Learning outcomes
After this session, you should have a solid understanding of
- the nature and purpose of an external audit in formulating strategies;
- major external forces that impact organizations;
- Porter’s Five-Forces Model and its relevance in formulating strategies;
- the impact of climate change on firms and strategies to cope with its effect;
- Megatrends, their identification and impact on strategic management;
- practical solutions for increasing robustness of strategic decisions,
- as well as the development and use of an External Factor Evaluation (EFE) matrix.
External audit
Overview
The essence of strategy formulation is coping with competition. Competition is caused not only by other players, but also by the broader environment (e.g., the underlying economics/structure of the industry) (Mintzberg 2014). The external strategic management audit1 focuses on identifying and evaluating environmental trends and events beyond the control of a single firm (David and David 2016).
The purpose of an external audit is to develop a finite list of opportunities that could benefit a firm as well as threats that should be avoided. As the term finite suggests, the external audit is not aimed at developing an exhaustive list of every possible factor that could influence the business; rather, it is aimed at identifying key variables that offer actionable responses.
Identifying and evaluating external opportunities and threats enables organizations to develop a clear mission, to design strategies to achieve long-term objectives, and to develop policies to achieve annual objectives. Firms should be able to respond either offensively or defensively to the factors by formulating strategies that take advantage of external opportunities or that minimize the impact of potential threats.
Key external forces
External forces can be divided into five broad categories:
- economic forces
- social, cultural, demographic, and environmental (S C D E) forces
- political, governmental, and legal forces
- technological forces
- competitive forces
When identifying and prioritizing key external factors in strategic planning, make sure the factors selected are (1) specific (i.e., quantified to the extent possible); (2) actionable (i.e., meaningful in terms of having strategic implications); and (3) stated as external trends, events, or facts rather than as strategies the firm could pursue (David and David 2016).
Key variables
Economic forces
Relevant economic variables such as those listed below must be quantified and actionable to be useful (David and David 2016, 222).
- Shift to service economy
- Availability of credit
- Level of disposable income
- Propensity of people to spend
- Interest rates
- Inflation rates
- GDP trends
- Consumption patterns
- Unemployment trends
- Currency rates
- Import/export factors
- Demand shifts for different goods and services
- Income differences by region and consumer group
- Price fluctuations
- Foreign countries’ economic conditions
- Monetary and Fiscal policy
- Stock market trends
- Tax rate variation by country and state
- Economic policies (e.g., OPEC policies)
Political, governmental, and legal forces
Local, state, and federal laws, as well as regulatory agencies and special-interest groups, can have a major impact on the strategies of small, large, for-profit, and nonprofit organizations (David and David 2016, 226).
- Environmental regulations
- Protectionist actions by countries
- Changes in patent laws
- Equal employment opportunity laws
- Level of defense expenditures
- Unionization trends
- Antitrust legislation
- Political conditions in countries
- Local, state, and federal laws
- Import-export regulations
- Tariffs
- Local, state, and national elections
Technological forces
New technologies such as AI, the Internet of Things, 3d printing, biotech, and robotics are fueling innovation in many industries, and impacting strategic-planning decisions (David and David 2016).
In high-tech industries, identification and evaluation of key technological opportunities and threats can be the most important part of the external strategic-management audit.
Competitive forces
An important part of an external audit is identifying rival firms and determining their strengths, weaknesses, capabilities, opportunities, threats, objectives, and strategies.
Key questions according to David and David (2016, 227):
- What are the strengths and weaknesses of our major competitors?
- What products and services do we offer that are unique in the industry?
- What are the objectives and strategies of our major competitors?
- How will our major competitors most likely respond to current economic, S C D E, political, governmental, legal, technological, and competitive trends affecting our industry?
- How vulnerable are the major competitors to our new strategies, products, and services?
- How vulnerable is our firm to successful counterattack by our major competitors?
- How does our firm compare to rivals in mastering the social-media conversation in this industry?
- To what extent are new firms entering and old firms leaving this industry?
- What key factors have resulted in our present competitive position in this industry?
- How are supplier and distributor relationships changing in this industry?
Visualization
Porter’s Five-Forces Model
Overview
Porter’s Five-Forces Model of competitive analysis is a widely used approach for developing strategies in many industries (Porter 1986).
