The firm's external environment consists of three main sectors: the Remote Environment, the Industry Environment, and the Operating Environment. All of these environmental sectors affect the firm's operations both on an international and domestic level.
The Remote Environment comprises five factors that are not influenced by a single firm. The main factors are: economic, social, political, technological, and ecological. These factors must be considered by the firm when working with the market.
The Industry Environment is made up of the entry barriers, supplier power, buyer power, substitute availability, and competitive rivalry. These contending forces are of the greatest importance to the firm in strategy formulation.
In dealing with the threat of entry there are six major barriers: economies of scale, product differentiation, capital requirements, cost disadvantages independent of size, access of distribution channels, and government policies. These can be overcome or dealt with individually, but some firms are not able to handle them and fail.
A supplier becomes powerful when it purchases in large quantities, the products purchased are not differentiated, the products purchased represent a significant cost of their product, the product does not save the buyer money, or the buyer poses a credible threat of backward integration.
A buyer becomes powerful if it is concentrated or purchases in large volume, the product purchased is standard or undifferentiated, the product purchased represents a significant portion of the cost, it earns low profits, quality is not a factor, the product purchased does not save the buyer money, or the buyer poses a credible threat of integrating backward.
Substitute products become a problem if a firm cannot differentiate the product or service in some way (i.e. cost or quality).
Jockeying for position by competitors becomes intense when competitors are numerous, industry growth is slow, product or service lacks differentiation, fixed costs are high or the product is perishable, capacity is augmented in large increments, exit barriers are high, and/or the rivals are diverse in strategies, origins, and "personalities."
The Operating Environment is also called the competitive or task environment. This sector of the external environment deals closely with competitors, creditors, customers, labor, and suppliers. In assessing the competitive position of the firm, the following criteria are usually dealt with: Market share, breadth of product line, effectiveness of sales distribution, proprietary and key-account advantages, price competitiveness, advertising promotion effectiveness, location and age of facility, capacity and productivity, experience, raw material costs, financial position, relative product quality, R&D advantages/position, caliber of personnel, and general images.
When determining customer profiles a firm uses the following types of information: Geographic, demographic, psychographic, and buyer behavior. Relationships with suppliers are important to a firm.
The firm relies on suppliers for financial support, services, materials, equipment, handling special requests, quick delivery, liberal credit terms, and broken-lot orders. Creditors are another viable member of the operational environment because the size and dollar amounts that the firm needs may require it to deal on credit.
There are some necessary considerations with the firm's creditors: Will they accept the firm's stock as collateral, is there a perceived acceptable payment record, strong working capital, loan terms that are comparable to others, and are the creditors able to extend a large enough line of credit.
In the area of human resources the firm's ability to obtain needed personnel is affected by three factors: reputation, employment rates, and availability of people with the needed skills.
Competitive advantage is a company's ability to outperform its competitors.
Competitive advantage can be achieved through low cost and differentiation. A company is said to have achieved competitive advantage when its profit rate is higher than the average for its industry. The profit rate is based on return of sales (ROS) or return of assets (ROA).
The most basic determinant of a firm's profit rate is the gross profit margin. There are three reasons why a firm's gross profit margin may be higher: the unit price is higher, unit cost is lower, or it has both a higher price and a lower unit cost. When a firm charges a premium price or differentiates its product, it is using generic business-level strategies, according to Michael Porter.
The building blocks of competitive advantage are efficiency, quality, innovation, and customer responsiveness. These building blocks are generic in that they provide four basic ways to lower cost and achieve differentiation. Any firm can adopt these no matter what industry it is in or what product or service it provides.
Efficiency is based on the cost of inputs required to produce a given output. The more efficient a firm, the lower the cost of its inputs required to produce a given output. Efficiency helps a firm attain a low-cost competitive advantage. Employee productivity can be the key to efficiency.
The impact of high product quality on competitive advantage is the creation of a brand name reputation, greater efficiency and, thus, lower costs. This enhanced reputation allows the firm to charge a higher price. At the same time the costs are down so profits are much higher, thus a higher competitive advantage. Quality has become imperative for survival in some firms.
Innovation is defined as anything new or novel about a firm's operation or product. Innovation gives a firm something unique. When a firm is the pioneer in its industry it can charge a higher price because of a lack of competition. Later, when there is competition, newcomers must deal with the pioneer's reputation.
To achieve customer responsiveness a firm must deliver exactly what the customer wants when the customer wants it. A firm must do everything it can to identify and satisfy customer needs. Steps taken to improve quality and efficiency are consistent with the goal of high customer responsiveness. There may be a need to customize goods and services to meet the demands of individual customers. Customer response time has become a big factor in increasing customer responsiveness. Other areas that aid in achieving higher customer responsiveness are superior design, superior service, and superior after-sales service and support.
Distinctive competencies come from two sources: resources and capabilities. These sources are both tangible and intangible. To achieve distinctive competency, a firm's resources must be both unique and valuable. A company's capabilities refer to its skills at coordinating resources and putting them to productive use. A company needs to develop strategies that build on existing resources and capabilities as well as build additional resources and capabilities.
The durability of a firm's competitive advantage depends on three factors: the height of barriers to imitation, capability of competitors, and dynamism of the industry. Barriers to imitation are the factors that make it difficult for a competitor to copy a firm's distinctive competencies. The major determinant of the capability of a competitor is its prior strategic commitments. A dynamic industry changes rapidly, thus it has a high rate of product innovation.
Companies fail for three related reasons: inertia, prior strategic commitments, and the Icarus Paradox. The inertia argument is that firms find it difficult to change their strategies and structures to adapt to changing competitive conditions. Prior strategic commitments not only limit a firm's ability to imitate its competitors but may also put it at a competitive disadvantage. The Icarus Paradox occurs when a firm becomes so dazzled by its early success that its believes more of the same effort is the way to future success.
To avoid failure a firm must focus on the building blocks of competitive advantage. A firm must identify the best industrial practice and adopt it. The best way to determine the best industrial practice is through benchmarking. Finally a firm must overcome inertia to survive.
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Copyright © Merri Incitti and Marilyn Shaw
This page last updated November 1995
The text of this chapter summary is original, but based loosely on introductory chapters in "Strategic Management An Integrated Approach," Third Edition, by Charles W. L. Hill and Gareth R. Jones, published by Houghton Mifflin, 1995, and in "Strategic Management: Formulation, Implementation & Control,'' by John A. Pearce II and Richard B. Robinson Jr., published by Irwin, 1995.
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