The Effects of the Economic Environment on Strategy

By Fathi Salem Mohammed, MBA

2009

Introduction:Strategy is the direction and scope of an organization over the long term, which achieves advantage in a changing environment through its configuration of resources and competences with the aim of fulfilling stockholder expectations. An organization's objectives are the overall plans for the firm as defined by management. Management attempts to achieve these objectives by developing strategies. Achieving management's objectives is always subject to business risks faced by the firm. Business risk is the risk that the organization will fail to achieve its objectives, these risks can arias from any of the factors affecting the organization and its environment, such as new technology eroding an organization's competitive advantage, or an organization failing to execute its strategies as well as its competitors. A comprehensive understanding of the organization’s internal and external environments is necessary for management to understand the organization’s present condition and its business risks. This understanding includes comprehension of the macro-environment and industry environments.

Layers of the business environment:1. The Macro-Environment is the highest-level layer. This consist of broad environment

factors that impact to greater or lesser extent on almost all organizations. Here, the PESTEL framework can be used to identify how future trends in political, economic, social, technological, environment (green) and legal environments might impinge on organizations.

1.1. PESTEL analysis (see Illustration 1) is a useful tool for understanding the “big picture” of the environment, in which you are operating, and the opportunities and threats that lie within it. By understanding the environment in which you operate (external to your company or department), you can take advantage of the opportunities and minimize the threats. Specifically the PEST or PESTLE analysis is a useful tool for understanding risks associated with market growth or decline, and as such the position, potential and direction for a business or organization.

2. The Industry EnvironmentEconomic theory defines an industry as ‘a group of firms producing the same principal product’ or, more broadly, ‘a group of firms producing products that are close substitutes for each other’. This concept of an industry can be extended into the public services through the idea of a sector. This section looks at Michael Porter’s five forces framework for industry analysis.2.1. Porter’s five forces framework (Competitive forces) was originally developed as a

way of assessing the attractiveness (profit potential) of different industries. The five forces constitute an industry’s ‘structure’ (see Illustration 2). The five forces are: the threat of entry into an industry; the threat of substitutes to the industry’s products or services; the power of buyers of the industry’s products or services; the power of suppliers into the industry; and the extent of rivalry between competitors in the industry. Porter’s essential message is that where these five forces are high, then industries are not attractive to compete in. There will be too much competition, and too much pressure, to allow reasonable profits.

The industry environment directly affects the firm and the types of strategies it must develop to compete. It is most relevant to the firm’s profit potential. Management attempts to position the firm where it can influence the industry factors and successfully defend against their influence. Remember, management has little or no control over the general environment factors but through its actions may have significant influence over industry factors. Generally, the larger the firm’s market share the more influence it can have on its industry environment.

Since firms must make strategic decisions that involve long-term commitments (e.g., investments in technology, plant, etc.), management must not only deal with the current environment, it must forecast the future. Effective management must analyze and forecast the general environment to identify opportunities and threats to the firm. In doing so, the following techniques are used:a. Scanning—A study of all segments in the general environment. The objective is to predict the effects of the general environment on the firm’s industry. Management can use this information to modify its strategies and operating plans. Scanning of the general environment is critical to firms in volatile industries. Sources of information for scanning include trade publications, newspapers, business publications, public polls, government publications, etc.

b. Monitoring—A study of environmental changes identified by scanning to spot important trends. As an example, the trend in aging of the population in this country would definitely be important to firms that provide services to retired individuals. Effective monitoring involves identifying the firm’s major stakeholders (e.g., customers, investors, employees, etc.).

c. Forecasting—Developing probable projections of what might happen and its timing. As an example, management might attempt to forecast changes in personal disposable income or the timing of introduction of a major technological development.

d. Assessing—Determining changes in the firm’s strategy that are necessary as a result of the information obtained from scanning, monitoring, and forecasting. It is the process of evaluating the implications of changes in the general environment on the firm.

2.1.1 Implications of five forces analysisThe five forces framework provides useful insights into the forces at work in the industry or sector environment of an organisation. It is important, however, to use the framework for more than simply listing the forces. The bottom-line is an assessment of the attractiveness of the industry. The analysis should conclude with a judgment about whether the industry is a good one to compete in or not.The analysis should next prompt investigation of the implications of these forces, for example:● Which industries to enter (or leave)? The fundamental purpose of the fiveforces model is to identify the relative attractiveness of different industries:industries are attractive when the forces are weak. Managers should investin industries where the five forces work in their favour and avoid or disinvestfrom markets where they are strongly against.● What influence can be exerted? Industry structures are not necessarily fixed,but can be influenced by deliberate managerial strategies. For example,organizations can build barriers to entry by increasing advertising spend toimprove customer loyalty. They can buy up competitors to reduce rivalryand increase power over suppliers or buyers. Influencing industry structureinvolves many issues relating to competitive strategy.

