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Chapter 3

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.

Image courtesy of Nomi887, http://en.wikipedia.org/wiki/File:Subway_world_map1edit.png .

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. [1]Despite its meteoric growth, many opportunities

remained. In China, for example, Subway had fewer than two hundred stores. In contrast, China hosts

Chapter from Mastering Strategic Management was adapted by The Saylor Foundation under

a Creative Commons Attribution NonCommercial ShareAlike .0 license without attribution as re Tuested by the work’s original creator or licensee. 01 , The Saylor Foundation. Saylor URL: http://www.saylor.org/books Saylor.org

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. Subw ay 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. [2]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.

[1] 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 Saylor URL: http://www.saylor.org/books Saylor.org

[2] 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

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3.1 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 envi ronment. 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. Saylor URL: http://www.saylor.org/books Saylor.org

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.” Simila rly, 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 Saylor URL: http://www.saylor.org/books Saylor.org

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.

Third, the environment shapes the va rious 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 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

xAn 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?

Saylor URL: http://www.saylor.org/books Saylor.org

3.2 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.

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 restri ctions and tariffs, and the stability of governments.

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

immigran ts 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. Saylor URL: http://www.saylor.org/books Saylor.org

Meanwhile, farmers argue that a tightening of immigr ation 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 condit ions within which organizations operate. It

includes 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.

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. Saylor URL: http://www.saylor.org/books Saylor.org

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.

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. 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.

Sometimes changes in the social segment arise fr om unexpected sources. Before World War II, the

American workforce was overwhelmingly male. When mi llions of men were sent to Europe and Asia to Saylor URL: http://www.saylor.org/books Saylor.org

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 we re appalling. Consider, for example, some of the

advice provided to male supervisors of female workers in the July 1943 issue of Transportation

Magazine: [1]

xOlder 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.

xGeneral experience indicates that “husky” girls—th ose who are just a little on the heavy side—are

more even tempered and efficient than their underweight sisters.

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

for feminine psychology. A girl ha s 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. Saylor URL: http://www.saylor.org/books Saylor.org

Women’s immense contributions to the war effort during World War II helped create positive

social changes in the ensuing decades.

Image courtesy of J. Howard Miller, http://en.wikipedia.org/wiki/File:We_Can_Do_It!.jpg .

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. Saylor URL: http://www.saylor.org/books Saylor.org

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. 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.

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 Saylor URL: http://www.saylor.org/books Saylor.org

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-eig ht 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.

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 Saylor URL: http://www.saylor.org/books Saylor.org

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. 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.[2]

At present, roughly one-third of Americans drink bottled water regularly.

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 economic conditions. In sum, bottled water producers have been provided

opportunities by the environmental segment of the general environment (specifically, the spread of poor-

tasting water to combat pollution) but are faced with threats from the social segment (the social

conscience of some consumers) and the economic se gment (the financial concerns of other consumers). Saylor URL: http://www.saylor.org/books Saylor.org

L Is for “Legal”

The legal segment centers on how the courts influence business activity. Examples of important legal

factors include employment laws, health and safety regulations, discrimination laws, and antitrust laws.

Intellectual property rights are a particularly daunting aspect of the legal segment for many organizations.

When a studio such as Pixar produces a movie, a software firm such as Adobe revises a program, or a

video game company such as Activision devises a new game, these firms are creating intellectual property.

Such firms attempt to make profits by selling copies of their movies, programs, and games to individuals.

Piracy of intellectual property—a process wherein illegal copies are made and sold by others—poses a

serious threat to such profits. Law enforcement agencies and courts in many countries, including the

United States, provide organizations with the necessary legal mechanisms to protect their intellectual

property from piracy. Saylor URL: http://www.saylor.org/books Saylor.org

In other countries, such as China, piracy of intellectual property is quite common. Three other general

environment segments play a role in making piracy a major concern. First, in terms of the social segment,

China is the most populous country in the world. Second, in terms of the economic segment, China’s

affluence is growing rapidly. Third, in terms of the technological segment, rapid advances in computers

and communication have made piracy easier over time. Taken together, these various general

environment trends lead piracy to be a major source of angst for firms that rely on intellectual property to

deliver profits.

