THE EXTERNAL ASSESSMENT

CHAPTER III

The External Assessment

OVERVIEW OF CLASS MODULE

In this module, we will examine the tools and concepts needed to conduct an external strategic
management audit (sometimes called environmental scanning or industry analysis). 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, consumer fear of
traveling, and stock market volatility.

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. This chapter presents a practical framework for gathering, assimilating, and analyzing external
information. The Industrial Organization (I/O) view of strategic management is introduced.

LEARNING OBJECTIVES

By the end of this module, the students should be able to:

1. Describe how to conduct an external strategic-management audit;
2. Discuss 10 major external forces that affect organizations;
3. Describe key sources of external information, including the Internet;
4. Discuss important forecasting tools used in strategic management and monitoring external trends
and events; and
5. Explain EFE and Competitive Profile Matrix.

LEARNING CONTEXT
THE NATURE OF EXTERNAL AUDIT

The purpose of an external audit is to develop a finite “Nothing focuses the mind better than
the constant sight of a competitor who
list of opportunities that could benefit a firm and threats that wants to wipe you off the map.”
should be avoided. As the term finite suggests, the external
audit is not aimed at developing an exhaustive list of every -Wayne Calloway
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.

Key External Forces

External forces
can be divided
into five broad categories:
(1) economic forces; (2)
social, cultural,
demographic, and natural
environment forces; (3)
political, governmental, and
legal forces; (4)
technological forces; and (5)
competitive forces.
Relationships among these
forces and an organization
are depicted in Figure 3.1.

Figure 3.1 Relationship between Key

External Forces and an Organization
Changes in external forces translate into changes in
consumer demand for both industrial and consumer products and services. External forces affect the
types of products developed, the nature of positioning and market segmentation strategies, the type of

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 THE EXTERNAL ASSESSMENT
services offered, and the choice of businesses to acquire or sell. External forces directly affect both
suppliers and distributors.

Identifying and evaluating external opportunities and threats enables organizations to develop a
clear mission, to design strategies to achieve long-term objectives, and to develop policies to achieve
annual objectives.

The Process of Performing an External Audit

To perform an external audit, a company must:

 Gather Competitive Intelligence and Information about Economic, Social, Cultural,

Demographic, Environmental, Political, Governmental, Legal, 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.

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.

 Gathered Information must 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 on flip charts or a chalkboard. A prioritized list of these factors could be obtained by
requesting that all managers 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. Other variables commonly used
include market share, breadth of competing products, world economies, foreign affiliates,
proprietary and key account advantages, price competitiveness, technological advancements,
population shifts, interest rates, and pollution abatement.

Freund emphasized that these key external factors should be (1) important to achieving long-
term and annual objectives, (2) measurable, (3) applicable to all competing firms, and (4)
hierarchical in the sense that some will pertain to the overall company and others will be more
narrowly focused on functional or divisional areas.1 A final list of the most important key
external factors should be communicated and distributed widely in the organization. Both
opportunities and threats can be key external factors.

INDUSTRIAL ORGANIZATION

The Industrial Organization (I/O) approach to competitive advantage advocates that external
(industry) factors are more important than internal factors in a firm achieving competitive advantage.
Proponents of the I/O view, such as Michael Porter, contend that organizational performance will be
primarily determined by industry forces.

I/O theorists contend that external factors in general and the industry in which a firm chooses to
compete has a stronger influence on the firm’s performance than do the internal functional decisions
managers make in marketing, finance, and the like.

The I/O view has enhanced our understanding of strategic management. However, it is not a
question of whether external or internal factors are more important in gaining and maintaining
competitive advantage.

EXTERNAL FORCES

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Businesses do not operate in a vacuum, and they are influenced by forces beyond their control.
How they respond—and how quickly they respond—to these external forces can make the difference
between success and failure, especially in today’s fast-paced business climate. We can organize the
external forces that affect business into the following six categories:

 Economic Forces

These refer to the nature and direction of the economy in which business operates.
Economic factors have a tremendous impact on business firms. The general state of the economy
(e.g., depression, recession, recovery, or prosperity), interest rate, stage of the economic cycle,
balance of payments, monetary policy, fiscal policy, are key variables in corporate investment,
employment, and pricing decisions.

