branding, such as the fashion industry, it can take a long time for a new entrant to become
well established in the market. When it takes time to become established, the costs of
entry are high.
Know-how. This can be time-consuming and expensive for a new entrant to acquire
Switching costs. Switching costs are the costs that a buyer has to incur in switching from
one supplier to a new supplier. In some industries, switching costs might be high. For
example, the costs for a company of switching from one audit firm to another might be
quite high, and deter a company from wanting to change its auditors. When switching costs
are high, it can be difficult for new entrants to break into a market.

Government regulation. Regulations within an industry, or the granting of rights, can

make it difficult for new entrants to break into a market. For example, it might be
necessary to obtain a licence to operate, or to become registered in order to operate within
an industry.

2. Threat from substitute products

There is a threat from substitute products when customers can switch fairly easily to
buying alternative products (substitute products). The threat from substitutes varies
between markets and industries, but a few examples of substitutes are listed below:

Domestic heating systems. Consumers might switch between gas-fired, oil fired and

14
electricity-fired heating systems.
Transport. Customers might switch between air, rail and road transport services.
Food and drink products. Consumers might switch between similar products, such as
coffee and tea. When there are substitute products that customers might buy, firms must
make their products more attractive than the substitutes. Competition within a market or
industry will therefore be higher when the threat from substitute products is high. Threats
from substitute products may vary over time. There are many examples in the past of
industries that have been significantly affected by the emergence of new substitute
products.

Plastic containers and bottles became a significant substitute for glass containers and
bottles.
Synthetic fibres became a substitute for natural fibres such as wool and cotton. Word
processors and personal computers became a substitute for typewriters, and the market
for typewriters was destroyed.

3. Bargaining power of suppliers

In some industries, suppliers have considerable power. When this occurs, they might
charge high prices that firms buying from them are unable to pass on to their own
customers. As a result, profitability in the industry is low, and the market is competitive.
Porter wrote: ‘Suppliers can exert bargaining power over participants in an industry by
threatening to raise prices or reduce the quality of purchased goods or services. Powerful
suppliers can thereby squeeze profitability out of an industry unable to recover cost
increases in its own prices.’

Example: Bargaining power of suppliers

An example of supplier power is possibly evident in the industry for personal computers.
Software companies supplying the computer manufacturers (such as Microsoft) have
considerable power over the market and seem able to obtain good prices for their
products. Computer manufacturers are unable to pass on all the high costs to their own
customers for PCs, and as a consequence, profit margins in the market for PC
manufacture are fairly low. Porter suggested that the bargaining power of suppliers
might be strong in any of the following situations:
when there are only a small number of suppliers to the market
when there are no substitutes for the products that are supplied
when the products of a supplier are differentiated, and so distinctly ‘better’ or more
suitable
than the products of rival suppliers
when the supplier’s product is an important component in the end products that are made
with it
when the industry supplied is not an important customer for the suppliers
when the suppliers could easily integrate forward, and enter the market as competitors
of their
existing customers.
The bargaining power of suppliers also depends on the importance of the product they
supply. For example, for a firm that manufactures cars the bargaining power of engine
suppliers will be greater than the bargaining power of suppliers of car mirrors.
4. Bargaining power of customers
Buyers can reduce the profitability of an industry when they have considerable buying
power. Powerful buyers are able to demand lower prices, or improved product

15
specifications, as a condition of buying. Strong buyers also make rival firms compete to
supply them with their products. In the UK, a notable example of buyer power is the
power of supermarkets as buyers in the market for many consumer goods. They are able
to force down the prices from suppliers of products for re-sale, using the threat of
refusing to buy and switching to other suppliers. As a result, profit margins in the
manufacturing industries for many consumer goods are very low.
Porter suggested that buyers might be particularly powerful in the following situations:
 when the volume of their purchases is high relative to the size of the supplier;
 when the products of rival suppliers are largely the same (‘undifferentiated’);
 when the costs of switching from one supplier to another are low;
 when the cost of purchased item is a significant proportion of the buyer’s total
 costs;
 when the profits of the buyer are low;
 when the buyer’s product is not affected significantly by the quality of the goods
 that it buys; and
 when the buyer has full information about suppliers and prices.

5. Competitive rivalry
Competition within an industry is obviously also determined by the rivalry between the
competitors. Strong competition forces rival firms to offer their products to customers at a
low price (relative to the product quality) and this keeps profitability fairly low. Porter
suggested that competitor rivalry might be strong in any of the following circumstances:
 when the rival firms are of roughly the same size and economic strength;
 when there are many competitors;
 when there is only slow growth in sales demand in the market;
 when the products of rival firms are largely the same (‘undifferentiated’);
 when fixed costs in the industry are high, so that firms still make some
 contribution to profit even when they cut prices;
 when supply capacity can only be increased in large incremental amounts (for
 example, in electricity supply industry, where increasing total supply to the market
 might only be possible by opening another power generation unit); and
 when the costs of withdrawing from the industry are high, so that even unprofitable
companies are reluctant to leave the market.