2.1.2 Key issues in using the five forces frameworkThe five forces framework has to be used carefully and is not necessarily complete,even at the industry level. When using this framework, it is important tobear the following three issues in mind:● Defining the ’right’ industry. Most industries can be analysed at different levels. For example, the airline industry has several different segments such as domestic and long haul and different customer groups such as leisure, business and freight.

The competitive forces are likely to be different for each of these segments and can be analysed separately. It is often useful to conduct industry analysis at a disaggregated level, for each distinct segment. The overall picture for the industry as a whole can then be assembled.● Converging industries. Industry definition is often difficult too because industry boundaries are continuously changing. For example, many industries, especially in high-tech arenas, are undergoing convergence, where previously separate industries begin to overlap or merge in terms of activities, technologies, products and customers. Technological change has brought convergence between the telephone and photographic industries, for example, as mobile phones increasingly include camera and video functions. For a camera company like Kodak, phones are increasingly a substitute and the prospect of facing Nokia or Samsung as direct competitors is not remote.● Complementary products. Some analysts argue for a ‘sixth force’, organizations supplying complementary products or services. These complementors are players from whom customers buy complementary products that are worth more together than separately. Thus Dell and Microsoft are complementors in so far as computers and software are complementary products for buyers. Microsoft needs Dell to produce powerful machines to run its latest generation software. Dell needs Microsoft to work its machines. Likewise, television programme makers and television guide producers are complements. Complementors raise two issues. The first is that complementors have opportunities for cooperation. It makes sense for Dell and Microsoft to keep each other in touch with their technological developments, for example. This implies a significant shift in perspective. While Porter’s five forces sees organisations as battling against each other for share of industry value, complementors may cooperate to increase the value of the whole cake. The second issue, however, is the potential for some complementors to demand a high share of the available value for themselves. Microsoft has been much more profitable than the manufacturers of complementary computer products and its high margins may have depressed the sales and margins available to companies like Dell. The potential for cooperation or antagonism with such a complementary ‘sixth force’ needs to be included in industry analyses.

2.2 The industry life cycleThe power of the five forces typically varies with the stages of the industry life cycle. The industry life cycle concept proposes that industries start small in their development stage, then go through period of rapid growth (the equivalent to ‘adolescence’ in the human life cycle), culminating in a period of ‘shakeout’.The final two stages are first a period of slow or even zero growth (‘maturity’), before the final stage of decline (‘old age’). Each of these stages has implications for the five forces.The development stage is an experimental one, typically with few players exercising little direct rivalry and highly differentiated products. The five forces are likely to be weak, therefore, though profits may actually be scarce because of high investment requirements. The next stage is one of high growth, with rivalry low as there is plenty of market opportunity for everybody.Buyers may be keen to secure supplies and lack sophistication about what they are buying, so diminishing their power. One downside of the growth stage is that barriers to entry may be low, as existing competitors have not built up much scale, experience or customer loyalty. Another potential downside is the power of suppliers if there is a shortage of components or materials that fast growing businesses need for expansion. The shake-out stage begins as the growth rate starts to decline, so that increased rivalry forces the weakest of the new entrants out of the business. In the maturity stage, barriers to entry tend to increase, as control over distribution is established and economies of scale and

experience curve benefits come into play. Products or service tend to standardise. Buyers may become more powerful as they become less avid for the industry’s products or services and more confident in switching between suppliers.For major players, market share is typically key to survival, providing leverage against buyers and competitive advantage in terms of cost. Finally, the decline stage can be a period of extreme rivalry, especially where there are high exit barriers, as falling sales force remaining competitors into dog-eat-dog competition. Exhibit 1 summarises some of the conditions that can be expected at different stages in the life cycle.

