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Analysis of the External Environment

BE1011 Paper 8
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Analysis of the External Environment

NORTHUMBRIA UNIVERSITY
SCHOOL OF THE BUILT AND NATURAL ENVIRONMENT

BE1011 Economics and Business Environment

Analysis of the External Environment
Level 7
Paper 8

Foreword
The paper contains the following sections:

Part One: Learning Objectives

Part Two: Learning Directions
Part Three: Supporting Notes and Tasks
Part four: Additional reading
Part five: Self - assessment tasks

Part One: Learning Objectives

On completion of this paper students will be able to:

Explain what is meant by the external environment of an organisation

Distinguish between the macro (or far) and micro (or near) external
environment
Explain and apply the PESTEL framework of macro environmental
analysis
Explain and apply the Five Forces Framework of micro environmental
analysis
Understand criticisms of the models for analysing the external environment

Part Two: Learning directions

1. Read the supporting notes
2. Read the supporting references
3. Carry out the self-assessment
tasks
Total

Estimated Time
3 hours
3 hours
2 hours
8 hours

Part Three: Supporting Notes and Tasks

Introduction
The strategic process might be considered to have three distinct phases
(Campbell, Stonehouse and Houston 2002, page 464) strategic analysis,
strategic evaluation and selection (or strategic choice) and strategic
implementation. This paper is concerned with the first of these, strategic
analysis.
The purpose of analysis is to gather and evaluate information about the
organisation and its environment in order to determine its strategic position.
When the strategic position is established this provides the basis from which
strategic choices can be made. The analysis should be sufficiently robust to
enable the organisation to identify and evaluate options from which it can
determine its future direction. The analysis should also identify issues that will
be of significance when the chosen strategic option is implemented.
There are two main aspects to the strategic position of an organisation:
external and internal. The external refers to the environment outside the
organisation. The internal refers to the environment within the organisation,
i.e. the organisation itself.
This paper focuses on the analysis of the external environment.

Two aspects of the external environment

There are two aspects to the analysis of the external environment: the far or
macro environment and the micro or near environment.
The far environment concerns those factors which have an influence on the
organisation but which the organisation itself cannot influence, for example
demographic or climate change. These are often factors that affect the whole
world or nation, or they may be closer to home, such as local government
policy in the particular area where an organisation operates.
On the other hand the near environment concerns the industry in which the
organisation works: for example its competitors, its suppliers, its customers
and markets.

In the first part of the paper the far external environment will be examined
using a PESTEL analysis and in the second part the near external
environment will be examined using a Five Forces analysis.

Frameworks for analysis of the macro environment

If you read different textbooks on strategic management you will discover a
number of similar mnemonics for the analysis of the macro external
environment, for example PEST (political, economic, social and
technological), STEP (same items in a different order), STEEP (social,
technological, economic, environmental and political) and that favoured by
Campbell et al (2011), which is SPENT (sociodemographic, political,
economic, natural and technological).
They all have a similar basis and this paper will consider the PESTEL analysis
(Johnson et al 2011 and other texts). The PESTEL framework builds on the
earlier mnemonics and includes all the aspects covered in the alternative
macro analysis frameworks mentioned above.
It is worth pausing for a moment to consider why an organisation should be
concerned with the macro environment if it cannot influence it. Surely an
organisation should be concerned with what it can do and not with what it
cannot do? The answer is that any organisation that fails to take account of
the environment in which it operates is unlikely to be successful for long.
These environmental influences are so important that they will affect every
part of an organisations strategy: where it will operate, what its products or
services will be, how it will be funded and who its customers are. This will
become clear as the far environment is considered in more detail.

PESTEL analysis
PESTEL stands for:
Political
Economic
Social/Cultural
Technological
Environmental
Legal
This is shown in diagrammatic form in the following illustration:

Macroenvironment PESTEL (1)

Exhibit 2.2
Exploring Corporate Strategy, Seventh Edition, Pearson Education Ltd 2005

Source: Johnson, Scholes and Whittington (2005, page 68)

As with any of the analytical frameworks the purpose of PESTEL is to act as a
checklist and ensure that no macro environmental influences are omitted.
Each of the factors identified in the PESTEL framework will now be
considered in turn and explained in greater detail with illustrative examples.
At the end of this section the limitations and criticisms of the PESTEL analysis
will be considered along with advice about how to carry it out most effectively.