The impact of growth or decline in gross national product and increases or decreases in
interest rates, inflation, and the value of the dollar are considered as prime examples of
significant impact on business operations.

To assess the local situation, an organization might seek information concerning the
economic base and future of the region and the effects of this outlook on wage rates, disposable
income, unemployment, and the transportation and commercial base. The state of world
economy is most critical for organizations operating in such areas.

 Social, Cultural, Demographic, and Natural Environment Forces

Social, cultural, demographic, and environmental changes have a major impact on virtually
all products, 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.

Social, cultural, demographic, and environmental trends are shaping the way people live,
work, produce, and consume.

 Political, Governmental, and Legal Forces

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. The increasing global interdependence among economies, markets,
governments, and organizations makes it imperative that firms consider the possible impact of
political variables on the formulation and implementation of competitive strategies.

 Technological Forces

Technological forces represent major opportunities and threats that must be considered in
formulating strategies. Technological advancements can dramatically 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.

 Global Forces

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 THE EXTERNAL ASSESSMENT
From a business perspective, it is a small world, and it’s only getting smaller. Free
trade among nations has allowed goods and services to flow across international borders more
efficiently and cheaply. Formal trade agreements among nations have forged unprecedented
links and interdependencies among economies.

It’s not just the local economy or even the national economy that businesses must track—
companies must also keep an eye on the world economy in order to anticipate and adapt to
changes that will impact their products and services.

 Competitive Forces

How do businesses stay competitive and still maintain a level of profitability that allows
them to be successful? The competitive environment has intensified with the development of new
technologies, the opening up of foreign markets, and the rise of consumer expectations.

The local hardware store now finds itself competing with “big box” stores such as Lowe’s
and Home Depot. These larger stores have enough clout with suppliers that they can often sell a
product to the consumer for less than an independent store can purchase it. Customers of these
large chains can order online, get their items the same day, and receive loyalty rewards, free
delivery, customization, and even service and installation.

Staying competitive is a challenge for every business, and business owners are finding
that benefits such as customer service, employee knowledge, and high quality can help them
survive.

Competitive Intelligence Programs

Competitive intelligence (CI), as formally defined by the Society of Competitive Intelligence

Professionals (SCIP), is a systematic and ethical process for gathering and analyzing information about
the competition’s activities and general business trends to further a business’s own goals (SCIP Web
site).

Good competitive intelligence in business, as in the military, is one of the keys to success. The
more information and knowledge a firm can obtain about its competitors, the more likely it is that it
can formulate and implement effective strategies. Major competitors’ weaknesses can represent
external opportunities; major competitors’ strengths may represent key threats.

Competitive Analysis: Porter’s Five-Forces Model

Michael Porter, an authority on competitive

strategy, contends that a corporation is most
concerned with the intensity of competition within its
industry.

The level of this intensity is determined by basic

competitive forces. The collective strength of these
forces, determines the ultimate profit potential in the
industry, where profit potential is measured in terms
of long-run return on invested capital.

1. Power of Buyers

This shouldn’t be underestimated by companies to drive prices down. How important each
individual buyer is to the company is something to reckon with. Buyers affect an industry through their
ability to force down prices, bargain for higher quality or more services, and play competitors against
each other.

Things to Ponder:

- Number or customers - Cost of changing

- Size of each order - Ability to substitute
- Differences between competitors - Price sensitivity

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2. Rivalry of Competitors

Knowing the strength of the rivalry, a company can also determine its own strength. In most
industries, corporations are mutually dependent. A competitive move by one firm can be expected to
have a noticeable effect on its competitors and thus may cause retaliation.

Intense rivalry is related to the presence of several factors:

- Number of competitors
- Quality differences
- Other differences
- Switching cost
- Customer loyalty
- Cost of leaving market

3. Power of Suppliers

A company should realize that suppliers can easily drive up their prices. They can easily put control
in a particular organization depending on how important or crucial the materials are to the company.
Suppliers can affect an industry through their ability to raise prices or reduce the quality of purchased
goods and services.