2.3 Comparative industry structure analysesThe industry life cycle notion underlines the need to make industry structure analysis dynamic. One effective means of doing this is to compare the five forces over time in a simple ‘radar plot’.Exhibit 2 provides a framework for summarising the power of each of the five forces on five axes. Power diminishes as the axes go outwards. Where the forces are low, the total area enclosed by the lines between the axes is large; where the forces are high, the total area enclosed by the lines is small. The larger the enclosed area, therefore, the greater is the profit potential. In Exhibit 2.4, the industry at Time 0 (represented by the bright blue lines) has relatively low rivalry (just a few competitors) and faces low substitution threats.The threat of entry is moderate, but both buyer power and supplier power are relatively high. Overall, this looks only a moderately attractive industry to invest in. However, given the dynamic nature of industries, managers need to look forward, here five years represented by the dark blue lines in Exhibit 2.4.11Managers are predicting in this case some rise in the threat of substitutes (perhaps new technologies will be developed). On the other hand, they predict a falling entry threat, while both buyer power and supplier power will be easing.Rivalry will still further reduce. This looks like a classic case of an industry in which a few players emerge with overall dominance. The area enclosed by the dark blue lines is large, suggesting a relatively attractive industry. For a firm confident of becoming one of the dominant players, this might be an industry well worth investing in.

2.4 Techniques for industry analysis. Firms use a variety of techniques to analyze their industries. In this section we will describe three of those techniques, competitor analysis, price elasticity analysis, and target market analysis.2.4.1 Competitor analysis. In formulating strategy, management must consider the strategies of the firm’s competitors. Competitor analysis is of vital importance to devising strategies in concentrated industries. Competitor analysis involves two major activities: (1) gathering information about competitors’ capabilities, objectives, strategies, and assumptions (competitor intelligence), and (2) using the information to understand the competitors’ behavior. Management uses a number of sources of information for competitor analysis including the competitor’s• Annual reports and SEC filings• Interviews with analysts• Press releases

However, management must also consider information derived from the actions of the competitor such as the following:• Research and development projects• Capital investments• Promotional campaigns• Strategic partnerships• Mergers and acquisitions• Hiring practices

In a competitor analysis, management seeks to understand• What are the competitor’s objectives?• What can and is the competitor doing based on its current strategy?• What does the competitor assume about the industry?• What are the competitor’s strengths and weaknesses?

Information from the analysis of the competitor’s objectives, assumptions, strategy and capabilities can be developed into a response profile of possible actions that may be taken by the competitor under varying circumstances. This will allow management to anticipate or influence the competitor’s actions to the firm’s advantage.

2.4.2 Price elasticity analysis

Price elasticity is measured as the percentage change in demand given a percentage change in price and is described as follows:

Example:

Let’s assume you have been watching a product for a few months and have been counting the number of the product sold at different prices. You find that when the price is $3.00, 75 units are sold. When the price is raised to $3.25, only 60 units are sold. Calculate the product’s price elasticity of demand.

Answer:

There are two important implications of this calculation: 1. Notice that the elasticity is negative. This means that prices and quantity demanded move in

opposite directions. As price increases, demand decreases, and as price decreases, demand increases.

2. The percentage change in quantity demanded is 2.8 times the percentage change in price. This product is fairly elastic, meaning the demand for the good is strongly affected by its price. There are other goods, for example gasoline for your car, that are much less sensitive to price changes. Another example is food. Since people must eat, the amount consumed might be virtually unaffected by price changes. Note, however, that consumers will begin to substitute lower cost foods for the ones with the greatest increases (e.g., chicken for beef).

     When elasticity is greater than 1, demand is said to be elastic.           When elasticity is less than 1, demand is inelastic.

In order to develop a pricing strategy, management may perform price elasticity analysis of product or service. By observing the effects of price changes management can obtain a better understanding of the relationship. Regression analysis may be used to perform a more sophisticated analysis.

2.4.3 Target market analysis.(1) A firm’s target market is the market in which the firm actually sells or plans to sell its product or services. A thorough understanding of the market is key to accurate sales forecasts. Just defining the market in geographic terms is not enough. Management should perform target market analysis to understand exactly who the firm’s customers are. Management needs to understand why customers purchase the firm’s product or service. For an individual customer the purpose might be to satisfy a basic need, to make things easier, or for entertainment. Target market analysis generally involves market segmentation, which involves breaking the market into groups that have different levels of demand for the firm’s product or service. For example, a clothing store like the GAP, that sells clothing primarily for teens, is interested in the size of the segment of the market—the number of teens in the geographical area that the store serves. Segmentation may be performed along any dimension that defines the firm’s market, including(a) Demographics (e.g., sex, education, income, etc.)(b) Psychographics (e.g., lifestyle, social class, opinions, activities, attitudes, etc.)

