CIMA E3Course Notes

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CIMA E3 Course Notes

Chapter 3 External analysis

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1.

External Analysis

External analysis is undertaken to enable an understanding of how the external environment has or will change so that the opportunities and threats which may arise by these external changes can be assessed and appropriate action taken. There are a number of models which facilitate the external analysis, and these are outlined in the next sections.

2.

PESTEL analysis

The PESTEL analysis examines the broad environment in which the organisation is operating. PESTEL is a mnemonic which stands for Political, Economic, Social, Technological, Environmental and Legal. These are simply 6 key areas in which to consider how current and future changes will affect the business. Strategies can then be developed which address any potential opportunities and threats identified. There are various alternatives to this, the most common being the slightly simpler PEST analysis.

Political
Political factors are how and to what degree a government intervenes in the economy. Specifically, political factors include areas such as tax policy, labour law, environmental law, trade restrictions, tariffs, and political stability. Political factors may also include goods and services which the government wants to provide or be provided (merit goods) and those that the government does not want to be provided (demerit goods). Furthermore, governments have great influence on the health, education, and infrastructure of a nation

Economic
Economic factors include economic growth, interest rates, exchange rates and the inflation rate. These factors have major impacts on how businesses operate and make decisions. For example, interest rates affect a firm's cost of capital and therefore to what extent a business grows and expands. Exchange rates affect the costs of exporting goods and the supply and price of imported goods in an economy

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Social
Social factors include the cultural aspects and include health consciousness, population growth rate, age distribution, career attitudes and emphasis on safety. Trends in social factors affect the demand for a company's products and how that company operates. For example, an aging population may imply a smaller and less-willing workforce (thus increasing the cost of labour). Furthermore, companies may change various management strategies to adapt to these social trends (such as recruiting older workers).

Technological
Technological factors include technological aspects such as R&D activity, automation, technology incentives and the rate of technological change. They can determine barriers to entry, minimum efficient production level and influence outsourcing decisions. Furthermore, technological shifts can affect costs, quality, and lead to innovation.

Environmental
Environmental factors include ecological and environmental aspects such as weather, climate, and climate change, which may especially affect industries such as tourism, farming, and insurance. Furthermore, growing awareness of the potential impacts of climate change is affecting how companies operate and the products they offer, both creating new markets and diminishing or destroying existing ones.

Legal
Legal factors include discrimination law, consumer law, employment law, and health and safety law. These factors can affect how a company operates, its costs, and the demand for its products.

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3.

Porters Five Forces

Porters five forces model is used to understand the industry/market which the business is operating within. It can be used: To understand how profitable an industry is to be in which can be used to decide whether to enter or exit the market. By firms operating in that industry to understand the forces impacting upon industry profitability and change how they operate to become more profitable themselves.

New Entrants

Supplier Power

Competitive Rivalry

Buyer Power

Substitutes

Each of the forces is analysed to find the size of the force. If on balance the forces are high, the industry profitability is low, and the market would not be a good one to enter. If the forces on balance are low, it is a profitable industry and a good one to enter. The forces are as follows:

Competitive Rivalry
The force will be high and the industry less profitable when:
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There are a lot of competitors There is little difference between the products Competitors are strong (i.e. big, have financial support, economies of scale) There are exit barriers (e.g. high cost of leaving a market). The keeps competitors in a market they might otherwise leave.

Competitor analysis - Competitors can be analysed by asking the following questions: What are their objectives? What are their strategies? (e.g. cost leadership, differentiation, market penetration, product development etc. - see chapter 5) What are their strengths and weaknesses? (Considering the nine Ms or value chain of competitors - see chapter 4) How will they react to our offensive moves (e.g. price cuts)? What threats do they pose?

Ultimately through understanding the competition the company can define a strategy which will enable them to address any potential threats they may pose and take advantage of any weaknesses to ensure the company continues to be profitable. Competitor intelligence (gaining information about competitors) and acting upon this is therefore a vital way to remain profitable in a competitive environment.

Threat of new entrants

This relates to new companies entering the market that are not currently there. The force will be high and the industry less profitable when: New companies can easily enter the market New companies are likely to or intend to enter the market

It is harder to enter the market when there are significant barriers to entry (factors which prevent new companies entering the market). These can include: High costs of entry (e.g. production facilities, IT) Patents Customer contracts in place Cost advantages of existing competitors are significant (e.g. due to scale of operation) Strong brands amongst competitors

Buyer Power
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This is the power that the customers have over the competitors in the industry. The force is high and industry less profitable when: Customers are large and provide a large proportion of company profits Customers can switch between competitors easily

Supplier Power
Supplier power is the power of the suppliers in the industry. It is high and the industry less profitable when: There are few alternative suppliers. Cost of changing suppliers is high.

