Chapter 3: Evaluating the External Environment

Chapter 3: Evaluating the External Environment

3.1 Evaluating the External Environment

3.2 The Relationship between an Organization and Its Environment

3.3 Evaluating the General Environment

3.4 Evaluating the Industry

3.5 Mapping Strategic Groups

3.6 Conclusion

3.1 Evaluating the External Environment

Learning Objectives

After reading this chapter, you should be able to understand and articulate answers to the following questions:

1. What is the general environment and why is it important to organizations?

2. What are the features of Porter’s five forces industry analysis?

3. What are strategic groups and how are they useful to evaluating the environment?

Subway Is on a Roll

As shown in the highlighted countries, Subway is well on its way to building a worldwide sandwich empire.

Wikimedia Commons – CC BY-SA 3.0.

Many observers were stunned in March 2011 when news broke that Subway had surpassed McDonald’s as the biggest restaurant chain in the world. At the time of the announcement, Subway had 33,749 units under its banner while McDonald’s had 32,737 (Kingsley, 2011). Despite its meteoric growth, many opportunities remained. In China, for example, Subway had fewer than two hundred stores. In contrast, China hosts more than 3,200 Kentucky Fried Chicken stores. Overall, Subway was on a roll, and this success seemed likely to continue.

How had Subway surpassed a global icon like McDonald’s? One key factor was Subway’s efforts to provide and promote healthy eating options. This emphasis took hold in the late 1990s when the American public became captivated by college student Jared Fogle. As a freshman at Indiana University in 1998, the 425 pound Fogle decided to try to lose weight by walking regularly and eating a diet consisting of Subway subs. Amazingly, Fogle dropped 245 pounds by February of 1999.

Subway executives knew that a great story had fallen into their laps. They decided to feature Fogle in Subway’s advertising and soon he was a well-known celebrity. In 2007, Fogle met with President Bush about nutrition and testified before the US Congress about the need for healthier snack options in schools. Today, Fogle is the face of Subway and

one of the few celebrities that are instantly recognizable based on his first name alone. Much like Beyoncé and Oprah, you can mention “Jared” to almost anyone in America and that person will know exactly of whom you are speaking. Subway’s line of Fresh Fit sandwiches is targeted at prospective Jareds who want to improve their diets.

Because American diets contain too much salt, which can cause high blood pressure, salt levels in restaurant food are attracting increased scrutiny. Subway responded to this issue in April 2011 when its outlets in the United States reduced the amount of salt in all its sandwiches by at least 15 percent without any alteration in taste. The Fresh Fit line of sandwiches received a more dramatic 28 percent reduction in salt. These changes were enacted after customers of Subway’s outlets in New Zealand and Australia embraced similar adjustments. Although the new sandwich recipes cost slightly more than the old ones, Subway plans to absorb these costs rather than raising their prices (Riley, 2011). This may be a wise strategy for retaining customers, who have become very price sensitive because of the ongoing uncertainty surrounding the American economy and the high unemployment.

References

Kingsley, P. 2011, March 9. How a sandwich franchise ousted McDonald’s. The Guardian. Retrieved from

http://www.guardian.co.uk/lifeandstyle/2011/mar/09/subway-biggest -fast-food-chain.

Riley, C. 2011, April. Subway lowers salt in its sandwiches. CNNMoney. Retrieved from http://money.cnn.com/

2011/04/18/news/companies/subway_salt/index.htm.

69 Mastering Strategic Management

3.2 The Relationship between an Organization and Its Environment

Learning Objectives

1. Define the environment in the context of business.

2. Understand how an organization and its environment affect each other.

3. Learn the difference between the general environment and the industry.

What Is the Environment?

For any organization, the environment consists of the set of external conditions and forces that have the potential

to influence the organization. In the case of Subway, for example, the environment contains its customers, its

rivals such as McDonald’s and Kentucky Fried Chicken, social trends such as the shift in society toward healthier

eating, political entities such as the US Congress, and many additional conditions and forces.

It is useful to break the concept of the environment down into two components. The general environment

(or macroenvironment) includes overall trends and events in society such as social trends, technological trends,

demographics, and economic conditions. The industry (or competitive environment) consists of multiple

organizations that collectively compete with one another by providing similar goods, services, or both.

Every action that an organization takes, such as raising its prices or launching an advertising campaign, creates

some degree of changes in the world around it. Most organizations are limited to influencing their industry.