(2) If the firm’s customers are businesses, segmentation might be performed in terms of other relevant dimensions including(a) Industry(b) Size (in terms of sales, total employees, etc.)(c) Location(d) How they purchase (e.g., seasonality, volume, who makes the purchasing decision)Unlike individuals, businesses purchase products to increase revenue, decrease costs, or maintain status quo.

(3) Target market analysis may be essential to the firm’s success. The greater the understanding management has of the firm’s market, the more effective it can be at making marketing decisions.Advertising, for example, can be tailored to particular market segments. The firm may even be able to use differential pricing in which they charge different prices to different market segments. As an example, airlines have long attempted to develop fare schedules and restrictions that segment the business traveler from the vacation traveler because the business traveler will generally pay more for a ticket.

3. Developing and Implementing StrategiesIn developing business strategies, management will often begin with a SWOT (strengths, weaknesses, opportunities and threats) analysis that evaluates the strengths and weaknesses of the firm as well as its opportunities and threats. This evaluation is then used to develop strategies to minimize risks and take advantage of major opportunities. This analysis is usually displayed in a SWOT matrix.SWOT analysis summarises the key issues from the business environment and the strategic capability of an organisation that are most likely to impact on strategy development. This can also be useful as a basis against which to judge future courses of action. The aim is to identify the extent to which the current strengths and weaknesses are relevant to, and capable of, dealing with the changes taking place in the business environment. It can also be used to assess whether there are opportunities to exploit further the unique resources or core competences of the organisation. Overall a SWOT analysis should help focus discussion on future choices and the extent to which an organisation is capable of supporting these strategies.

The SWOT matrix (TWOS matrix) is used to generate strategic options by building directly on the information about the strategic position that is summarised in a SWOT analysis. In this sense the TOWS matrix not only helps generate strategic options it also addresses their suitability. Each box of the TOWS matrix is used to identify options that address a different combination of the internal factors (strengths and weaknesses) and the external factors (opportunities and threats). For example, the top left-hand box should list options that use the strengths of the organisation to take advantage of opportunities in the business environment. In contrast the bottom right-hand box should list options that minimise weaknesses and also avoid threats.

Business strategies are generally classified as being product differentiation or cost leadership.1. Product differentiation. Product differentiation involves modification of a product to make it more attractive to the target market or to differentiate it from competitors’ products. Products may be differentiated in the following ways:

Physical characteristics (e.g., aesthetics, durability, reliability, performance, serviceability, features,

etc.) Perceived differences (e.g., advertising, brand name, etc.) Support service differences (e.g., exchange policies, assistance, after-sale

support, etc.)

By differentiating its products, the firm may be able to charge higher prices than its competitors or higher prices for the same products sold in different market segments.

2. Cost leadership. Striving for cost leadership fundamentally involves focusing on reducing the costs and time to produce, sell, and distribute a product or service. A number of techniques are used to attempt to reduce costs and time, including process reengineering, lean manufacturing (production), supply chain management, strategic alliances, and outsourcing.

Process reengineering involves a critical evaluation and major redesign of existing processes to achieve breakthrough improvements in performance. Process reengineering differs from total quality management (TQM) in that TQM involves gradual improvement of processes, while reengineering often involves radical redesign and drastic improvement in processes. Many of the significant improvements in processes over the

last few years have been facilitated with innovations in information technology.

Lean manufacturing is a management technique that involves the identification and elimination of all types of waste in the production function. Operations are reviewed for those components, processes, or products that add cost rather than value. A basic premise underlying lean manufacturing is by focusing on improving design, increasing flexibility, and reducing time, defects, and inventory, costs can be minimized.

Supply chain management. (1) The term supply chain describes the flow of goods, services, and information from basic raw materials through the manufacturing and distribution process to delivery of the product to the consumer, regardless of whether those activities occur in one or many firms. Supply chain also called value delivery network.

EXAMPLE: A supply chain is illustrated below.