The Five Forces model summarised

The Five Forces model is summarised below, showing some of the key factors
that help to determine the strength of each of the forces in the industry or market.
Threats from potential entrants
Time and cost of entry
Building a brand
Specialist knowledge required
Economies of scale
Technology protection for existing
firms (patents, design rights)

Suppliers’ bargaining power

Number of suppliers
Size of suppliers
Uniqueness of service
Ability to buy substitute
products
Cost of switching to a different

16
supplier
Importance of the product to
the firm

Competitive rivalry
Number of competitors
Size of competitors
Quality differences
Other differences
Costs for customers of switching to
a competitor
Customer loyalty
Ease of leaving the market (barriers
to exit)

Customers’ bargaining power

Number of customers
Size of each order
Differences between
products/services of competitors
Costs for customers of
switching to a competitor
Price differences and price
sensitivity

Threats from substitutes

The existence of substitutes
The performance of substitute
products
Costs of switching to a substitute
product
Relative prices
Fashion trends

Using the Five Forces model

In your examination, you might be required to use the Five Forces model to analyse the
strength of competition in a market or an industry, in a question containing a case study or
scenario. To do this, you should take each of the Five Forces in turn and consider how it
might apply to the particular case study or scenario. Here are two simple examples, with
suggestions about the strength of competition. Your own views might differ.

Example: Five forces – legal services

The Five Forces model can be used to analyse the market for legal services
(the services of firms of solicitors) in a local area, where competition is
between small and medium-sized firms.
Threat from potential entrants. This is likely to be fairly low. New
entrants must be qualified solicitors, and it could take time to establish a
sufficiently large client base.
Suppliers’ bargaining power. Solicitors have no significant suppliers;
therefore the bargaining power of suppliers is non-existent.
Customers’ bargaining power. Most firms of solicitors have a fairly
large number of customers. Customers need legal services. The
bargaining power of customers is probably low.
Threat from substitutes. There are no substitutes for legal services,
except perhaps for some ‘do-it-yourself’ legal work.
Competitive rivalry. This is likely to be very weak. Firms of competitors
will not usually seek to compete with other firms by offering lower fees.
The conclusion is that competition in the market for legal services in a local
region is very weak.

Example: Five forces – CDs and DVDs

The Five Forces model can be used to analyse the competition for Amazon, the company
17
that supplies books, CDs and DVDs through online ordering on its website. It has no direct
competitor.
Threat from potential entrants. This is likely to be fairly low because of the costs of
establishing a selling and distribution system and the time it might take a new competitor
to create ‘brand awareness’.
Suppliers’ bargaining power. Amazon obtains its books and other products from a
large number of different suppliers. The bargaining power of most suppliers is therefore
likely to be weak, with suppliers needing Amazon more than Amazon needs individual
suppliers.
Customers’ bargaining power. Amazon has a very large customer base, and the
bargaining power of customers is non-existent.
Threat from substitutes. Substitutes are bookshops, shops selling CDs and DVDs,
internet downloads of films and music, and possibly eBay and other online auction sites
as a channel for selling second-hand books. In the longer term electronic books might be
another substitute.
Competitive rivalry. Amazon has no direct competitor.
In conclusion, the major competition in the market served by Amazon is probably the
threat from substitute products.

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PRODUCT LIFE CYCLE MODEL
Section overview
The ‘classical’ product life cycle
Cost implications of the product life cycle
Relevance of the product life cycle to strategic management
Cycle of competition

The ‘classical’ product life cycle

A ‘life cycle’ is the period from birth or creation of an item to the end of its life. Products,
companies and industries all have life cycles. A product life cycle begins with its initial
development and ends at the time that it is eventually withdrawn from the market at the
end of its life. A product is said to go through several stages of demand. The ‘classical’
life cycle for a product, or even an entire industry, goes through four stages or phases:
 Introduction;
 Growth;
 Maturity; and
 Decline.

Introduction phase- During this stage of a product life cycle, there is some sales demand
but total sales are low. Firms that make and sell the product incur investment costs, and
start-up costs and running costs are high. The product is not yet profitable.

Growth phase - During the growth phase, total sales demand in the market grows at a
faster rate. New entrants are attracted into the market by the prospect of high sales and
profits. At an early stage during the growth phase, companies in the market begin to earn
profits.

Maturity phase - During the maturity phase, total annual sales remain fairly stable.
Prices and profits stabilise. The opportunity for more growth no longer exists, although
the life of the product might be extended, through product updates. More companies might
seek to improve profits by differentiating their products more from those of competitors,
and selling to a ‘niche’ market segment.