KEY TAKEAWAY

xTo transform an avocado into guacamole, a chef may choose to use a mortar and pestle. A mortar is a

mashing device that is shaped liked a baseball bat, while a pestle is a sturdy bowl within which the

mashing takes place. Similarly, PESTEL reflects the general environment factors—political, economic,

social, technological, environmental, and legal—that can crush an or ganization. In many cases, executives

can prevent such outcomes by performing a PESTEL analysis to diagnose where in the general

environment important opportunities and threats arise. Saylor URL: http://www.saylor.org/books Saylor.org

EXERCISES

1. What does each letter of PESTEL mean?

2. Using a recent news article, identify a trend that has a positive and negative implication for a particular

industry.

3. Can you identify a general environment trend that has positive implications for nursing homes but

negative implications for diaper makers?

4. Are all six elements of PESTEL important to every organization? Why or why not?

5. What is a key trend for each letter of PESTEL and one industry or firm that would be affected by that

trend?

[1] 1943 guide to hiring women. 2007, September–October. Savvy & Sage, p. 16.

[2] Plastic recycling facts. earth911.com. Retrieved from http://earth911.com/recycling/plastic/plastic-bottle-

recycling-facts

Saylor URL: http://www.saylor.org/books Saylor.org

3.3 Evaluating the Industry

LEARNING OBJECTIVES

1. Explain how five forces analysis is useful to organizations.

2. Be able to offer an example of each of the five forces.

The Purpose of Five Forces Analysis

Visit the executive suite of any company and the chance s are very high that the chief executive officer and

her vice presidents are relying on five forces analysis to understand their industry. Introduced more than

thirty years ago by Professor Michael Porter of the Harvard Business School, five forces analysis has long

been and remains perhaps the most popular analytical tool in the business world.

Adapted from Porter, M. (1980). Competitive strategy. New York: Free Press.

The purpose of five forces analysis is to identify how much profit potential exists in an industry. To do so,

five forces analysis considers the interactions among the competitors in an industry, potential new Saylor URL: http://www.saylor.org/books Saylor.org

entrants to the industry, substitutes for the industry’s offerings, suppliers to the industry, and the

industry’s buyers. [1]If none of these five forces works to undermine profits in the industry, then the profit

potential is very strong. If all the forces work to undermine profits, then the profit potential is very weak.

Most industries lie somewhere in between these extrem es. This could involve, for example, all five forces

providing firms with modest help or two forces encouraging profits while the other three undermine

profits. Once executives determine how much profit potential exists in an industry, they can then decide

what strategic moves to make to be successful. If the situation looks bleak, for example, one possible move

is to exit the industry.

The Rivalry among Competitors in an Industry

The competitors in an industry are firms that produce similar products or services. Competitors use a

variety of moves such as advertising, new offerings, and price cuts to try to outmaneuver one another to

retain existing buyers and to attract new ones. Because competitors seek to serve the same general set of

buyers, rivalry can become intense. Subway faces fierce competition within the restaurant business,

for example. This is illustrated by a quote from the man who built McDonald’s into a worldwide icon.

Former CEO Ray Kroc allegedly once claimed that “if any of my competitors were

drowning, I’d stick a hose in their mouth.” While this sentiment was (hopefully) just a figure of speech,

the announcement in March 2011 that Subway had surpassed McDonald’s in terms of numbers of stores

might lead the hostility of McDonald’s toward its rival to rise.

Understanding the intensity of rivalry among an industry’s competitors is important because the degree of

intensity helps shape the industry’s profit potential. Of particular concern is whether firms in an industry

compete based on price. When competition is bitter and cutthroat, the prices competitors charge—and

their profit margins—tend to go down. If, on the other hand, competitors avoid bitter rivalry, then price

wars can be avoided and profit potential increases.