As shown, the firm’s operations include only the assembly and distribution processes.Other firms supply raw materials, perform subassembly, and are the resellers of the final product. In viewing the supply chain, it is critical to go beyond the firm’s immediate suppliers and customers to encompass the entire chain.(2) To improve operations and manage the relationships with their suppliers many firms use a process known as supply chain management. A key aspect of supply chain management is the sharing of key information from the point of sale to the final consumer back to the manufacturer, the manufacturer’s suppliers, and the suppliers’ suppliers. As an example, if a manufacturer/distributor shares its sales forecasts with its suppliers and they in turn share their sales forecasts with their suppliers, the need for inventories for all firms is significantly decreased.The manufacturer/distributor, for example, needs far less raw materials inventory than normally would be the case because its suppliers are aware of the manufacture’s projected needs and is prepared to have the materials available when needed. Specialized software facilitates this process of information sharing along the supply chain network.

(3) Supply chain management also focuses on improving processes to reduce time, defects, and costs all along the supply chain. By focusing on the entire supply chain, management may evaluate the full cost of inefficient processes, defective materials, and inaccurate forecasts of sales.

(4) However, supply chain management presents the company with a number of problems and risks including those arising from(a) Incompatible information systems(b) Refusal of some companies to share information(c) Failure of suppliers or customers to meet their obligations.

3.1 Methods of Pursuing StrategiesA Strategic method is the means by which a strategy can be pursued. These methods can be divided into three types:

3.1.1 Organic Development is where strategies are developed by building on and developing an organisation's own capabilities. For many organisations, internal development (sometimes known as 'internal development') has been the primary method of strategy development for several reasons:

For products that are highly technical in design or method of manufacture, businesses may choose to develop new products themselves, since the process of development is seen as the best way of acquiring the necessary capabilities to compete successfully in the marketplace.

A similar argument may apply to the development of new markets by direct involvement. Market knowledge may be a core competence creating competitive advantage over other organisations that are more distant from their customers.

Although the final cost of developing new activities internally may be greater than that of acquiring other companies, the spread of cost over time may be more favourable and realistic. Also the slower rate of change which internal development brings may also minimise the disruption to other activities.

An organisation may have no choice about how new ventures are developed. In many instances those breaking new ground may not be in a position to develop by acquisition or joint development, since they are the only ones in the field.

Internal development also may avoid the often traumatic political and cultural problems arising from post-acquisition integration and coping with the different traditions and incompatible expectations of two organisations.

3.1.2 Mergers and AcquisitionsAcquisition is where strategies are developed by taking over ownership of another organisation. There are many different motives for developing through acquisition or merger:

The speed with which it allows the company to enter new product or market areas. The competitive situation may influence a company to prefer acquisition. In markets that

are static and where market shares of companies are reasonably steady, it can be a difficult proposition for a new company to enter the market, since its presence may create excess capacity. If, however, the new company enters by acquisition, the risk of competitive reaction is reduced.

Deregulation was a major driving force behind merger and acquisition activities where regulation had created a level of fragmentation that was regarded as sub-optimal.

There may be financial motives for acquisitions. If the share value or price/earnings (P/E) ratio of a company is high, the motive may be to spot and acquire a firm with a low share value or P/E ratio.

An acquisition may provide the opportunity to exploit an organisation's core competences in a new arena.

Cost efficiency is a commonly stated a reason for acquisitions (by cutting out duplication or by gaining scale advantages).

Learning can be an important motive. Institutional shareholders may expect to see continuing growth and acquisitions may be a

quick way to deliver this growth. Growth through acquisitions can also be very attractive to ambitious senior managers as

it speeds the growth of the company. There are some stakeholders whose motives are speculative rather than strategic. They

favour acquisitions that might bring a short-term boost to share value.

A strategic alliance is where two or more organisations share resources and activities to pursue a strategy. Strategic alliances involve collaborative agreements between two or more firms. They may be organized as joint ventures, equity ventures, equity investments, or simple agreements (such as comarketing or codevelopment agreements). Firms enter into strategic alliances for a number of reasons, including to(1) Refocus the firm’s efforts on its core competencies and value creation activities(2) Speed innovation(3) Compensate for limited resources(4) Reduce risk.

4. Estimating the Effects of Economic ChangesSuccessful management involves being able to anticipate changes in economic conditions and competitor actions and devising strategies and plans to react to those changes. To begin with, management must thoroughly understand the effects of economic changes on the firm. “How will demand for the firm’s products or services be affected?” and “How will the change affect the firm’s costs?” are key questions. In order to estimate the effects, management will collect and analyze historical data. Quantitative techniques such as regression analysis may be used. Management will also examine the effects of any competitor analysis that has been performed. The following table illustrates the process.

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