Things to Ponder:

- Number of suppliers
- Size of suppliers
- Uniqueness of service
- Ability to substitute
- Cost of changing

4. Threat of Substitute

One the threats is the power of outsourcing. A substitute product is a product that appears to be
different but can satisfy the same need as another product. Substitutes limit the potential returns of an
industry by placing a ceiling on the prices firms in the industry can profitably charge.

Sometimes a difficult task, the identification of possible substitute products or services means
searching for products or services that can perform the same function, even though they have a
different appearance and may not appear to be easily substitutable.

Things to Ponder:

- Substitute performance
- Cost changing

5. Threat of New Entrants

If a new player is equally competitive and there are no durable barriers to enter in the market, then
a company can weaken its position in the market. New entrants to an industry typically bring to it new
capacity, a desire to gain market share, and substantial resources – threats.

The threat of entry depends on the presence of entry barriers and the reaction that can be
expected from existing competitors. An entry barrier is an obstruction that makes it difficult for a
company to enter an industry.

Possible barriers to entry:

- Time and cost of entry

- Specialist knowledge
- Economies of scale
- Cost advantages
- Technology protection

FORECASTING TOOLS AND TECHNIQUES

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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

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

services, stronger competitors, and shifts in government priorities, changing social values, unstable
economic conditions, and unforeseen events.

Making Assumptions

Planning would be impossible without assumptions. McConkey defines assumptions as the “best
present estimates of the impact of major external factors, over which the manager has little if any
control, but which may exert a significant impact on performance or the ability to achieve desired
results.”

Strategists are faced with countless variables and imponderables that can be neither controlled
nor predicted with 100 percent accuracy. Wild guesses should never be made in formulating strategies,
but reasonable assumptions based on available information must always be made.

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, speeches at
professional and shareholders’ meetings, television programs, interviews, and conversations with
stakeholders. Published sources of strategic information include periodicals, journals, reports,
government documents, abstracts, books, directories, newspapers, and manuals. The Internet has
made it easier for firms to gather, assimilate, and evaluate information.

Most college libraries subscribe to Standard & Poor’s (S&P’s) Industry Surveys. These documents
are exceptionally up-to-date and give valuable information about many different industries. Each report
is authored by a Standard & Poor’s industry research analyst and includes the following sections:

1. Current Environment
2. Industry Trends
3. How the Industry Operates
4. Key Industry Ratios and Statistics
5. How to Analyze a Company
6. Glossary of Industry Terms
7. Additional Industry Information
8. References
9. Comparative Company Financial Analysis

INDUSTRY ANALYSIS: THE EXTERNAL FACTOR EVALUATION

An External Factor Evaluation (EFE) Matrix allows strategists to summarize and evaluate
economic, social, cultural, demographic, environmental, political, governmental, legal, technological,
and competitive information. Illustrated in Table 3-1, the EFE Matrix can be developed in five steps:

1. List key external factors as identified in the external-audit process. Include a total of 15 to 20
factors, including both opportunities and threats that affect the firm and its industry. List the
opportunities first and then the threats. Be as specific as possible, using percentages, ratios, and
comparative numbers whenever possible. Recall that Edward Deming said, “In God we trust.
Everyone else bring data.”

2. Assign to each factor a weight that ranges from 0.0 (not important) to 1.0 (very important). The
weight indicates the relative importance of that factor to being successful in the firm’s industry.
Opportunities often receive higher weights than threats, but threats can receive high weights if
they are especially severe or threatening. Appropriate weights can be determined by comparing
successful with unsuccessful competitors or by discussing the factor and reaching a group
consensus. The sum of all weights assigned to the factors must equal 1.0.

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3. Assign a rating between 1 and 4 to each key external factor to indicate how effectively the firm’s
current strategies respond to the factor, where 4 = the response is superior, 3 = the response is
above average, 2 = the response is average, and 1 = the response is poor. Ratings are based on
effectiveness of the firm’s strategies. Ratings are thus company-based, whereas the weights in
Step 2 are industry-based. It is important to note that both threats and opportunities can receive a
1, 2, 3, or 4.