Substitutes
Substitutes are products which fulfil the same needs as the needs met by the product in the industry being examined. A substitute of cinema might be the theatre, DVDs, sport or other forms of entertainment. Where customers can have there needs met from many different types of products, it becomes easy for them to switch, if prices rise for instance. This makes profitability in the industry low.

Example European airline industry

Industry information Historically the industry has been dominated by many large airlines. In Europe, a number of major European airlines are mainly or partly state owned operations which receive Government subsidies. The availability of landing and take-off slots is controlled and constrained. There have been a significant number of new entrants over recent years, primarily in the Low cost end of the market, offering a low price and no frills flights. A number of the larger airlines have followed suit and set up their own low cost subsidiaries. The industry is also aware that they must also compete with other forms of transport such as rail, bus and cars. Airline manufacturers are small in number and very large, operating on a global basis. While the long term industry trend is one of growth, there has been a recent slump in passenger numbers. Purchasing is increasing done over the internet which allows quick and easy ordering and price comparisons by consumers.

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Porters Five Forces Analysis Competition - High Significant competition. Some very large companies, some of which have subsidies. Exit costs are very high (e.g. selling aircraft/ending leases). There is significant price competition. Threat of new entrants - Low Barriers to entry include: lack of availability of new subsidies, difficulties in getting new routes, high costs of entry. Barriers are significant therefore, and given the significant competition that already exists it is unlikely that new entrants will be tempted to enter the market now. Buyer power - Medium There are few significant sized customers, but customers can switch between companies very easily. There is very little difference between products to stop switching. The internet has made it increasing easy to compare prices. Substitutes - Medium There are significant numbers of substitutes, car, rail, bus, ferry, but these offer a much slower form of transport, and are totally impractical for very long distances. Video conferencing might be more of a substitute for long distance flights. Supplier power - Medium Routes are restricted - giving significant power to the authorities allocating routes. Few aircraft suppliers, although there is significant competition between them. Aircraft can also be purchased second-hand. Other supplies - relatively low supplier power Overall Profitability is therefore relatively low, particularly due to the high industry competition.

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4.

Evaluating overseas markets Porters Diamond

Prior to setting up in an overseas country the organisation will need to assess the potential in that market. Examining the PESTEL and Five Forces factors as they relate to that country should be the starting point for understanding the market. In addition to these models Porters Diamond can also be used.

Porters Diamond The Competitive Advantage of Nations

After having looked at the general factors which make an industry profitable Michael Porter turned his attention to that factors which make one nation more profitable in a particular industry than another. He outlined his findings in the book The Competitive Advantage of Nations in which he outlined 4 key elements.

Domestic Structure Structure and and Rivalry rivalry

Basic Advanced

Factor Conditions

Demand Conditions

Related and Supporting Industries

The more of each of these for elements that a country has at home, the more likely that it will be successful when it competes in overseas markets. a) Factor conditions

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Relates to the availability of a countrys inputs. Countries that have access to the factors necessary to produce the product will have an advantage over countries which do not. Basic factors require no investment. These include: Unskilled labour Raw materials Weather

Advanced factors require investment. For example.: b) Skilled labour Infrastructure (e.g. transport, communications) Knowledge Capital availability Demand conditions (in the home market)

The greater the demand and more discerning the consumers in the home market the greater the need for innovation and cost reduction by companies in that market. When these companies sell abroad they will have more sophisticated and cheaper products than competitors from other countries and therefore have an advantage over them. c) Related and supporting industries (in the home market)

If the suppliers to the industry are plentiful and competitive it will enable cheap and effective production of products. When companies expand abroad they will therefore have better and cheaper products than local competitors. d) Firm Strategy, Structure and Rivalry

If there are a lot of home based competitors who have been competing heavily against one another for many years, then those firms are likely to have innovated and reduced costs to compete. Again when they sell overseas they will have a advantages compared with overseas competitors who have not innovated and reduced costs.

Example
The success of the car industry in Germany can be aligned well to the four factors: a) Factor conditions: Educated workforce, with a strong engineering focus, well located for distribution throughout Europe
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b) Strategy, Structure and Rivalry: A long history of car making, with a range of highly successful, high quality car makers competing heavily to be the best over many years (BMW, Mercedes, Audi, VW). A home culture where efficiency and quality are important. c) Demand conditions: A wealthy home public who can afford high quality cars, and who are discerning in their choice of car particularly over quality. d) Supporting industries: A range of parts suppliers, and other leading engineering companies.

