4. External Environ.ppt
- 1. THE EXTERNAL ENVIRONMENT Two of the primary determinants of organizational performance are the industry environment in which a company competes and the country (or countries) in which it is located. Both of these factors are aspects of the company’s external environment. In order to succeed a company must either fit its strategy to the industry environment in which it operates, or be able to reshape the industry environment to its advantage through its chosen strategies.
- 2. THE FIVE FORCES MODEL The task facing managers is to analyze competitive forces in an industry environment in order to identify the opportunities and threats confronting a company. Michael E. Porter of the Harvard School of Business Administration has developed a framework that helps managers in this analysis. Porter’s frame- work, known as the five forces model focuses on five forces that shape competition within an industry:
- 3. The risk of new entry by potential competitors, The degree of rivalry among established com- panies within an industry, The bargaining power of buyers, The bargaining power of suppliers, and The closeness of substitutes to an industry's products.
- 4. Within Porter's framework, a strong competitive force can be regarded as a threat since it depresses profits. A weak competitive force can be viewed as an opportunity, for it allows a company to earn greater profits. Because of industry evolution, the strength of the five forces may change through time. In such circumstances, the task facing strategic managers is to recognize opportunities and threats as they arise and to formulate appropriate strategic responses.
- 5. The risk of new entry by potential competitors Established companies try to discourage potential competitors from entering, since the more companies enter an industry, the more difficult it becomes for established companies to hold their share of the market and to generate profits. Thus a high risk of entry by potential competitors represents a threat to the profitability of established companies. On the other hand, if the risk of new entry is low, established companies can take advantage of this opportunity to raise prices and earn greater returns.
- 6. Barrier to Entry The concept of barriers to entry implies that there are significant costs to joining an industry. The greater the costs that potential competitors must bear, the greater are the barriers to entry. High entry barriers keep potential competitors out of an industry even when industry returns are high. Following are the sources of barrier to entry:
- 7. Brand Loyalty: Brand loyalty is buyers' preference for the products of established companies. A company can create brand loyalty through -continuous advertising of brand and company names, -patent protection of products, -product innovation, -an emphasis on high product quality, and good after-sales service. Significant brand loyalty makes it difficult for new entrants to take market share away from established companies.
- 8. Absolute Cost Advantages: Lower absolute costs give established companies an advantage that is difficult for potential competitors to match. Absolute cost advantages can arise from superior production techniques. These techniques can be due to -past experience, patents, or secret processes; -control of particular inputs required for production, such as labor, materials, equipment, or management skills; or -access to cheaper funds because existing companies represent lower risks than potential companies.
- 9. Economies of Scale: Economies of scale are the cost advantages associated with large company size. Sources of scale economies include -cost reductions gained through mass-producing a standardized output, -discounts on bulk purchases of raw-material inputs and component parts, -the spreading of fixed costs over a large volume, and -scale economies in advertising.
- 10. Rivalry among established companies The second of Porter's five competitive forces is the extent of rivalry among established companies within an industry. If this competitive force is weak, companies have an opportunity to raise prices and earn greater profits. But if it is strong, significant price competition, including price wars, may result from the intense rivalry.
- 11. The extent of rivalry among established companies within an industry is largely a function of three factors: (1)Industry competitive structure, (2)Demand conditions, and (3)The height of exit barriers in the industry.
- 12. 1. Competitive Structure: Competitive structure refers to the number and size distribution of companies in an industry. Different competitive structures have different implications for rivalry. Structures vary from fragmented to consolidated. A fragmented industry contains a large number of small or medium-sized companies, none of which is in a position to dominate the industry.
- 13. A consolidated industry is dominated by a small number of large companies or, in extreme cases, by just one company (a monopoly). Fragmented industries range from agriculture, video rental, and health clubs, to real estate brokerage and suntanning parlors. Consolidated industries include aerospace, automobiles, and pharmaceuticals.
- 14. Many fragmented industries are characterized by low entry barriers and commodity-type products that are hard to differentiate. The combination of these traits rends to result in boom-and-bust cycles. Low entry barriers imply that whenever demand is strong and profits are high there will be a flood of new entrants hoping to cash in on the boom.
- 15. Often the flood of new entrants into a booming fragmented industry creates excess capacity. Once excess capacity develops, companies start to cut prices in order to utilize their spare capacity. The result is a price war, which depresses industry profits, forces some companies out of business, and deters potential new entrants.
