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Friday, 14 March 2014

Strategic analysis tools: PEST and Porter's Five Forces

PEST framework:

Political: These are political or legal factors affecting the organization, such as legislation or government policy, stability of the government, government attitudes to competition and so on.

Economic: These are economic factors such as tax rates, inflation, interest rates, exchange rates, consumer disposable income, unemployment levels and so on.
Social: These are social, cultural or demographic factors (i.e. population shifts, age profiles etc.) and refers to attitudes, value and beliefs held by people; also changes in lifestyles, education and health and so on.

Technological: These are changes in technology that an organization might use and impact on the way work is done, such as new system or manufacturing processes.

Some authors have expanded the mnemonic PEST into PESTEL- to include explicit reference to ethical or environmental and legal factors.

If you are asked to apply the PEST model to an organization, simply look for things that might affect the organization, and put each of them under the most appropriate heading. A brief explanation as to why you feel each activity creates either an opportunity or threat will suffice.

The competitive environment- five forces model:

As well as the general environmental factors, part of external analysis also requires an understanding of the competitive environment and what are likely to be the major competitive forces in the future. A well established framework for analyzing and understanding the nature of the competitive environment is Porter’s five forces model.

1.      Rivalry among existing firms;                      2.         Bargaining power of buyers;
3.      Bargaining power of suppliers.                                4.         Threat of new entrants;
1.      Threat of substitute products or services.

The collective strength of these forces determines the profit potential, defined as long run return on invested capital, of the industry. Some industries have inherently high profits due to the weakness of these forces. Others, where the collective force is strong, will exhibit low returns on investment.

The model can be used in several ways.

1.     To help management decide whether to enter a particular industry. Presumably, they would only wish to enter the ones where the forces are weak and potential returns high.

2.     To influence whether to invest more in an industry. For a firm already in an industry and thinking of expanding capacity, it is important to know whether the investment costs will be recouped. The present strength of the forces will be evident in present profits, so management will wish to forecast how the forces may change through time. Alternatively, they may decide to sell up and leave the industry now if they perceive the forces are strengthening.

3.     To identify what competitive strategy is needed. The model provides a way of establishing the factors driving profitability in the industry. These factors affect all the firms in the industry. For an individual firm to improve its profitability above that of its peers, it will need to deal with these forces better than they. If successful, it will enjoy a stronger share price and may survive in the industry longer. Both increase shareholder wealth.

Each of the five forces is explained below.

Threat of entry

Entrance can affect the profitability of the industry in two ways:

1.      Through the impact of actual entry. A new entrant will reduce profits in the industry by:

(a)        Reducing prices either as an entry strategy or as a consequence of increased industry capacity. There is also the danger that a price war may break out as rivals try to recover share or push out the new rival.

(b)        Increasing costs of participation of incumbents through forcing product quality improvements, greater promotion or enhanced distribution.

(c)        Reducing economies of scale available to incumbents by forcing them to produce at lower volumes due to loss of market share.
2.      By forcing firms to follow pre-emptive strategies to stop them from entering. In view of the above danger, firms may take action to forestall entry of new rivals by:

                   (a)        Charging an entry-deterring price which is so low as to make the market unattractive to new, and possible higher cost, rivals.

                   (b)        Maintenance of high capital barriers through deliberate investment in product or production technologies or in continuous promotion of research and development.

                               Porter suggests that the strength of the treat of market entry depends on the availability of barriers to entry against the entrant. These are:

             1.    Economies of scale. Incumbent firms will enjoy lower unit costs due to spreading their fixed costs across a larger output and through the ability to drive better bargains with their suppliers. This gives them the ability to charge prices below the unit costs of new entrants and hence render them unprofitable.

             2.    Product differentiation. If established firms have strong brands, unique product features or established good relations with customers, it will be hard for an entrant to rival these by a price reduction, and expensive and time consuming to emulate them.

             3.    Capital requirements. If large financial resources will be needed by a rival to enter, the effect will be to exclude many potential entrants. Porter argues this will be particularly effective if the investment is needed in dedicated capital assets with no alternative use or in promotion. Few would-be entrants will want to take the risk.
             4.    Switching costs. These are one-off costs for a customer, to switch to the new rival. If they are high enough, they will eliminate any price advantage the new rival may have. Examples include connection charges, termination costs, special service equipment and operator training costs.

             5.    Access to distribution channels. If the established firms are vertically integrated, this leaves the entrant needing either to bear the costs of setting up its own distribution or depending on its rivals for its sales. Both will reduce potential profits.

             6.    Cost advantages independent of Scale. These make the established firm to have lower costs. Examples are unique low-cost technologies, cheap resources, or experience effects (a fall in cost gained from having longer experience in the industry, usually influenced by cumulative production volume).

             7.    Government policy. Some national governments jealously guard their domestic industries by forbidding imports or using legal and bureaucratic techniques to stall import competition. Also, some governments prefer to allow existing firms to grow large to give them the economies of scale that they will need to compete in a global market. Therefore, they try to restrict industry competition.

             Pressure from substitute products:

             Substitute products are ones that satisfy the same need despite being technically dissimilar. Examples include aeroplanes and trains, e-mail and postal services, and soft drinks and ice cream.

