Chapter Four:

Environmental Analysis
Chapter outline:
 The nature of external audit
 Sources of external information
 Forecasting tools and techniques
 Competitive analysis: Porter’s five forces model

Introduction
An external audit focuses on identifying and evaluating trends and events beyond the control of
a single firm, such as increased foreign competition, population shifts to the Sunbelt, an aging
society, information technology, and the computer revolution. An external audit reveals key
opportunities and threats confronting an organization so that managers can formulate strategies
to take advantage of the opportunities and avoid or reduce the impact of threats.
1.1 The nature of external audit
The purpose of an external audit is to develop a finite list of opportunities that could benefit a
firm and 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. 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
The Process of Performing an External Audit
The process of performing an external audit must involve as many managers and employees as
possible. To perform an external audit, a company first must gather competitive intelligence and
information about social, cultural, demographic, environmental, economic, political, legal,
governmental, and technological trends. Individuals can be asked to monitor various sources of
information such as key magazines, trade journals, and newspapers. These persons can submit
periodic scanning reports to a committee of managers charged with performing the external
audit. This approach provides a continuous stream of timely strategic information and involves
many individuals in the external-audit process.

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Once information is gathered, it should be assimilated and evaluated. A meeting or series of
meetings of managers is needed to collectively identify the most important opportunities and
threats facing the firm. These key external factors should be listed above. A prioritized list of
these factors could be obtained by requesting all managers to rank the factors identified, from 1
for the most important opportunity/threat to 20 for the least important opportunity/threat. These
key external factors can vary over time and by industry. Relationships with suppliers or
distributors are often a critical success factor.
Freund emphasized that these key external factors should be:
Important to achieving long-term and annual objectives,
Measurable,
Applicable to all competing firms, and
Hierarchical in the sense that some will pertain to the overall company and others will be
more narrowly focused on functional or divisional areas.
A final list of the most important key external factors should be communicated and distributed
widely in the organization.
Key External Forces
External forces can be divided into five broad categories:
1. Economic forces;
2. Social, cultural, demographic, and environmental forces;
3. Political, governmental, and legal forces;
4. Technological forces; and
5. Competitive forces.
Economic Forces
Economic factors have a direct impact on the potential attractiveness of various strategies. For
example, as interest rates rise, then funds needed for capital expansion become more costly or
unavailable. Also, as interest rates rise, discretionary income declines, and the demand for
discretionary goods falls. As stock prices increase, the desirability of equity as a source of capital
for market development increases. Also, as the market rises, consumer and business wealth
expands. Price fluctuation refers to general price fluctuation. They affect the economic factors
and affect the customers buying behaviors.

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The customers are more conscious about the economic changes and responds according to the
changes in key variable factors. So, any change in the price affects the customer buying trend
directly.
Monetary policies and Fiscal policies are changed every year. The person or businesses engaged
in business for profit making or non profit organizations always have to keep an eye on the
economic structure of the countries.
As far as the tax rates are concerned, government also changes the tax rate with the passage of
time. So it affects the economic forces.

It is important to monitor key economic factors such as:

Foreign countries’ economic conditions
Import/export factors
Demand shifts for goods/services
Income differences by region/customer
Price fluctuations
Exportation of labor & capital
Monetary policies
Fiscal policies
Tax rates etc.
A summary of economic variables that often represent opportunities and threats for organizations
is provided in Table given below.

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 Social, Cultural, Demographic, and Environmental Forces
Social, cultural, demographic, and environmental changes have a major impact upon virtually all
products (Preferences change), services, markets, and customers. Small, large, for-profit, and
nonprofit organizations in all industries are being staggered and challenged by the opportunities
and threats arising from changes in social, cultural, demographic, and environmental variables.
We may use the following analysis in understanding the Social, Cultural, Demographic, and
Environmental Forces:
Population growing older
Increase in younger population
Ethnic balance changing
Gap between rich and poor widening
Ethnic balance changes due to the migration of the people from different areas to different areas.
This affects the ethical behavior very much. As the traditions and norms are very much different
in different areas, therefore the behavior of the migrated people also have a major affect on the
behavior of the resident people. Due to the increased gap between rich and the poor, there is a
tremendous change in the social behavior of the people.

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A summary of important social, cultural, demographic, and environmental variables that
represent opportunities or threats for virtually all organizations is given in Table below.