Subway’s move to cut salt in its sandwiches, for example, may lead other fast-food firms to revisit the amount of

salt contained in their products. A few organizations wield such power and influence that they can shape some

elements of the general environment. While most organizations simply react to major technological trends, for

example, the actions of firms such as Intel, Microsoft, and Apple help create these trends. Some aspects of the

general environment, such as demographics, simply must be taken as a given by all organizations. Overall, the

environment has a far greater influence on most organizations than most organizations have on the environment.

Why Does the Environment Matter?

Understanding the environment that surrounds an organization is important to the executives in charge of the

organizations. There are several reasons for this. First, the environment provides resources that an organization

needs in order to create goods and services. In the seventeenth century, British poet John Donne famously noted

that “no man is an island.” Similarly, it is accurate to say that no organization is self-sufficient. As the human

body must consume oxygen, food, and water, an organization needs to take in resources such as labor, money,

and raw materials from outside its boundaries. Subway, for example, simply would cease to exist without the

contributions of the franchisees that operate its stores, the suppliers that provide food and other necessary inputs,

and the customers who provide Subway with money through purchasing its products. An organization cannot

survive without the support of its environment.

Second, the environment is a source of opportunities and threats for an organization. Opportunities are

events and trends that create chances to improve an organization’s performance level. In the late 1990s, for

example, Jared Fogle’s growing fame created an opportunity for Subway to position itself as a healthy alternative

to traditional fast-food restaurants. Threats are events and trends that may undermine an organization’s

performance. Subway faces a threat from some upstart restaurant chains. Saladworks, for example, offers a variety

of salads that contain fewer than five hundred calories. Noodles and Company offers a variety of sandwiches,

pasta dishes, and salads that contain fewer than four hundred calories. These two firms are much smaller than

Subway, but they could grow to become substantial threats to Subway’s positioning as a healthy eatery.

Executives must also realize that virtually any environmental trend or event is likely to create opportunities for

some organizations and threats for others. This is true even in extreme cases. In addition to horrible human death

and suffering, the March 2011 earthquake and tsunami in Japan devastated many organizations, ranging from

small businesses that were simply wiped out to corporate giants such as Toyota whose manufacturing capabilities

were undermined. As odd as it may seem, however, these tragic events also opened up significant opportunities for

other organizations. The rebuilding of infrastructure and dwellings requires concrete, steel, and other materials.

Japanese concrete manufacturers, steelmakers, and construction companies are likely to be very busy in the years

ahead.

Natural disasters devastate many organizations.

Kim Seng – Monthly Newsletter – November 2011 – CC BY-NC-ND 2.0.

Third, the environment shapes the various strategic decisions that executives make as they attempt to lead

their organizations to success. The environment often places important constraints on an organization’s goals, for

71 Mastering Strategic Management

example. A firm that sets a goal of increasing annual sales by 50 percent might struggle to achieve this goal during

an economic recession or if several new competitors enter its business. Environmental conditions also need to be

taken into account when examining whether to start doing business in a new country, whether to acquire another

company, and whether to launch an innovative product, to name just a few.

Key Takeaway

• An organization’s environment is a major consideration. The environment is the source of resources that the organizations needs. It provides opportunities and threats, and it influences the various strategic decisions that executives must make.

Exercises

1. What are the three reasons that the environment matters?

2. Which of these three reasons is most important? Why?

3. Can you identify an environmental trend that no organizations can influence?

3.2 The Relationship between an Organization and Its Environment 72

3.3 Evaluating the General Environment

Learning Objectives

1. Explain how PESTEL analysis is useful to organizations.

2. Be able to offer an example of each of the elements of the general environment.

The Elements of the General Environment: PESTEL Analysis

An organization’s environment includes factors that it can readily affect as well as factors that largely lay beyond

its influence. The latter set of factors are said to exist within the general environment. Because the general

environment often has a substantial influence on an organization’s level of success, executives must track trends

and events as they evolve and try to anticipate the implications of these trends and events.

PESTEL analysis is one important tool that executives can rely on to organize factors within the general

environment and to identify how these factors influence industries and the firms within them. PESTEL is an

anagram, meaning it is a word that created by using parts of other words. In particular, PESTEL reflects the

names of the six segments of the general environment: (1) political, (2) economic, (3) social, (4) technological,

(5) environmental, and (6) legal. Wise executives carefully examine each of these six segments to identify major

opportunities and threats and then adjust their firms’ strategies accordingly (Table 3.1 “PESTEL”).

Table 3.1 PESTEL

Examining the general enviornment involves gaining an understanding of key factors and trends in broader

society. PESTEL analysis is a popular framework for organizing these factors and trends and isolating how they

influence industries and the firms within them. Below we describe each of the six dimensions associated with

PESTEL analysis: political, economic, social, technological, environmental, and legal.