Political factors
In this framework the political and legal are separated, although many
frameworks conflate them. This separation is considered useful because
political factors, for example government policy, may have a strong influence
on organisations, even if the policy changes are not accompanied by a
change in legislation.
The political environment is that which is under the direct control or influence
of the government (Campbell et al 2011). This may the national, regional or
local government or supranational bodies such as the European Union and
United Nations. Every country will be different in terms of the degree of
centralisation or devolution of power. In some countries, for example in

Switzerland, there is a quite a high degree of power at the local level, whereas
other countries are very centralised.
Political factors will include any type of government policy or regulation. It
might include:

Taxation
Nationalisation of private industries
Privatisation of public sector functions
Regulation or deregulation of industry
Regulation of foreign trade Social welfare policies
Consumer protection
Promotion of economic growth
Control of monopoly power

There are numerous examples of government policies that seek to encourage

or discourage activities some of which will be very specific to a particular
industry

Economic factors
The economic environment refers to any factors in the macro-economy that
might affect either the organisation or its markets or customers. As with the
political factors discussed before, economic factors might be global, national
or more local.
It will be noted that many of the political factors are closely related to
economic matters as governments generally regard control or influence over
the economy as one of their major functions. Government influence on the
national economy is through fiscal and monetary policy (Campbell et al 2011).
Fiscal policy is the management of government revenue, for example from
taxation, and expenditure, e.g. on health and education, and monetary policy
is concerned with the supply and price of money e.g. interest rates.
Economic factors might include the following:
Economy growing or in recession
Interest rates i.e. the amount charged to borrow money
Inflation (i.e. if prices are increasing year-on-year) or the opposite,
deflation
Levels of income
Income distribution i.e. whether there is an even distribution of income or
groups of very rich and very poor people
Productivity i.e. the amount produced per worker
Exchange rates i.e. the value of one currency when it is exchanged for
another
Levels of employment i.e. the proportion of the population that is
economically active

It can be seen from the above list that any organisation is likely to be affected
by economic factors, either directly e.g. availability and cost of loans, cost of
supplies; or indirectly e.g. income and therefore purchasing power of potential
customers

Social/cultural factors
Social and cultural factors cover a huge area. This includes demographic
changes: not just to population size but also to household size, the structure
of the population, the age distribution of the population, immigration and
emigration. It includes cultural factors such as religious beliefs and the way
that attitudes may change over time. Attitudes have a substantial effect on
customers preferences. Campbell et al (2011, page 130) give the example of
alcoholic drinking, where some cultures favour beer, some wine and in other
countries for religious reasons most people do not drink alcohol at all.
Social cultural factors may include the following:
Demography
Population size
Household size
Immigration/emigration
Birth and death rates
Lifestyle preferences
Attitudes to work and leisure
Levels of education
Religious observance
Social mobility (the ability of individuals to move between strata in society)

Technological factors
The analysis of technological factors involves knowledge not just of new
technology but how that technology might impact on the organisation in
different ways e.g. new production processes as well as new types of
products.
Under this heading might also be considered the attitude of government and
industry to technology.
Technological factors may include the following:
New discoveries
Transfer of knowledge
Information Technology
Telecommunications
Use of the Internet
Document imaging documents are stored electronically enabling the
paperless office
Government spending on research
Rate of obsolescence

Changes in transport

Some of the items in the above list will affect almost any organisation e.g. Use
of the Internet, but there will also be technological changes that are specific to
a particular industry

Environmental factors
The environmental factors will include anything that concerns the natural
environment. This includes relatively stable natural phenomena, such as
mineral deposits and changing phenomena such as the weather. It also
refers to attitudes towards the environment.
In some frameworks these environmental factors are included under a
heading of nature or technology or social /cultural etc. But environmental
factors can be so important and their importance is likely to increase in the
future, due to factors such as climate change, that it seems valuable to have a
separate category.
Some natural influences may be huge in their impact, affecting every type of
organisation over a wide geographical area; one recent example is the
tsunami in the Indian Ocean at the end of 2004. Alternatively a small river
flood may have disastrous consequences for a few households but no wider
implications.
Other environmental factors may have an influence on one specific industry:
an example often given is the way that ice cream sales increase when the
weather is hot.
Environmental factors may include the following:
Mineral deposits
Landscape quality
Weather
Hurricanes
Earthquakes
Volcanoes
Avalanches
Deforestation
Desertification
Floods
Climate change
Legislation on environment
Waste disposal
Energy conservation