Decline phase - Eventually, total annual sales in the market will start to fall. As sales
fall, so too do profits. Companies gradually leave the market. At some point in time, it is
no longer possible to produce and sell the product at a profit, and the product is therefore
discontinued by the last of the companies that makes it.

A ‘classical’ product life cycle is shown in the following diagram.

19
Note that it is not all products that have a classical life cycle. Unsuccessful products
never become profitable. A business entity might be able to ‘revitalise’ and redesign a
product, so that when it enters a decline phase, its sales can be increased again, and it
goes into another period of growth and maturity. The length of a product life cycle can be
long or short. A broad type of product, such as a motor car, has a longer life cycle than
particular types of the product, such as a Volkswagen Beetle or a Ford Escort. At each
phase of a product’s life cycle:
 selling prices will be altered;
 costs may differ;
 the amount invested (capital investment) may vary; and
 spending on advertising and other marketing activities may change.

Cost implications of the product life cycle

Life cycle costing can be important in new product launches as a company will of course
want to make a profit from the new product and the technique considers the total costs
that must be recovered. These will include:
 Research and development costs (decisions made at the development phase impact
later costs);
 Training costs;
 Machinery costs;
 Production costs;
 Distribution and selling costs;
 Marketing costs;
 Working capital costs; and
 Retirement and disposal costs.
Stage
Costs
Stage Costs
Product R&D costs
development Capital expenditure decisions

Introduction to the market Operating costs

Marketing and advertising to raise
product
awareness
(strong focus on market share)
Set up and expansion of distribution
channels

Growth Costs of increasing capacity

Maybe learning effect and economies of
scale
Increased costs of working capital

Maturity Incur costs to maintain manufacturing

capacity
Marketing and product enhancement
costs to
extend maturity

Decline Close attention to costs needed as

20
withdrawal
Decision might be expensive

Withdrawal Asset decommissioning costs

Possible restructuring costs
Remaining warranties to be supported
Benefits of PLCC
Product Life cycle costing (PLCC) compares the revenues and costs of the product over its
entire life. The benefits of this include the following:
 The potential profitability of products can be assessed before major development
 of the product is carried out and costs incurred. Non-profit-making products can
 be abandoned at an early stage before costs are committed;
 Techniques can be used to reduce costs over the life of the product;
 Pricing strategy can be determined before the product enters production. This
 may lead to better control of marketing and distribution costs;
 Attention can be focused on reducing the research and development phase to
 get the product to market as quickly as possible. The longer the company can
 operate without competitors entering the market the more revenue can be earned
 and the sooner the product will reach the breakeven point; and
 By monitoring the actual performance of products against plans, lessons can be
 learnt to improve the performance of future products. It may also be possible to
 improve the estimating techniques used.

Relevance of the product life cycle to strategic management

Strategic management should consider the cash flows and profitability of a product over
its entire life cycle. When a decision is being made about whether or not to develop a new
product, management should consider the likely sales and returns over the entire life
cycle. For existing products, management need to assess the position of a product in its
life cycle, and what the future prospects for the product, in terms of profits and cash
returns, might be.

Timing market entry and exit

The product life cycle concept might help companies to make strategic decisions about
when to enter a market and when to leave it. Entrepreneurial companies might look for
opportunities to enter a new market during the introductory phase, in the expectation that
the product will become
successful and the company will win a large share of the market by being one of the first
companies to enter it. More cautious companies, looking for growth opportunities, might
delay their entry into the market until the growth phase, when the product is already
making a profit for its producers. Companies are unlikely to enter a market during the
maturity phase unless they see growth opportunities in a particular part of the market, or
unless the costs of entry into the market are low. A company might need to make a
strategic decision about leaving a market, when the product is in its decline phase. It
should be possible to make profits in a declining market, but better growth opportunities
might exist in other markets and a company might benefit from a change in its strategic
direction.

Life cycle analysis as a technique for competition analysis

Life cycle analysis is also useful for assessing strategic position and the nature of
competition in a market. The number of competitors in the market ‘now’, and the number
of competitors that might exist in the future, will be influenced by the phase that the
product has reached during its life cycle.