Every industry is unique to some degree, but there are some general characteristics that help to predict

the likelihood that fierce rivalry will erupt. Rivalry tends to be fierce, for example, to the extent that the

growth rate of demand for the industry’s offerings is low (because a lack of new customers forces firms to

compete more for existing customers), fixed costs in th e industry are high (because firms will fight to have Saylor URL: http://www.saylor.org/books Saylor.org

enough customers to cover these costs), competitors ar e not differentiated from one another (because this

forces firms to compete based on price rather than based on the uniqueness of their offerings),

and exit barriers in the industry are high (because firms do not have the option of leaving the industry

gracefully). Exit barriers can include emotional barriers, such as the bad publicity associated with massive

layoffs, or more objective reasons to stay in an industry, such as a desire to recoup considerable costs that

might have been previously spent to enter and compete.

Industry concentration is an important aspect of competition in many industries. Industry concentration

is the extent to which a small number of firms dominate an industry. Among circuses, for example,

the four largest companies collectively own 89 percent of the market. Meanwhile, these companies tend

to keep their competition rather polite. Their advertising does not lampoon one another, and they do not

put on shows in the same city at the same time. This does not guarantee that the circus industry will be

profitable; there are four other forces to consider as well as the quality of each firm’s strategy.

But low levels of rivalry certainly help build the profit potential of the industry.

In contrast, the restaurant industry is fragmented, meaning that the largest rivals control just a small

fraction of the business and that a large number of firms are important participants. Rivalry in

fragmented industries tends to become bitter and fierce. Quiznos, a chain of sub shops that is roughly 15

percent the size of Subway, has directed some of its advertising campaigns directly at Subway, including

one depicting a fictional sub shop called “Wrong Way” that bore a strong resemblance to Subway.

Within fragmented industries, it is almost inevitable that over time some firms will try to steal customers

from other firms, such as by lowering prices, and that any competitive move by one firm will be matched

by others. In the wake of Subway’s success in offering foot-long subs for $5, for example, Quiznos has

matched Subway’s price. Such price jockeying is delightful to customers, of course, but it tends to reduce

prices (and profit margins) within an industry. Indeed, Quiznos later escalated its attempt to attract

budget-minded consumers by introducing a flatbread sandwich that cost only $2. Overall, when choosing

strategic moves, Subway’s presence in a fragmented indu stry forces the firm to try to anticipate not only Saylor URL: http://www.saylor.org/books Saylor.org

how fellow restaurant giants such as McDonald’s and Burger King will react but also how smaller sub

shop chains like Quiznos and various regional and local players will respond.

The Threat of Potential New Entrants to an Industry

Competing within a highly profitable industry is desira ble, but it can also attract unwanted attention from

outside the industry. Potential new entrants to an industry are firms that do not currently compete in the

industry but may in the future. New entrants tend to reduce the profit potential of an industry by increasing

its competitiveness. If, for example, an industry consisting of five firms is entered by two new firms, this means

that seven rather than five firms are now trying to attract the same general pool of customers. Thus executives

need to analyze how likely it is that one or more new entrants will enter their industry as part of their effort

to understand the profit potential that their industry offers.

New entrants can join the fray within an industry in several different ways. New entrants can be start-up

companies created by entrepreneurs, foreign firms that decide to enter a new geographic area, supplier

firms that choose to enter their customers’ business, or buyer firms that choose to enter their suppliers’

business. The likelihood of these four paths being taken varies across industries. Restaurant firms such as

Subway, for example, do not need to worry about their buyers entering the industry because they sell

directly to individuals, not to firms. It is also unlikely that Subway’s suppliers, such as farmers, will make

a big splash in the restaurant industry.