According to Porter (1986), the state of competition in an industry depends on five basic forces. The collective strength of these forces determines the ultimate profit potential of that industry.
Knowledge/analysis of the underlying sources of competitive pressures provides the groundwork for effective strategic courses of action.
Visualization
Contending forces
Threat of entry
New entrants bring new capacity, substantial resources and a desire to gain market share from the incumbents.
The seriousness of the threat of entry depends on the barriers of entry.
There are six major sources of barriers to entry:
- Economies of scale
- Product differentiation
- Capital requirements
- Cost disadvantages independent of size
- Access to distribution channels
- Government policy
It seems reasonable to posit that a new entrant will be deterred if:
- Incumbents have previously attacked new entrants.
- Incumbents possess substantial resources to fight back – excess cash, unused borrowing power, productive capacity, clout with distribution channels and customers.
- Incumbents can cut prices to keep market share.
- There is industry-wide excess capacity.
- Industry growth is slow.
Powerful suppliers and buyers
Suppliers can exert bargaining power on industry players by raising prices, or reducing the quality of goods/services. A supplier group is powerful if:
- It is dominated by a few companies and is more concentrated than the industry it sells to.
- Its product is unique, differentiated or if it has built up switching costs.
- It is not obliged to contend with other products for sale to the industry.
- It poses a credible threat of integrating forward into the industry’s business.
- The industry is not an important customer of the supplier group.
Similarly, customers can force down prices, demand higher quality/more service or play competition off against each other. A buyer group is powerful if:
- It is concentrated or purchases in large volumes.
- The products it purchases from the industry are standard/undifferentiated.
- The purchases form a component of its own product, and represent a significant fraction of its cost.
- It earns low profits, and has an incentive to lower its purchasing costs.
- The industry’s product is unimportant to the quality of the buyer’s products/services.
- The industry’s product does not save the buyer money.
- Buyers pose a credible threat of integrating backward.
Substitute products
Substitute products/services limit the potential of an industry by placing a ceiling on the prices that can be charged. The more attractive the price-performance trade-off offered by substitute products, the greater the impact on the industry’s profitability.
Substitute products that deserve the most attention strategically are those that:
- are subject to trends improving their price-performance trade-off with the industry’s product and
- are produced by industries earning high profits.
Tactics
Maneuvers such as price competition, product introductions, advertising battles, etc. are often used by rivals jockeying for position (i.e., “ploys”).
Intense rivalry is related to the presence of a number of factors:
- Competitors are numerous, or are roughly equal in size and power
- Industry growth is slow, precipitating fights for market share
- The product/service lacks differentiation or switching costs
- Fixed costs are high, or the product is perishable
- Capacity is normally augmented in large increments
- Exit barriers are high
- Rivals are diverse in strategies, origins and ‘personalities’
Megatrends
Overview
The concept of megatrends in strategic management refers to long-term, global, and transformative trends that significantly impact various aspects of society, the economy, industries, and organizations. These trends are characterized by their sustained and pervasive influence over many years, often spanning decades. Megatrends shape the business landscape, influence consumer behavior, drive technological innovation, and create both opportunities and challenges for businesses and other stakeholders.
Key characteristics and aspects of the concept of megatrends include:
- Long-term perspective: Megatrends unfold over extended periods, typically spanning 10 to 20 years or more. They represent enduring shifts in societal, economic, and technological dynamics.
- Global impact: Megatrends transcend geographical boundaries and affect countries, regions, and industries worldwide. They have a broad and pervasive reach.
- Transformational effects: Megatrends bring about fundamental changes and transformations in various domains, including demographics, technology, environment, politics, and culture. They reshape the way people live, work, and interact.
- Cross-industry relevance: Megatrends impact multiple industries and sectors, often requiring organizations to adapt, innovate, and adjust their strategies to remain competitive and relevant.
- Strategic implications: Organizations must consider megatrends in their strategic planning processes. Failure to do so can result in missed opportunities or exposure to risks associated with not aligning with the evolving landscape.
Examples
The Zukunftsinstitut identifies 12 long-term, transformative forces that impact all aspects of society, economy, and individual lives:
Globalisation, urbanization, silver society, health, new work, knowledge culture, connectivity, mobility, neo-ecology, individualisation, gender-shift, and security.