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 Competitive Forces
“Collection and evaluation of information on competitors is essential for successful strategy
formulation” Competition in virtually all industries can be described as intense.
Identifying rival firms: Strengths, Weaknesses, Capabilities, Opportunities, Threats,
Objectives and Strategies
Key Questions about Competitors:
Their strengths
Their weaknesses
Their objectives and strategies
Their responses to all external variables (e.g. social, political, demographic, etc.)
Their vulnerability to our alternative strategies
Our vulnerability to successful strategic counterattack Our product and service
positioning relative to competitors
􀂃 Entry and exit of firms in the industry
 Key factors for our current position in industry
 Sales and profit rankings of competitors over time
 Nature of supplier and distributor relationships
 The threat of substitute products or services
Competitive Intelligence Programs
Systematic and ethical process for gathering and analyzing information about the competition’s
activities and general business trends to further a business’ own goals.
Every organization must have an intelligence programmed. It should be ethical and systematic
for gathering and analyzing the information about competitor activities and activities involve in
general business
Political, Governmental, and Legal Forces
Change in government regulations which create opportunities and threats. For example,
antitrust legislation where there is an effort to ban the monopolies. Some organizations think
that monopolies should be banned. Similarly, tax rates and lobbying efforts for special,
lobbying entries are those efforts which are made in order to pass special resolution laws of
their own choice. Patents law and intellectual are also relates to the same stories.

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Federal, state, local, and foreign governments are major regulators, deregulators, subsidizers,
employers, and customers of organizations. Political, governmental, and legal factors, therefore,
can represent key opportunities or threats for both small and large organizations. For industries
and firms that depend heavily on government contracts or subsidies, political forecasts can be the
most important part of an external audit. Changes in patent laws, antitrust legislation, tax rates,
and lobbying activities can affect firms significantly.
Impact of political variables on government regulations:
Government regulation/deregulation
Tax law changes
Special tariffs
Political Action Committees (PACs)
Voter participation rates
Number of patents
Changes in patent laws
A summary of political, governmental, and legal variables that can represent key opportunities
or threats to organizations is provided in Table below.

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 Technological forces

Technological forces represent major opportunities and threats that must be considered in
formulating strategies. Technological advancements dramatically can affect organizations'
products, services, markets, suppliers, distributors, competitors, customers, manufacturing
processes, marketing practices, and competitive position. Technological advancements can create
new markets, result in a proliferation of new and improved products, change the relative
competitive cost positions in an industry, and render existing products and services obsolete.
Technological changes can reduce or eliminate cost barriers between businesses, create shorter
production runs, create shortages in technical skills, and result in changing values and
expectations of employees, managers, and customers. Technological advancements can create
new competitive advantages that are more powerful than existing advantages. No company or
industry today is insulated against emerging technological developments. 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.
Organizations that traditionally have limited technology expenditures to what they can fund after
meeting marketing and financial requirements urgently need a reversal in thinking. The pace of
technological change is increasing and literally wiping out businesses every day. An emerging
consensus holds that technology management is one of the key responsibilities of strategists.
Firms should pursue strategies that take advantage of technological opportunities to achieve
sustainable, competitive advantages in the marketplace.
4.2. Sources of external information
A wealth of strategic information is available to organizations from both published and
unpublished sources. Unpublished sources include customer surveys, market research, and
speech at professionals and shareholders’ meetings, Television programs, interviews, and
conversations and stakeholders. Published sources of strategic information include periodicals,
journals, reports, government documents, abstracts, books, directories, newspapers and manual.
The Internet provides another source for gathering strategic information, as do corporate,
university, and public libraries. Suppliers, distributors, salespersons, customers, and competitors
represent other sources of vital information.

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4.3.Forecasting tools and techniques
Forecasts are educated assumptions about future trends and events. Forecasting is a complex
activity because of factors such as technological innovation, cultural changes, new products,
improved services, stronger competitors, and shifts in government priorities, social values,
unstable economic conditions, and unforeseen events. Managers often must rely upon published
forecasts to identify key external opportunities and threats effectively.
Forecasting tools can be broadly categorized in to two groups: Quantitative techniques and
qualitative techniques. Quantitative forecasts are most appropriate when historical data are
available and when the relationships among key variables are expected to remain the same in the
future.
No forecast is perfect, and some forecasts are even wildly inaccurate. This fact accents the need
for strategists to devote sufficient time and effort to study the underlying bases for published
forecasts and to develop internal forecasts of their own. Key external opportunities and threats
can be effectively identified only through good forecasts. Accurate forecasts can provide major
competitive advantages for organizations. Forecasts are vital to the strategic-management
process and to the success of organizations.

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4.4 Competitive analysis: Porter’s five forces model

The central point lays the stress on rivalry of the competing firm. This relates to the intensity of
the rivalry. How the firms compete with each other and to what extent? That should be taken into
account very carefully. Potential entry for new competitors shows a balance between different
firms competing in a market. It also refers whenever a new partner enter into a market he may
become threat for one and opportunity for other competing partners. As all the new entries and
existing firms are competing with each other so the new entry will definitely make an effect on
every one transacting in the market.
A potential development of substitute products also develops an environment of competition in
the market among the competing partners. As all firms want to compete in term of quality and
substitute will lasts for longer in the market if the quality of the substitute will be greater than the
existing alternate. Other factors also have a major impact on the substitutes.

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Collective bargaining power of suppliers and consumers: if vendors are less in the market and
the organizations that have to purchase from those vendors are more then the demand for those
suppliers will be more as the firms have to purchase from that less suppliers. The reverse is the
case if suppliers are more and buyers are less. Then the demand for those suppliers will be less.
Such circumstances create difficulties in bargaining.

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