4. Multiply each factor’s weight by its rating to determine a weighted score.

5. Sum the weighted scores for each variable to determine the total weighted score for the
organization.

Table 3.1 EFE Matrix for a Local Ten-Theater Cinema

Complex
Regardless of the number of key
opportunities and threats included in an EFE Matrix, the highest possible total weighted score for an
organization is 4.0 and the lowest possible total weighted score is 1.0. The average total weighted
score is 2.5. A total weighted score of 4.0 indicates that an organization is responding in an
outstanding way to existing opportunities and threats in its industry. In other words, the firm’s
strategies effectively take advantage of existing opportunities and minimize the potential adverse
effects of external threats. A total score of 1.0 indicates that the firm’s strategies are not capitalizing
on opportunities or avoiding external threats.

An example of an EFE Matrix is provided in Table 3.1 for a local ten-theatre cinema complex. Note
that the most important factor to being successful in this business is “Trend toward healthy eating
eroding concession sales” as indicated by the 0.12 weight. Also note that the local cinema is doing
excellent in regard to handling two factors, “TDB University is expanding 6 percent annually” and
“Trend toward healthy eating eroding concession sales.”

Perhaps the cinema is placing flyers on campus and also adding yogurt and healthy drinks to its
concession menu. Note that you may have a 1, 2, 3, or 4 anywhere down the Rating column. Note also
that the factors are stated in quantitative terms to the extent possible, rather than being stated in
vague terms. Quantify the factors as much as possible in constructing an EFE Matrix.

Finally, note that the total weighted score of 2.58 is above the average (midpoint) of 2.5, so this
cinema business is doing pretty well, taking advantage of the external opportunities and avoiding the
threats facing the firm. There is definitely room for improvement, though, because the highest total
weighted score would be 4.0. As indicated by ratings of 1, this business needs to capitalize more on the
“two new neighborhoods nearby” opportunity and the “movies rented from Time Warner” threat.

***Note also that there are many percentage-based factors among the group. Be quantitative to the
extent possible! Note also that the ratings range from 1 to 4 on both the opportunities and threats.

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THE COMPETITIVE PROFILE MATRIX

The Competitive Profile Matrix (CPM) identifies a firm’s major competitors and its particular
strengths and weaknesses in relation to a sample firm’s strategic position. The weights and total
weighted scores in both a CPM and an EFE have the same meaning.

However, critical success factors in a CPM include both internal and external issues; therefore, the
ratings refer to strengths and weaknesses, where 4 = major strength, 3 = minor strength, 2 = minor
weakness, and 1 = major weakness.

The critical success factors in a CPM are not grouped into opportunities and threats as they are in
an EFE. In a CPM, the ratings and total weighted scores for rival firms can be compared to the sample
firm. This comparative analysis provides important internal strategic information. A sample CPM is
provided in table 3.2 and 3.3.

Table 3.2 Example of Competitive Profile Matrix

In this example, the two most important factors to being successful in the industry are
“advertising” and “global expansion,” as indicated by weights of 0.20. If there were no weight column
in this analysis, note that each factor then would be equally important.

Thus, having a weight column makes for a more robust analysis, because it enables the analyst to
assign higher and lower numbers to capture perceived or actual levels of importance. Note in Table 3-2
that Company 1 is strongest on “product quality,” as indicated by a rating of 4, whereas Company 2 is
strongest on “advertising.” Overall, Company 1 is strongest, as indicated by the total weighted score of
3.15.

Other than the critical success factors listed in the example CPM, factors often included in this
analysis include breadth of product line, effectiveness of sales distribution, proprietary or patent
advantages, location of facilities, production capacity and efficiency, experience, union relations,
technological advantages, and e-commerce expertise.

A word on interpretation: Just because one firm receives a 3.2 rating and another receives a 2.80
rating in a Competitive Profile Matrix, it does not follow that the first firm is 20 percent better than the
second. Numbers reveal the relative strengths of firms, but their implied precision is an illusion.
Numbers are not magic. The aim is not to arrive at a single number, but rather to assimilate and
evaluate information in a meaningful way that aids in decision making.

SOURCE:

 David, Fred R. (2011). “Strategic Management: Concepts and Cases.” 13th Edition. Pearson
Education, Inc.

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