P Political factors include elements such as tax policies, changes in trade restrictions and tariffs, and the stability of governments.

E Economic factors include elements such as interest rates, inflation rates, gross domestic product, unemployment rates, levels of disposable income, and the general growth or decline of the economy.

S Social factors include trends in demographics such as population size, age, and ethnic mix, as well as cultural trends such as attitudes toward obesity and consumer activism.

T Technological factors include, for example, changes in the rate of new product development, increases in automation, and advancements in service industry delivery.

E Environmental factors include, for example, natural disasters and weather patterns.

L Legal factors include laws involving issues such as employment, health and safety, discrimination, and antitrust.

P Is for “Political”

The political segment centers on the role of governments in shaping business. This segment includes elements

such as tax policies, changes in trade restrictions and tariffs, and the stability of governments (Table 3.2 “Political

Factors”). Immigration policy is an aspect of the political segment of the general environment that offers

important implications for many different organizations. What approach to take to illegal immigration into the

United States from Mexico has been a hotly debated dilemma. Some hospital executives have noted that illegal

immigrants put a strain on the health care system because immigrants seldom can pay for medical services and

hospitals cannot by law turn them away from emergency rooms.

Table 3.2 Political Factors

Examples of several key trends representing political factors in the general environment are illustrated below.

3.3 Evaluating the General Environment 74

The extent to which companies developing clean energy sources should be subsidized by the government versus being left on their own to compete with providers of traditional energy sources is currently a hotly contested political issue.

The use of child labor was once commonplace in the United States now firms face political scrutiny when using overseas suppliers that employ child labor.

The word tariff derived from an Arabic word meaning “fees to be paid.” By levying tariffs and implementing other trade restrictions, governments can — to some extent — protect domestic firms from international competition.

The stability of the US government provides a source of confidence for foreign firms who want to do business in the United States. Countries that face frequent regime change and political turmoil have a harder time attracting foreign investments.

One of the most important duties of elected officials in the United States is to debate and set new tax policies.

Proposals to provide support to businesses are often featured within political campaigns.

Meanwhile, farmers argue that a tightening of immigration policy would be harmful because farmers rely

heavily on cheap labor provided by illegal immigrants. In particular, if farmers were forced to employ only

legal workers, this would substantially increase the cost of vegetables. Restaurant chains such as Subway would

then pay higher prices for lettuce, tomatoes, and other perishables. Subway would then have to decide whether

to absorb these costs or pass them along to customers by charging more for subs. Overall, any changes in

immigration policy will have implications for hospitals, farmers, restaurants, and many other organizations.

E Is for “Economic”

The economic segment centers on the economic conditions within which organizations operate. It includes

75 Mastering Strategic Management

elements such as interest rates, inflation rates, gross domestic product, unemployment rates, levels of disposable

income, and the general growth or decline of the economy (Table 3.3 “Economic Factors”). The economic crisis

of the late 2000s has had a tremendous negative effect on a vast array of organizations. Rising unemployment

discouraged consumers from purchasing expensive, nonessential goods such as automobiles and television sets.

Bank failures during the economic crisis led to a dramatic tightening of credit markets. This dealt a huge blow

to home builders, for example, who saw demand for new houses plummet because mortgages were extremely

difficult to obtain.

Table 3.3 Economic Factors

Examples of several key trends representing economic factors in the general environment are illustrated below.

The unemployment rate is the percentage of the labor force actively lookin for employment within the last four

weeks. During the Great Depression of the 1930s, the United States suffered through an unemployment rate of

approximately 25%.

Housing starts in an economic indicator that measures the number of houses, apartments, and condos on which new construction has been started. Because construction involves a wide array of industries–concrete, steel, wood, drywall, plumbing, banks, and many others–housing starts are a carefully watched measure of economic conditions.

Gross domestic product (GDP) refers to the market value of goods and services within a country produced in a given time period and serves as a rough indicator of a country’s standard of living. The United States has a much larger GDP than China, but China has enjoyed a much higher rate of GDP growth in recent years.

The Federal Reserve System (commonly referred to as “The Fed”) is the United States’ central banking system. The Fed attempts to strengthen the economy through its decisions, such as setting short-term interest rates.

Discretionary income refers to the amount of money individuals have to spend after all necessary bills are paid. As discretionary income increases, firms such as boutique clothing retailers that sell nonessential goods and services are more likely to prosper.