Legal factors

Legal factors simply refer to legislation, but legislation can change an industry
overnight, so its importance cannot be underestimated. Any legislation that
may affect an organisation, or its customers, comes under this heading. The
legislation may be supra national, national or local.
Legislation may be primarily about health and safety, for example laws
requiring the use of seat belts in motor vehicles, but this will affect a number
of organisations in very different ways. It will require car manufacturers to
change the design of their vehicles to incorporate seats belts and to source
supplies, it will provide an opportunity for growth for seat belt manufacturers,
and it will involve law enforcement and criminal justice agencies in new tasks.
Legal factors may include the following:
Legislation
Employment law
Health and safety
Product safety

Limitations and criticisms of PESTEL analysis

A number of criticisms have been advanced of the PESTEL and similar
analytic frameworks. The first is made by Hussey (1998) who points out that
a simple listing of factors is inadequate because the external environment is
highly integrated and one factor is likely to trigger changes in other factors; it
therefore makes no sense to view the factors in isolation from each other.
Hussey (1998, page 84) gives the example of changing technology that has
influenced every other factor in his model.
Indeed, as we have already seen in our description of the PESTEL factors
they are inter-related and the same factor might be classed under different
headings by different authors.
This relates to another criticism, which is the difficulty of carrying out an
analysis of the macro-environment when it is so complex and fast changing.
Campbell et al (2011, page 129) also point out that at any one time the
changes taking place may be conflicting and contradictory.
Such is the difficulty of the task, and the risk of analysis being overtaken by
sudden events with far-reaching consequences (e.g. tsunami mentioned
previously), that it may be questioned if a macro-environmental analysis is
possible or worthwhile.
In answer it may be said that although some events cannot be predicted,
others can and therefore analysis may be valuable if it is carried out in a way
that is likely to produce the most effective and useful results. The next section
considers how an effective analysis may be produced.

Effective use of PESTEL analysis

The effective use of the PESTEL analytic framework must move away from
the production of a simple list and instead be part of an ongoing and analytic
activity.
Campbell et al (2011, page 137) state that four stages are involved in macroenvironmental analysis:

scanning the macro environment for actual and potential changes

assessing the relevance and importance of the changes
analysing changes in detail and relationships between them
assessing the potential impact of the changes

These four stages show the importance of analysis as a pro-active activity,

factors are identified through scanning but must then be assessed and
analysed in detail with the specific intention of identifying relevant and
significant trends, these can then be used to predict actual and future
changes and the likely impact on the organisation concerned.
It is important to note that an environmental factor may be a concern for one
entity but an opportunity for another even organisations working in the same
industry. For example ongoing increases in oil prices might make consumers
consider more carefully the fuel consumption of a motor vehicle when they are
planning to purchase. This might be a problem for the producers of gasguzzlers but an opportunity to increase sales for producers of fuel-efficient
cars or producers of cars using alternative fuels.
Johnson et al (201108, page 50) suggest that the most important thing to do is
to identify the key drivers of change, which they identify as the
environmental factors likely to have a high impact on the success or failure of
strategy They also make the point, which relates back to the earlier criticism
made by Hussey (1998) that often it is the combined effect of separate factors
that is important, rather than all of the factors separately. One way forward is
to develop scenarios of events to enable plausible alternative futures to be
considered. (Johnson et al 2011, page 51-54)

The Five Forces Framework

In the previous section we considered a technique for analysing the far or
macro environment, external to the organisation. In this section we consider a
technique for analysing the near or micro external environment, which might
alternatively be described as the industry within which an organisation
operates.
Porter (1980) devised the Five Forces Framework. It consists of:
The threat of entry
The power of suppliers
The power of buyers
The threat of substitutes
Rivalry amongst existing competitors

Johnson et al (2011, page 55)

In the following sections these five are considered in more detail. It is
important to note that these forces are not independent but closely related to
each other, as the above diagram illustrates.
The purpose of the Five Forces Framework is to analyse both the nature and
the strength of competition within an industry. Armed with this information
managers can then develop their competitive strategy.

The threat of entry

The first force to consider is the threat of entry i.e. how easy is it for new
organisations to enter the industry and compete for resources, markets and
customers? This depends upon the barriers to entry, if the barriers are high it
is difficult for someone to enter; if they are low it is less difficult. There are
different types of barrier.
1. Economies of scale
It is often cheaper, per item, to produce a large quantity than a small quantity.
For example to produce any quantity may require certain machinery and
employees with specific expertise; but the additional, marginal cost, of
producing 1,000 rather than 500 items may be small. So in some industries
costs are reduced by large organisations that are able to benefit from
economies of scale. A new organisation will not have this advantage.