Using Porters Diamond to analyse organisations

Porters diamond can be used to assess an organisations likely competitiveness in foreign markets. The company is likely to be competitive where: a) b) The four factors are significant in the home market The four factors are not present in the target market.

With all four factors in their home market and many other countries with few of these factors, it should be no surprise that German car manufacturers lead the market for high quality cars. It can also be used to assess the likely threat from overseas competition. There is likely to be significant threat from them where: a) b) The four factors are not present in the home market The four factors are present in the foreign competitors market.

5.

Environmental uncertainty

The business environment is ever changing, and as such organisations must continually adapt and change if they are going to be successful. To help businesses to manage uncertainty there are a range of techniques that they can use.

Scenario Analysis
Whether analysing the broad environment (PESTEL analysis) or the industry environment (Porters Five Forces) it is important not just to consider the current position but also the future possible scenarios.

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Scenario analysis is the examination of different possible scenarios which may unfold in the future as any of the PESTEL factors or five forces change and evolve. So for example scenarios might be considered where: The economy goes into recession A competitor enters or leaves the market Exchange rates fall dramatically Competitors develop a new product which is cheaper than the current products available. A major suppler goes into liquidation.

The analyses of the consequences of this scenario help the organisation to: Define a strategy which will reduce risk of events causing problems for the organisation. Prepare to take appropriate action if the situation arises.

Real options
In finance an option is the right but not obligation to do something e.g. buy currency at a pre-agreed rate. Real options take the same idea and apply it to real life projects such that a real option is the right but not the obligation to make an investment with the aim of generating a return (in present value terms). With a normal NPV calculation the assumption is always the investment will go ahead straight away. With a real option, the assumption is that there is the option to go ahead with the investment now or at some point in the future, for example to: Make a follow-on investment after seeing how well the initial investment fared (e.g. expansion into a new market). Wait and learn, so that uncertainty is resolved before further decisions are taken (e.g. waiting until economic uncertainty is resolved). Avoid the investment (abandon) if circumstances to not work out favourably.

As a result, the options pricing model developed by Black and Scholes to value financial instruments, can be used to price such real options. While you will not be asked to do that in this subject, you should be aware that a real options evaluation for possible future strategic investments that can be made now or delayed, can help in evaluation of each of these
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options to decide whether to proceed or not (and when) with some strategic decisions.

Forecasting
Forecasting is the process of using past data to predict the future. This can be useful in strategic analysis to help made predictions to resolve uncertainty. Methods of forecasting include: Time-series analysis using past trends, seasonal and cyclical variations to predict future changes Regression analysis using the statistical line of best fit of past data to estimate the future Econometrics this use of past economic data to predict future economic conditions. Most econometrics is simply regression analysis applied to economics. Jury Forecasts teams of experts make predictions which are then averaged. Delphi technique this takes jury forecasts a step further. Each expert makes their prediction, which is then averaged and summarised. The experts then debate and discuss this revision and then make a revised prediction, which is again averaged and summarised. This process continues until a common ground is met.

Game theory
Game theory is the study of mathematical models of conflict and cooperation between intelligent rational decision-makers. Game theory works out the logical consequences when businesses are competing and making the most logical decisions based on the information available to them. This can then help decision makers to predict the likely end consequences of competition (for example when competing in an auction for a contract) to help the organisation to make better decisions.

Foresight
Foresight aims to predict possible future qualitative outcomes in real life situations, largely based on expert opinion. It differs from forecasting which is quantitative in nature.
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Methods of foresight include: Scenario analysis (as seen earlier) Delphi technique (as seen earlier) Visioning Looking at the longer term vision of the future, for the environment and business and using that to consider how the business will respond. It is a longer term, bigger picture approach to scenario planning. Role playing playing out possible scenarios and using the results to understand likely outcomes and plan future responses to different situations.

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Strategic Mock Exams E3, F3 and P3 Based around the latest Preseen 2 full mocks are available for each strategic subject Full marking and detailed feedback Full mock marking Detailed and personalised feedback to focus on helping to pass the exams Personal coaching on your mock exam 1hr personal coaching session with your marker Personalised feedback and guidance Exam technique and technical review Strategic and Financial analysis of the Pre-seen Strategic analysis - all key business strategy models in E3 Financial analysis based around the F3 syllabus Risk analysis based around the P3 syllabus 30 page strategic report Full video analysis of how all key models apply to the unseen Video introduction to all the key models Personal Coaching Courses Personal coaching to get you through the exam Tuition Course Personalised tuition to give you the required syllabus knowledge tailored to your needs Revision Course - Practise past exam questions with personal feedback on your technical weaknesses and exam approach and technique Resit Course Identifying weaknesses from past attempts and providing personalised guidance and study guides to get you through the exam

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