             Substitutes affect industry profitability in several ways:

             1.    They put an upper limit on the prices the industry can charge without experiencing large-scale loss of sales to the substitute.

2.    They can force expensive product or service improvements on the industry.
3.      Ultimately, they can render the industry technologically obsolete.

The power of substitutes depends on:

1.    Relative price/Performance: A coach journey is cheaper than a rail journey which is in turn cheaper than a flight. However, coach is slower than a train. The trade-off is far less clear between e-mail and postal services for simple messages, since e-mail is both quicker and cheaper!

2.      The extent of switching costs.

Bargaining power of buyers:

Buyers use their power to trade around the industry participants to gain lower prices and/or improvements to product or service quality. This will impact on profitability. Their power will be greater if:

1.     Buyer power is concentrated in a few hands. This denies the industry any alternative markets to sell to if the prices offered by buyers are low.

2.     Products are undifferentiated. This enables the buyer to focus on price as the important buying criterion.

3.     The buyer earns low profits. In this situation, they will try to extract low prices for their inputs. This effect is enhanced if the industry’s supplies constitute a large proportion of the buyer’s costs.

4.     Buyers are aware of alternative producer prices. This enables them to trade around the market. Improvements in information technology have significantly increased this, by enabling a reduction in ‘search costs.’

5.     Low switching costs. In this case, the switching costs might include the need to change the final product specification to accept a different input or the adoption of a new ordering and payments system.

Bargaining power of Suppliers:

The main power of suppliers is to raise their prices to the industry and hence take over some of its profits for themselves. Power will be increased by:

1.     Supply industry dominated by a few firms: Provided that the buying industry does not have similar monopolistic firms, the supplier will be able to raise prices. For example, the ‘Wintel’ domination in personal computers developed because IBM did not insist on exclusive access to Microsoft’s operating systems or Intel’s processors.

2.     The suppliers have proprietary product differences. These unique features of images make it impossible for the industry to buy elsewhere. For example, branded food suppliers rely on this to offset the buyer power of the large grocery chains.

Rivalry among existing competitors:

Some industries feature cut-throat competition, while others are more relaxed. The latter have the higher profitability. Porter suggests that the factors determining competition are:

1.       Numerous rivals, such that any individual firm may suddenly reduce price and trigger a price war. If there are fewer firms of similar size, they will tend to, formally or informally, recognize that it is not in their interest to cut prices.

2.       Low industry growth rate. Where growth is slow, the participants will be forced to compete against one another to increase their sales volumes.

3.       High fixed or storage costs. The former, sometimes called operating gearing, put pressure on firms to increase volumes to take up capacity. Because variable costs are low, this is usually accomplished by cutting prices. This is common in transportation and telecommunications. Similarly, high storage costs are often the cause of a sudden dumping of stocks on to the market.

4.       Low differentiation or switching costs mean that price competition will gain customers and so be commonplace.

5.       High strategic stakes. This is where a lot depends on being successful in the market. Often this is because the firms are using the market as a springboard into other lines of business. For example, banks may fight for a share of the current (chequing) account or mortgage markets in order to provide a customer base for their insurance and investment products.

6.       High exit barriers. These are economic or strategic factors making exit from unprofitable industries expensive. They can include the costs of redundancies and cancelled leases and contracts, the existence of dedicated assets with no other value or the stigma of failure.

Illustration: Porter’s five forces applied to the confectionery industry:

            The following data relate to the UK confectionery market:
Ø   Yearly spend is approximately Rs. 100 per head of population;
Ø   Overall (slight) growth of 2% per annum;

Ø   Chocolate is the country’s no. 1 impulse buy;

Ø   The market is dominated by three major producers who share a total of 68% of the market (Nestle 20%; Amul (20%; Cadbury 28%);

Ø   There are many smaller companies operating within the chocolate confectionery and sugar confectionery sectors.

Using Porter’s Five Forces Model, a structural analysis of the industry shows:

n   The threat of entry: low. Main barriers to entry:

- Economies of scale, particular chocolate to compete with the leaders;
- Advertising necessary for band awareness (the leaders jointly spend approaching Rs.
  100 p.a.)

- Access to distribution channels: concentrated retail supermarket;

- Cost advantages independent of size;
- Experience in production and distribution of major operators.

n   Threat of substitutes: Moderate/high. Growth in light food snacks, introduces possibilities: healthier snacks; fun fruit packaging; savory snacks.

n   Supplier power: Moderate

- Milk, sugar subject to EU prices, therefore inflated but stable;

- Cocoa subject to price fluctuations, but larger manufacturers can hedge against this by
  backward integration.

n    Buyer Power: Potentially high

- As there is a concentration of buyers (the six largest retailers account for 60% of total UK

-  Competition for shelf space in high;

- There is a threat of backward integration, especially with brand only products being
  introduced BUT;

- Only 30% of confectionery is sold through supermarkets; other outlets include petrol stations, off-licenses, vending machines, and so on, so the effect is offset a little.

n  Competitive rivalry is high

n  Substitutes threaten, competitors are in balance:

-          There is slow market growth;
-          There are high exit barriers (Capital intensive);
-          Major spending on advertising.

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