2. Differentiation
If different companies within the industry produce differentiated products, and
customers are loyal to these products, for example a brand name, then it will
be difficult to persuade customers to switch to a new product.
3. Capital requirements
In some industries it is not possible to enter on a small scale and a substantial
capital investment is required in order to participate. An example would be oil
refining.
4. Costs independent of size
In some industries there will be costs independent of size, for example
intellectual copyright.
5. Access to distribution channels
In some industries there are limited channels of distribution and it may be
difficult for a new competitor to gain access to these channels. An example
would be a new airline would have difficulty gaining access to major airports
where there is high competition for take-off and landing slots.
6. Government policy
The final barrier is government policy and regulation. Some industries are
heavily regulated with licences required for companies that wish to operate in
it.

Power of suppliers
The second force concerns the suppliers to an industry i.e. the providers of
the resources needed for an organisation to carry out its activities. The
bargaining power of suppliers also depends upon a number of factors.
1. Resources are only available from restricted sources
If the resources required are scarce or unique then the suppliers are likely to
have more power than if they are readily available and easily substituted.
2. Cost of switching is high
Resources may be easily substituted but the costs of switching to another
supplier may be high.
3. Forward integration (take over the supply)
If an organisation is dissatisfied with its suppliers then it may take them over
or enter into a partnership or alliance. This weakens the power of the supplier
but may be of mutual benefit as it guarantees future custom.
4. Industry is not an important customer
If the industry is not important to the suppliers then they have no reason to
pay regard to the industry but may favour other larger customers.

Power of buyers
Are the customers powerful?
The power of buyers, or customers, is determined by the following factors:
1. Buyers are concentrated/dispersed and purchase small/large
quantities
If the buyers are concentrated and purchase large quantities of the products
then they will be more powerful than if the opposite situation exists.
2. Businesses are concentrated and large
If the number of businesses is concentrated and large then there may be less
choice available for customers, this relates to the next item.
3. Alternatives
If it is easy for buyers to switch to alternative products then they will be more
powerful. This will depend upon whether there are other products readily
available and if there are any costs involved in switching to alternatives.
4. Cost of the product
If the product is a large proportion of the buyers costs they will have a greater
incentive to shop around for a cheaper price
5. Importance of the product
If the product is unimportant to buyers, i.e. easily dispensed with or
substituted, then buyers will be more powerful, as it will be difficult to retain
their loyalty and commitment to a particular product.

Threat of substitutes
A substitute is something that meets the same needs or competes for
discretionary expenditure it is not just another brand of the same thing. This
will depend upon the following:
1. Relative price and performance of substitutes
If substitutes are cheaper and perform as well then there is a greater threat
from them. Sometimes a substitute may be one but not the other and whether
there is a threat from the substitute will depend on consumer preference,
which may be determined by the following two items
2. Switching costs for buyers
It may cost money for a buyer to switch to another product, for example they
may have to change other items as well in order to make them compatible
e.g. new type of computer hardware may require different software
3. Buyer propensity to substitute
Buyers may be loyal to a product, even if its price or performance are not
obviously better and so be reluctant to switch to another product, for example
they may prefer to buy locally or from a Fair Trade source.

4. Buyer lifestyle and preferences including fashion

Buyers may choose to spend discretionary expenditure on completely
different items as lifestyles and trends change: for example holidays rather
than antiques

Rivalry amongst existing competitors

It will already have been noted that there are links between the four forces
mentioned so far. All of these forces then combine to determine how much
rivalry there is between competitors
The amount of rivalry will depend on the following:
1. Number of competitors
Generally the more competitors the more rivalry
2. Growing or stagnating industry
There will be more rivalry in a mature industry that is stagnating or contracting
than in a growing industry.
3. Product differentiation and switching costs
If there is little differentiation between products and low switching costs for
buyers then rivalry will usually be higher
4. Exit barriers
If it is difficult for businesses to leave the industry because exit costs are high;
then rivalry will be higher
5. Diverse competitors with different approach
However if the competitors do not have similar products or are focused on
different markets then rivalry may be lower