On the other hand, entrepreneurs launch new restaurant concepts every year, and one or more of these

concepts may evolve into a fearsome competitor. Also, competitors based overseas sometimes enter

Subway’s core US market. In February 2011, Australia-based Oporto opened its first US store in

California. [2]Oporto operates more than 130 chicken burger restaurants in its home country. Time will

tell whether this new entrant has a significant effect on Subway and other restaurant firms. Because a

chicken burger closely resembles a hamburger, McDonald’s and Burger King may have more to fear from

Oporto than does Subway. Saylor URL: http://www.saylor.org/books Saylor.org

Every industry is unique to some degree, but some general characteristics help to predict the likelihood

that new entrants will join an industry. New entry is less likely, for example, to the extent that existing

competitors enjoy economies of scale (because new entrants struggle to match incumbents’ prices),

capital requirements to enter the industry are high (because new entrants struggle to gather enough cash

to get started), access to distribution channels is limited (because new entrants struggle to get their

offerings to customers), governmental policy discourages new entry, differentiation among existing

competitors is high (because each incumbent has a group of loyal customers that enjoy its unique

features), switching costs are high (because this discourages customers from buying a new entrant’s

offerings), expected retaliation from existing competit ors is high, and cost advantages independent of size

exist.

The Threat of Substitutes for an Industry’s Offerings

Executives need to take stock not only of their direct competition but also of players in other industries

that can steal their customers. Substitutes are offerings that differ from the goods and services provided

by the competitors in an industry but that fill similar needs to what the industry offers.How strong of a

threat substitutes are depends on how effective substitutes are in serving an industry’s customers.

At first glance, it could appear that the satellite tele vision business is a tranquil one because there are only

two significant competitors—DIRECTV and DISH Network. These two industry giants, however, face a

daunting challenge from substitutes. The closest substi tute for satellite television is provided by cable

television firms, such as Comcast and Charter Communications. DIRECTV and DISH Network also need

to be wary of streaming video services, such as Netflix, and video rental services, such as Redbox. The

availability of viable substitutes places stringent limits on what DIRECTV and DISH Network can charge

for their services. If the satellite television firms raise their prices, customers will be tempted to obtain

video programs from alternative sources. This limits the profit potential of the satellite television

business.

In other settings, viable substitutes are not available, and this helps an industry’s competitors enjoy

profits. Like lightbulbs, candles can provide lighting within a home. Few consumers, however, would be Saylor URL: http://www.saylor.org/books Saylor.org

willing to use candles instead of lightbulbs. Candles simply do not provide as much light as lightbulbs.

Also, the risk of starting a fire when using candles is far greater than the fire risk of using lightbulbs.

Because candles are a poor substitute, lightbulb makers such as General Electric and Siemens do not need

to fear candle makers stealing their customers and undermining their profits.

The dividing line between which firms are competitors and which firms offer substitutes is a challenging

issue for executives. Most observers would agree that, from Subway’s perspective, sandwich maker

Quiznos should be considered a competitor and that grocery stores such as Kroger offer a substitute for

Subway’s offerings. But what about full-service restaurants, such as Ruth’s Chris Steak House, and “fast

causal” outlets, such as Panera Bread? Whether firms such as these are considered competitors or

substitutes depends on how the industry is defined. Under a broad definition—Subway competes in the

restaurant business—Ruth’s Chris and Panera should be considered competitors. Under a narrower

definition—Subway competes in the sandwich business—Panera is a competitor and Ruth’s Chris is a

substitute. Under a very narrow definition—Subway competes in the sub sandwich business—both Ruth’s

Chris and Panera provide substitute offerings. Thus clearly defining a firm’s industry is an important step

for executives who are performing a five forces analysis.

The Power of Suppliers to an Industry

Suppliers provide inputs that the firms in an industry need to create the goods and services that they in

turn sell to their buyers. A variety of supplies are important to companies, including raw materials,

financial resources, and labor. For restaurant firms such as Subway, key suppliers include such firms as Sysco

that bring various foods to their doors, restaurant supply stores that sell kitchen equipment, and

employees that provide labor.