- Globalization: Increasing interconnectedness of the world through trade, communication, and cultural exchange.
- Urbanization: The growth of cities and the shift of populations from rural to urban areas.
- Silver Society: The aging population and the societal changes that come with it.
- Health: The growing focus on health and well-being, including advancements in medical technology and healthcare.
- New Work: Changes in the work environment, including remote work, flexible hours, and the gig economy.
- Knowledge Culture: The importance of knowledge and education in the modern world.
- Connectivity: The rise of digital connectivity and the internet of things.
- Mobility: Innovations in transportation and the movement of people and goods.
- Neo-Ecology: The shift towards sustainable and environmentally friendly practices.
- Individualization: The trend towards more personalized and individualized lifestyles.
- Gender Shift: Changes in gender roles and the move towards gender equality.
- Security: The increasing focus on safety and security in various aspects of life.
Excursus: Two-way door decisions
Some decisions are consequential and irreversible or nearly irreversible – one-way doors – and these decisions must be made methodically, carefully, slowly, with great deliberation and consultation. If you walk through and don’t like what you see on the other side, you can’t get back to where you were before. We can call these Type 1 decisions. But most decisions aren’t like that – they are changeable, reversible – they’re two-way doors. If you’ve made a suboptimal Type 2 decision, you don’t have to live with the consequences for that long. You can reopen the door and go back through. Type 2 decisions can and should be made quickly by high judgment individuals or small groups. Jeff Bezos, 2015 Letter to the shareholders
A two-way door decision is a concept popularized by Jeff Bezos, referring to decisions that are easily reversible. If you make a two-way door decision and it turns out to be wrong, you can simply “walk back through the door” and return to your previous state without significant consequences.
Implications for strategic management:
- Flexibility and agility: Two-way door decisions allow organizations to be more flexible and agile. Since these decisions can be reversed, they encourage experimentation and innovation without the fear of long-term negative impacts.
- Speed of decision-making: These decisions can be made quickly, enabling faster responses to market changes and opportunities. This can be a significant competitive advantage in dynamic industries.
- Risk management: By distinguishing between one-way (irreversible) and two-way (reversible) decisions, companies can allocate resources and attention more effectively. Critical, irreversible decisions can be given the thorough analysis they require, while reversible decisions can be made swiftly.
- Empowerment: employees can be empowered to make two-way door decisions on their own, fostering a culture of trust and autonomy. This can lead to higher job satisfaction and innovation.
The concept relates well to the idea of incremental decision-making, which involves making decisions through small, manageable steps rather than large, irreversible changes. This approach allows organizations to test and adjust their strategies incrementally, reducing the risk of significant failures.
EFE matrix
Purpose
An External Factor Evaluation (EFE) matrix allows strategists to summarize and evaluate economic, social, cultural, demographic, environmental, political, governmental, legal, technological, and competitive information.
The EFE matrix shows how the organization responds to existing opportunities and threats in its industries. Or, in other words, how the firm’s existing strategies effectively take advantage of existing opportunities and minimize the potential adverse effects of external threats.
Development
The following steps should be taken in order to create a EFE matrix:
- List the key external factors (grouped by opportunities and threats).
- Assign a weighting to the factors (on a scale of 0-100%).
- Rate the effectiveness of the current strategies on a scale of 1-4.
- Multiply the weight by the rating.
- Sum the weighted scores.
A total weighted score of 4.0 indicates that the organization is responding in an outstanding way to existing threats and opportunities in the industry.