Limitations and criticisms of the Five Forces Framework

This framework has been in use for a long time and is still seen to be valuable
but there are some limitations to its use which are explained below:
Other factors, especially individual company competence, may be more
important in determining profitability than the five forces..
Secondly the framework implies that the forces will apply equally to all
businesses in the industry but in reality this is unlikely to be the case. For
example a company with a strong brand will have customers who are less
inclined to substitute its products than a company without a strong brand
loyalty.
Thirdly that the concepts of buyer and supplier power relate to the markets in
which a business procures the supplies it needs and where it sells its
products. In reality both buyer and supplier markets may be more complex

than the framework implies, for example markets may be segmented with
different types of customers and products.
Fourthly the framework works best when the macro-environment is constant,
but as we have seen from the PESTEL analysis this is unlikely to be the case
and it therefore needs constant re-appraisal and to be considered only in
conjunction with an analysis of the external environment and (as following
papers will show) the internal environment of an organisation.
Fifthly the framework implies that the relations in business between buyers,
suppliers and competitors are always adversarial but in reality they may be
complex, collaborative and more like partnerships.
You will find it useful to consider these criticisms when considering the case
study of the pharmaceutical industry in the task below, as most are relevant to
that industry.

Conclusion
Analyses of the external environment, both the far and near external
environment, are extremely useful but they have their limitations and need to
be used with care. In particular they need to take account of complexity and
rapid change and cannot be used in isolation. They also need to take account
of the characteristics of the specific organisation concerned. This leads to the
analysis of the internal environment, which will be considered in other papers.

Supporting Reference
Read the case study The global pharmaceutical industry: swallowing a bitter
pill in Johnson et al (2011, pages 547 556)
Students should read the case study and then carry out the following tasks

Optional Task
Textentry1
Title
Text

Feedback

TASK
1. Carry out a PESTEL analysis of the
pharmaceutical industry. What do you think
are the key drivers for change?
You should have found a number of important factors
under each of the six categories. These are some of
the factors you may have identified:
Political: governments wishing to
contain/cut healthcare costs; public
concern over safety and international

price comparisons
Economic: sales link to GDP, growth in
emerging markets; availability of capital
finance, patients paying themselves
links income levels with sales.
Social: ageing populations drive
increased demand; pressure to act
ethically; better informed patients with
rising expectations
Technological: Scientific and medical
innovation; more personalised health
care; IT enabling e-prescribing and
better informed patients
Environmental: Emphasis on
sustainability by investors and
employees
Legal: Increased regulation and liability
claims especially in the USA

Key drivers are the emphasis on costcontainment and value-for-money.

You may have identified other matters that
you think are key drivers. This is not
surprising. as we are considering the future,
there will be differences of opinion as to which
factors are the most important and deserve
the most emphasis.
TASK
2. How useful do you think a five forces analysis
of the pharmaceutical industry would be?

FEEDBACK
There have been many changes in the
pharmaceutical industry since it began Five
Forces analyses that looked at the origins of the
industry, the recent past and the immediate future
would have different outcomes. This is a crucial
learning point about carrying out environmental
analysis
Significant learning points from a Five Forces
analysis might be:

Threat of entry: historically high barriers to

entry but this has dramatically changed

with patent expiry and generic entrants.

Possibility of entry by biotech companies
Power of buyers; historically fragmented
individual medical practitioners but now
increasingly concentrated with a major
impact on the market
Power of suppliers: historically low but
declining R&D activity has increased cost
of true breakthrough opportunities
Substitutes: Generics and biosimilars
increasingly important.
Competitive rivalry: always strong and now
increased competition on price and due to
industry consolidation with mergers and
acquisitions

It is worth noting that within the pharmaceutical

industry there are significant differences between
sectors; the generic, OTC and vaccine markets
are relatively mature, the ethical market is
moving away from growth towards a shake-out
and the biotech sector is under development.

Finally you may have noticed how the macro factors

(PESTEL) and the micro factors (Five Forces) are
connected -the far environment clearly has an effect
on the near environment.

References
Campbell D, Edgar D and Stonehouse G (2011) Business strategy: an
introduction 3rd Edition Basingstoke: Palgrave Macmillan
Campbell D, Stonehouse G and Houston B (2002) Business strategy:
an introduction 2nd Edition Oxford: Butterworth Heinemann
Hussey D. (1998) Strategic Management 4th Edition Oxford:
Butterworth Heinemann
Johnson G. Scholes K. and Whittington R. (2005) 7th ed Exploring
Corporate Strategy: Text and Cases Harlow: Pearson Education
Johnson G. Whittington R and Scholes K. (2011) 9th ed Exploring
Strategy: Text and Cases Harlow: Pearson Education
Johnson G. & Scholes K. (2001) Exploring Public Sector Strategy
London: Prentice Hall
Kay J. (1993) Foundations of Corporate Success OUP
Porter M.E. (1980) Competitive Strategy: Techniques for analysing
industries and competitors Free press