Some businesses, however, actually prospered during the crisis. Retailers that offer deep discounts, such as

Dollar General and Walmart, enjoyed an increase in their customer base as consumers sought to find ways to

economize. Similarly, restaurants such as Subway that charge relatively low prices gained customers, while high-

end restaurants such as Ruth’s Chris Steak House worked hard to retain their clientele.

3.3 Evaluating the General Environment 76

Decisions about interest rates made by the Federal Reserve create opportunities for some organizations and threats for others.

S Is for “Social”

A generation ago, ketchup was an essential element of every American pantry and salsa was a relatively unknown

product. Today, however, food manufacturers sell more salsa than ketchup in the United States. This change

reflects the social segment of the general environment. Social factors include trends in demographics such as

population size, age, and ethnic mix, as well as cultural trends such as attitudes toward obesity and consumer

activism (Table 3.4 “Social Factors”). The exploding popularity of salsa reflects the increasing number of Latinos

in the United States over time, as well as the growing acceptance of Latino food by other ethnic groups.

Table 3.4 Social Factors

Examples of several key trends representing social factors in the general environment are illustrated below.

77 Mastering Strategic Management

The rise of upscale cupcake outlets reflects a current trend in American eateries: pricey specialty stores are very popular among some consumers.

Hunters remain a powerful force in American society, but their ranks shrunk by 10% between 1996 and 2006. Wildlife agencies worry about the loss of license-fee revenue will affect their ability to manage land and water resources, and lower levels of demand for their products threaten the success of gun makers.

In the 1800s, most American couples raised many children. Farmers, for example, took this approach because it supplied labor that small farms needed in order to operate. Today, most families are smaller.

One in three Americans is obese, due in part to the increasing prevalence of fast-good restaurants and the popularity of sedentary activities such as playing video games.

Hemline theory contends that women’s skirt lengths predict stock market increases and declines. The idea was born in the 1920s when economist George Taylor noticed that many women raised their skirts to reveal their silk stockings when times were good, but lowered their skirts to hide the fact that they weren’t wearing stockings when times were tough.

The tendency to collect material items while being reluctant to throw them away has led to a rise in self-storage outlets as well as awareness of a hoarding epidemic.

Sometimes changes in the social segment arise from unexpected sources. Before World War II, the American

workforce was overwhelmingly male. When millions of men were sent to Europe and Asia to fight in the war,

however, organizations had no choice but to rely heavily on female employees. At the time, the attitudes of many

executives toward women were appalling. Consider, for example, some of the advice provided to male supervisors

of female workers in the July 1943 issue of Transportation Magazine:1

• Older women who have never contacted the public have a hard time adapting themselves and are

inclined to be cantankerous and fussy. It’s always well to impress upon older women the importance of

friendliness and courtesy.

• General experience indicates that “husky” girls—those who are just a little on the heavy side—are

more even tempered and efficient than their underweight sisters.

• Give every girl an adequate number of rest periods during the day. You have to make some allowances

for feminine psychology. A girl has more confidence and is more efficient if she can keep her hair

tidied, apply fresh lipstick and wash her hands several times a day.

The tremendous contributions of female workers during the war contradicted these awful stereotypes. The main

role of women who assembled airplanes, ships, and other war materials was to support the military, of course,

but their efforts also changed a lot of male executives’ minds about what females could accomplish within

organizations if provided with opportunities. Inequities in the workplace still exist today, but modern attitudes

among men toward women in the workplace are much more enlightened than they were in 1943.

3.3 Evaluating the General Environment 78

Women’s immense contributions to the war effort during World War II helped create positive social changes in the ensuing decades.

Wikimedia Commons – public domain.

Beyond being a positive social change, the widespread acceptance of women into the workforce has created

important opportunities for certain organizations. Retailers such as Talbot’s and Dillard’s sell business attire to

women. Subway and other restaurants benefit when the scarceness of time lead dual income families to purchase

take-out meals rather than cook at home.

79 Mastering Strategic Management

A surprising demographic trend is that both China and India have more than twice as many English-speaking college graduates each

year than does the United States.

T Is for “Technological”

The technological segment centers on improvements in products and services that are provided by science.

Relevant factors include, for example, changes in the rate of new product development, increases in automation,

and advancements in service industry delivery (Table 3.5 “Technological Factors”). One key feature of the modern

era is the ever-increasing pace of technological innovation. In 1965, Intel cofounder Gordon E. Moore offered

an idea that has come to be known as Moore’s law. Moore’s law suggests that the performance of microcircuit

technology roughly doubles every two years. This law has been very accurate in the decades since it was offered.

Table 3.5 Technological Factors

Examples of several key trends representing technological factors in the general environment are illustrated

below.