Cycle of competition
A cycle of competition is another concept for understanding the behaviour of competitors
in a market. When one company achieves some success in a market, competitors might try
to do something even better in order to gain a competitive advantage. A new initiative by
21
one company will result in a counter-measure from another company. Each company in
the market tries to do something different and better. A typical cycle of competition
affects prices and quality. If one company has a large share of a profitable market, a
rival company might start to sell its product at a lower price. Another rival company
might improve the quality of its product, but sell it at the same price as rivals in the
market. The first company might respond to these initiatives by its rivals by improving its
product quality and reducing the selling price. The effect of a cycle of competition in a
growing market is that prices fall and quality might improve. In the maturity phase of a
product’s life cycle, or in the decline phase, it becomes more difficult to lower prices
without reducing quality. Competitors might try to gain a bigger share of the market by
selling at a lower price, but the product quality might be reduced. This can lead to a
‘spiral’ of falling prices and falling quality, to the point where the product is no longer
profitable, and it is less
attractive to customers. The concept of the cycle of competition is useful for strategic
analysis, because it can help to explain the strategies of companies in a market, and to
assess what future initiatives by competitors might be.

BOSTON CONSULTING GROUP MATRIX (BCG MATRIX)

Section overview
The Boston Consulting Group developed a product-market portfolio for strategic planning.
It allows the strategic planners to select the optimal strategy for individual products or
business units, whilst also ensuring that the selected strategies for individual units are
consistent with the overall corporate objectives. The objective of the matrix is to assist
with the allocation of funds to different products or business units.

The matrix is a 2 × 2 matrix.

One side of the matrix represents the rate of market growth for a particular product or
business unit.
The other side of the matrix represents the market share that is held by the product or
business unit.

Notes
Market growth - The mid-point of the growth side of the matrix is often set at 10% per
year. If market growth is higher than this, it is ‘high’ and if annual growth is lower, it is
‘low’. It should be said that 10% is an arbitrary figure.

Market share - This is usually measured as the annual sales for a particular product or
business unit as a proportion of the total annual market sales. For example, if the product
of Entity X has annual sales of ₦100,000 and total annual sales for the market as a
whole are ₦1,000,000; Entity X has a 10% market share.

In the BCG matrix, however, market share is measured as annual sales for the product as
a percentage or ratio of the annual sales of the biggest competitor in the market. The mid-
point of this side of the matrix represents a situation where the sales for the firm’s product
or business unit are equal to the annual sales of its biggest competitor. If a product or
business unit is the market leader, it has a ‘high’ relative market share. If a product is not
the market leader, its relative
market share is ‘low’.

The BCG matrix is shown as follows. The individual products or business units of the firm
can be plotted on the matrix as a circle. The size of the circle shows the relative money
value of sales for the product. A large circle therefore represents a product with large
annual sales.

BCG matrix
The products or business units are categorised according to which of the four quadrants it
is in. The four categories of product (or business unit) are:
22
  Question mark (also called ‘problem child’);
 Star;
 Cash cow; and
 Dog.

Question mark
A question mark is a product with a relatively low market share in a high-growth market.
Since the market is growing quickly, there is an opportunity to increase market share, but
initially it will require a substantial investment of cash to increase or even maintain
market share. A strategic decision that needs to be taken is whether to invest more heavily
to increase market share in a growing market, whether to seek a profitable position in the
market, but not as market leader, or whether to withdraw from the market because the
cash flows from the product are negative. The BCG analysis states that a firm cannot last
long with a small market share, as bigger companies will be able to apply great cost and
price pressure as they enjoy economies of scale.

Star
A star has a high relative market share in a high-growth market. It is the market leader.
However, a considerable investment of cash is still required to maintain its leading
position. Initially, they probably use up more cash than they earn, and at best are cash-
neutral. Over time, stars should gradually become self-financing. At some stage in the
future, they should start to earn high returns.

Cash cow
A cash cow is a product in a market where market growth is lower, and possibly even
negative. It has a high relative market share, and is the market leader. It should be
earning substantial net cash inflows, because it has high economies of scale and will have
become efficient through experience. Other companies will not mount an attack as they
perceive that the market is old and near decline. Cash cows should be providing the
business entity with the cash that it needs to
invest in question marks and stars.

Dog
A dog is a product in a low-growth market that is not the market leader. It is unlikely that
the product will gain a larger market share, because the market leader will defend the
position of its cash cow. A dog might be losing money, and using up more cash than it
earns. If so, it should be evaluated for potential closure. However, a dog may be
providing positive cash flows. Although the entity has a relatively small market share in a
low-growth market (or declining market), the
product may be profitable. A strategic decision for the entity may be to choose between
immediate withdrawal from the market (and perhaps selling the business to a buyer, for
example in a management buyout) or enjoying the cash flows for a few more years
before eventually withdrawing from the market. It would be an unwise decision, however,
to invest more capital in ‘dogs’, in the hope of increasing market share and improving cash
flows, because gaining market share in a low-growth market is very difficult to achieve.

Using the BCG matrix

Companies must invest in products and business units for the future. They need to invest in
some question marks as well as in stars, and this uses up cash. Much of the cash for
investing in other products will come from cash cows. The BCG matrix model can help
management to decide on a portfolio of products or

Deciding strategies using the BCG matrix

Relative market share
23