- 16. A fragmented industry structure constitutes a threat rather than an opportunity. Most booms will be relatively short-lived because of the ease of new entry and will be followed by price wars and bankruptcies.
- 17. The nature and intensity of competition for consolidated industries are much more difficult to predict. The one certainty about consolidated industries is that the companies are interdependent— that is, the competitive actions of one company directly affect the profitability of others in the industry.
- 18. In a consolidated industry, the competitive action of one company directly affects the market share of its rivals, forcing a response from them. The consequence of such competitive interdependence can be a dangerous competitive spiral, with rival companies trying to undercut each other's prices, pushing industry profits down in the process.
- 19. The interdependence of companies in consolidated industries and the possibility of a price war constitute a major threat. Companies often seek to reduce this threat by following the price-lead set by a dominant company in the industry.
- 20. 2. Demand Conditions: Growing demand tends to moderate competition by providing greater room for expansion. When demand is growing, companies can increase revenues without taking market share away from other companies. Thus growing demand gives a company a major opportunity to expand operations.
- 21. Conversely, declining demand results in more competition as companies fight to maintain revenues and market share. When demand is declining, a company can attain growth only by taking market share away from other companies. Thus declining demand constitutes a major threat, for it increases the extent of rivalry between established companies.
- 22. 3. Exit Barriers: Exit barriers are a serious competitive threat when industry demand is declining. Exit barriers are economic, strategic, and emotional factors that keep companies competing in an industry even when returns are low. If exit barriers are high, companies can become locked into an unfavorable industry. Common exit barriers include the following:
- 23. • Investments in plant and equipment that have no alternative uses and cannot be sold off. If the company wishes to leave the industry, it has to write off the book value of these assets. • High fixed costs of exit, such as severance pay to workers who are being made redundant. • Emotional attachments to an industry, as when a company is unwilling to exit from its original industry for sentimental reasons.
- 24. • Strategic relationships between business units. For example, within a multi-industry company, a low-return business unit may provide vital inputs for a high-return business unit based in another industry. Thus the company may be unwilling to exit from the low-return business. • Economic dependence on the industry, as when a company is not diversified and so relies on the industry for its income.
- 25. The Bargaining Power of Buyers Buyers can be viewed as a competitive threat when they force down prices or when they demand higher quality and better service (which increase operating costs). Alternatively, weak buyers give a company the opportunity to raise prices and earn greater returns. According to Porter, buyers are most powerful in the following circumstances:
- 26. • When the supply industry is composed of many small companies and the buyers are few in number and large. These circumstances allow the buyers to dominate supply companies. • When the buyers purchase in large quantities. In such circumstances, buyers can use their purchasing power as leverage to bargain for price reductions. • When the supply industry depends on the buyers for a large percentage of its total orders.
- 27. • When the buyers can switch orders between supply companies at a low cost, thereby playing off companies against each other to force down prices. • When it is economically feasible for the buyers to purchase the input from several companies at once. • When the buyers can use the threat to supply their own needs through vertical integration as a device for forcing down prices.
- 28. The Bargaining Power of Suppliers Suppliers can be viewed as a threat when they are able to force up the price that a company must pay for input or reduce the quality of goods supplied, thereby depressing the company's profitability. Alternatively, weak suppliers give a company the opportunity to force down prices and demand higher quality. According to Porter, suppliers are most powerful in the following circumstances:
- 29. • When the product that suppliers sell has few substitutes and is important to the company. • When the company's industry is not an important customer to the suppliers. In such instances, the suppliers' health does not depend on the company's industry, and suppliers have little incentive to reduce prices or improve quality. • When suppliers' respective products are differentiated to such an extent that it is costly for a company to switch from one supplier to another. In such cases, the company depends on its suppliers and cannot play them off against each other.
- 30. • When, to raise prices, suppliers can use the threat of vertically integrating forward into the industry and competing directly with the company. • When buying companies cannot use the threat of vertically integrating backward and supplying their own needs as a means to reduce input prices.
- 31. The Threat of Substitute Products The existence of close substitutes presents a strong competitive threat, limiting the price a company can charge and thus its profitability. However, if a company's products have few close substitutes (that is, if substitutes are a weak competitive force), then, other things being equal, the company has the opportunity to raise prices and earn additional profits.