3.3 Evaluating the General Environment 80

Unsuccessful technological innovations such a Smell-O-Vision (a system that would release different odors that matched the events shown on screen) highlight the risk associated with the technology sector. Image watching a show on horse stables!

The adoption rate of new technology is closely monitored by market research firms. The Internet reached 50 million users in 4 years. To reach the same number of users took 13 years for TV and 38 years for radio.

The dramatic changes in the video game industry over the past 25 years highlight the need to constantly adapt to technological factors to maintain market leadership. Once-mighty Atari has given way to current leaders Sony, Nintendo, and Microsoft.

Moore’s law suggests that the performance of microcircuit technology roughly doubles every two years.

The amount of government spending for research and development affects numerous industries. The government’s decision to dramatically scale back moon-based space programs may reduce the pace of scientific breakthroughs.

One implication of Moore’s law is that over time electronic devices can become smaller but also more powerful.

This creates important opportunities and threats in a variety of settings. Consider, for example, photography.

Just a decade ago, digital cameras were relatively large and they produced mediocre images. With each passing

year, however, digital cameras have become smaller, lighter, and better. Today, digital cameras are, in essence,

minicomputers, and electronics firms such as Panasonic have been able to establish strong positions in the market.

Meanwhile, film photography icon Kodak has been forced to abandon products that had been successful for

decades. In 2005, the firm announced that it would stop producing black-and-white photographic paper. Four

years later, Kodachrome color film was phased out.

Successful technologies are also being embraced at a much faster rate than in earlier generations. The Internet

reached fifty million users in only four years. In contrast, television reached the same number of users in thirteen

years while it took radio thirty-eight years. This trend creates great opportunities for organizations that depend on

emerging technologies. Writers of applications for Apple’s iPad and other tablet devices, for example, are able

to target a fast-growing population of users. At the same time, organizations that depend on technologies that

are being displaced must be aware that consumers could abandon them at a very rapid pace. As more and more

Internet users rely on Wi-Fi service, for example, demand for cable modems may plummet.

81 Mastering Strategic Management

Moore’s law explains how today’s iPhone can be one hundred times faster, one hundred times lighter, and ten times less expensive

than a “portable” computer built in the 1980s.

Wikimedia Commons – CC BY 2.0.

Although the influence of the technological segment on technology-based companies such as Panasonic and

Apple is readily apparent, technological trends and events help to shape low-tech businesses too. In 2009, Subway

started a service called Subway Now. This service allows customers to place their orders in advance using text

messages and avoid standing in line at the store. By offering customers this service, Subway is also responding to

a trend in the general environment’s social segment: the need to save time in today’s fast-paced society.

E Is for “Environmental”

The environmental segment involves the physical conditions within which organizations operate. It includes

factors such as natural disasters, pollution levels, and weather patterns (Table 3.6 “Environmental Factors”). The

threat of pollution, for example, has forced municipalities to treat water supplies with chemicals. These chemicals

increase the safety of the water but detract from its taste. This has created opportunities for businesses that provide

better-tasting water. Rather than consume cheap but bad-tasting tap water, many consumers purchase bottled

water. Indeed, according to the Beverage Marketing Corporation, the amount of bottled water consumed by the

average American increased from 1.6 gallons in 1976 to 28.3 gallons in 2006 (Earth911). At present, roughly one-

third of Americans drink bottled water regularly.

Table 3.6 Environmental Factors

Examples of several key trends representing enviornmental factors in the general environment are illustrated

below.

3.3 Evaluating the General Environment 82

The Subaru automotive plant in Lafayette, Indiana, was the first auto manufacturing facility to achieve zero landfill status.

Debate has raged over climate change in recent years. To the extend that more policy markers and consumers believe that human activity is increasing temperatures on the Earth, opportunities could increase for solar energy companies.

Individuals embracing the three Rs of green living–reduce, reuse, recycle–has fueled new business concepts such as Recycle Match, a firm that brings together waste products with businesses that need those materials.

Concern about the environmental effects of burning fossil fuels has contributed to the growing popularity of scooters.

The increase in the number of food cooperatives reflects growing interest in sustainable, natural foods that are produced with a high degree of social responsibility.

As is the case for many companies, bottled water producers not only have benefited from the general environment

but also have been threatened by it. Some estimates are that 80 percent of plastic bottles end up in landfills.

This has led some socially conscious consumers to become hostile to bottled water. Meanwhile, water filtration

systems offered by Brita and other companies are a cheaper way to obtain clean and tasty water. Such systems also

hold considerable appeal for individuals who feel the need to cut personal expenses due to e