The relative bargaining power between an industry’s competitors and its suppliers helps shape the profit

potential of the industry. If suppliers have greater leverage over the competitors than the competitors

have over the suppliers, then suppliers can increase their prices over time. This cuts into competitors’

profit margins and makes them less likely to be prosperous. On the other hand, if suppliers have less

leverage over the competitors than the competitors have over the suppliers, then suppliers may be forced

to lower their prices over time. This strengthens competitors’ profit margins and makes them more likely Saylor URL: http://www.saylor.org/books Saylor.org

to be prosperous. Thus when analyzing the profit potential of their industry, executives must carefully

consider whether suppliers have the ability to demand higher prices.

Every industry is unique to some degree, but some general characteristics help to predict the likelihood

that suppliers will be powerful relative to the firm s to which they sell their goods and services. Suppliers

tend to be powerful, for example, to the extent that the suppliers’ industry is dominated by a few

companies, if it is more concentrated than the indust ry that it supplies and/or if there is no effective

substitute for what the supplier group provides. These circumstances restrict industry competitors’ ability

to shop around for better prices and put suppliers in a position of strength.

Supplier power is also stronger to the extent that industry members rely heavily on suppliers to be

profitable, industry members face high costs when changing suppliers, and suppliers’ products are

differentiated. Finally, suppliers possess power to the extent that they have the ability to become a new

entrant to the industry if they wish. This is a strategy calledforward vertical integration. Ford, for

example, used a forward vertical integration strategy when it purchased rental car company (and Ford

customer) Hertz. A difficult financial situation forced Ford to sell Hertz for $5.6 billion in 2005. But

before rental car companies such as Avis and Thrifty drive too hard of a bargain when buying cars from an

automaker, their executives should remember that au tomakers are much bigger firms than are rental car

companies. The executives running the automaker might simply decide that they want to enjoy the rental

car company’s profits themselves and acquire the firm.

Strategy at the Movies

Flash of Genius

When dealing with a large company, a small supplier can get squashed like a bug on a windshield. That is

what college professor and inventor Dr. Robert Kearns found out when he invented intermittent

windshield wipers in the 1960s and attempted to supply them to Ford Motor Company. As depicted in the

2008 movieFlash of Genius , Kearns dreamed of manufacturing the wipers and selling them to Detroit

automakers. Rather than buy the wipers from Kearns, Ford replicated the design. An angry Kearns then

spent many years trying to hold the firm accountable for infringing on his patent. Kearns eventually won Saylor URL: http://www.saylor.org/books Saylor.org

in court, but he paid a terrible personal price along the way, including a nervous breakdown and

estrangement from his family. Kearns’s lengthy battle with Ford illustrates the concept of bargaining

power that is central to Porter’s five forces model. Even though Kearns created an exceptional new

product, he had little leverage when dealing with a massive, well-financed automobile manufacturer.

The Power of an Industry’s Buyers

Buyers purchase the goods and services that the firms in an industry produce. For Subway and other

restaurants, buyers are individual people. In contrast, the buyers for some firms are other firms rather than

end users. For Procter & Gamble, for example, buyers are retailers such as Walmart and Target who

stock Procter & Gamble’s pharmaceuticals, hair care products, pet supplies, cleaning products, and other

household goods on their shelves.

The relative bargaining power between an industry’s competitors and its buyers helps shape the profit

potential of the industry. If buyers have greater leve rage over the competitors than the competitors have

over the buyers, then the competitors may be forced to lower their prices over time. This weakens

competitors’ profit margins and makes them less likely to be prosperous. Walmart furnishes a good

example. The mammoth retailer is notorious among manufacturers of goods for demanding lower and

lower prices over time. [3]In 2008, for example, the firm threatened to stop selling compact discs if record

companies did not lower their prices. Walmart has the power to insist on price concessions because its

sales volume is huge. Compact discs make up a small portion of Walmart’s overall sales, so exiting the

market would not hurt Walmart. From the perspective of record companies, however, Walmart is their

biggest buyer. If the record companies were to refuse to do business with Walmart, they would miss out

on access to a large portion of consumers.

