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
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
backward integration.
n Buyer
Power: Potentially high
-
As there is a concentration of buyers (the six largest retailers account for
60% of total UK
food);
- 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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