Example
EFE matrix for a local 10-theater cinema complex
| Key External Factors | Weight | Rating | Score |
|---|---|---|---|
| Opportunities | |||
| 1. Two new neighborhoods developing within 3 miles | 0.09 | 1 | 0.09 |
| 2. TDB University is expanding 6% annually | 0.08 | 4 | 0.32 |
| 3. Major competitor across town recently closed | 0.08 | 3 | 0.24 |
| 4. Demand for going to cinemas growing 10% | 0.07 | 2 | 0.14 |
| 5. Disposable income among citizens up 5% in prior year | 0.06 | 3 | 0.15 |
| 6. Rowan County is growing 8% annually in population | 0.05 | 3 | 0.15 |
| 7. Unemployment rate in county declined to 3.1% | 0.03 | 2 | 0.06 |
| 8. Unemployment rate in county declined to 3.1% | 0.03 | 2 | 0.06 |
| Threats | |||
| 9. Trend toward healthy eating eroding concession sales | 0.12 | 4 | 0.48 |
| 10. Demand for online movies and DVDs growing 10% | 0.06 | 2 | 0.12 |
| 11. Commercial property adjacent to cinemas for sale | 0.06 | 3 | 0.18 |
| 12. TDB University installing an on-campus movie theater | 0.04 | 3 | 0.12 |
| 13. County and city property taxes increasing 25% | 0.08 | 2 | 0.6 |
| 14. Local religious groups object to R-rated movies | 0.04 | 3 | 0.12 |
| 15. Movies rented at local Red Box’s up 12% | 0.08 | 2 | 0.16 |
| 16. Movies rented last quarter from Time Warner up 15% | 0.06 | 1 | 0.06 |
| Total | 1.00 | 2.58 |
Mini Case
Anthropic2 is dedicated to developing AI systems that are safe and beneficial for society. The company is involved in various initiatives to ensure AI is used responsibly.
Apply what you have learned about external strategic audits and develop an EFE matrix that identifies and assesses the key external factors for Anthrophic.
- Divide into small groups to conduct a brief research and analysis.
- Use online resources to gather data on the AI industry, competitors, and external factors.
- Develop a (simplified) EFE mnatrix
- Prepare a presentation or report summarizing your matrix.
Review and consolidation
The following questions are designed to review and consolidate what you have learned and are a good starting point for preparing for the exam.
- Describe the nature and purpose of an external assessment in formulating strategies.
- How can robustness in strategic decision-making be increased?
- How can organizations assess the cost-effectiveness of their strategies and make informed decisions about resource allocation in light of the many uncertainties of our complex world?
- What is Porter’s Five-Forces Model and what is its relevance in formulating strategies?
- What are (legal) key sources of information for identifying opportunities and threats?
- Why is [a megatrend] considered as a megatrend? Justify your answer.
- Why must megatrends be considered in the process of strategy formulation and evaluation?
- Explain the significance of an EFE matrix total weighted score of 3.67 versus a 1.59.
- How have external factors resulted in a major overhaul to the traditional retail industry as we once knew it?
- Describe how political elections can be an important external factor for companies to consider. Select an industry and reveal some key political factors impacting firms.
- Explain how Facebook, Twitter, and Instagram can represent a major threat or opportunity for a company in different industries.
- Identify and explain a recent economic, social, political, or technological trend that significantly affects the HNU.
- Discuss the following statement: Major opportunities and threats usually result from an interaction among key environmental trends rather than from a single external event or factor.
- Do you agree with Porter’s view that competitive positioning within an industry is a key determinant of competitive advantage(s)?
- Why do anual reports often state external risk information in really vague terms; why should strategists avoid including such vagueness in external assessments (e.g., in developing an EFE Matrix)?
Homework
Read Peteraf (1993) and make notes on following questions:
- What is the Resource-Based View (RBV) of the firm, and how does it differ from other perspectives in strategic management?
- What are principal elements of a firm’s resources, as discussed in the paper?
Can you provide examples? - Please provide an explication of the concept of resource heterogeneity.
In what way is it regarded as a pivotal element in the determination of competitive advantage in accordance with the RBV? - What is the significance of the immobility of resources in the RBV?
To what extent is it a factor in the sustainability of competitive advantage? - Define dynamic capabilities and their role in the RBV.
How do dynamic capabilities enable firms to adapt and innovate over time? - Please describe the relationship between a firm’s resources, competitive advantage, and value creation for customers.
- How does the RBV contribute to our understanding of why some firms consistently outperform others in the marketplace?
- Please outline the implications of the paper for strategic management.
How can businesses leverage the insights from the RBV to enhance their competitiveness?
Literature
Footnotes
The external strategic management audit is sometimes also called environmental scanning or industry analysis.↩︎
You might also read an essay by Dario Amodei, the CEO of antrophic about “Machines of Loving Grace — How AI Could Transform the World for the Better”↩︎
Social, cultural, demographic, and environmental forces
SCDE-forces are shaping the way people live, work, produce, and consume, e.g. (David and David 2016, 224):