On the other hand, if buyers have less leverage over the competitors than the competitors have over the

buyers, then competitors can raise their prices and enjoy greater profits. This description fits the textbook

industry quite well. College students are often dismayed to learn that an assigned textbook costs $150 or

more. Historically, textbook publishers have been able to charge high prices because buyers had no

leverage. A student enrolled in a class must purchase the specific book that the professor has selected. Saylor URL: http://www.saylor.org/books Saylor.org

Used copies are sometimes a lower-cost option, but textbook publishers have cleverly worked to

undermine the used textbook market by releasing new editions after very short periods of time.

Of course, the presence of a very high profit industry is attractive to potential new entrants. Firms such as

the publisher of this book, have entered the textbook market with lower-priced offerings. Time will tell

whether such offerings bring down textbook prices. Like any new entrant, upstarts in the textbook

business must prove that they can execute their strate gies before they can gain widespread acceptance.

Overall, when analyzing the profit potential of their industry, executives must carefully consider whether

buyers have the ability to demand lower pric es. In the textbook market, buyers do not.

Every industry is unique to some degree, but some general characteristics help to predict the likelihood

that buyers will be powerful relative to the firms from which they purchases goods and services. Buyers

tend to be powerful, for example, to the extent that there are relatively few buyers compared with the

number of firms that supply the industry, the industry’s goods or services are standardized or

undifferentiated, buyers face little or no switching costs in changing vendors, the good or service

purchased by the buyers represents a high percentage of the buyer’s costs, and the good or service is of

limited importance to the quality or price of the buyer’s offerings.

Finally, buyers possess power to the extent that they have the ability to become a new entrant to the

industry if they wish. This strategy is called backward vertical integration. DIRECTV used to be an

important customer of TiVo, the pioneer of digital vide o recorders. This situation changed, however, when

executives at DIRECTV grew weary of their relationship with TiVo. DIRECTV then used a backward

vertical integration strategy and started offering DIRECTV-branded digital video recorders. Profits that

used to be enjoyed by TiVo were transferred at that point to DIRECTV.

The Limitations of Five Forces Analysis

Five forces analysis is useful, but it has some limi tations too. The description of five forces analysis

provided by its creator, Michael Porter, seems to a ssume that competition is a zero-sum game, meaning

that the amount of profit potential in an industry is fixed. One implication is that, if a firm is to make

more profit, it must take that profit from a rival, a supplier, or a buyer. In some settings, however, Saylor URL: http://www.saylor.org/books Saylor.org

collaboration can create a larger pool of profit that benefits everyone involved in the collaboration. In

general, collaboration is a possibility that five forces analysis tends to downplay. The relationships among

the rivals in an industry, for example, are depicted as adversarial. In reality, these relationships are

sometimes adversarial and sometimes collaborative. General Motors and Toyota compete fiercely all

around the world, for example, but they also have worked together in joint ventures. Similarly, five forces

analysis tends to portray a firm’s relationships with its suppliers and buyers as adversarial, but many

firms find ways to collaborate with these parties for mutual benefit. Indeed, concepts such as just-in-time

inventory systems depend heavily on a firm working as a partner with its suppliers and buyers.

KEY TAKEAWAY

x“How much profit potential exists in our industry?” is a key question for executives. Five forces analysis

provides an answer to this question. It does this by considering the interactions among the competitors in

an industry, potential new entrants to the industry, substitutes for the industry’s offerings, suppliers to

the industry, and the industry’s buyers.

EXERCISES

1. What are the five forces?

2. Is there an aspect of industry activity that the five forces seems to leave out?

3. Imagine you are the president of your college or university. Which of the five forces would be most

important to you? Why?

[1] Porter, M. E. 1979, March–April. How competitive forces shape strategy. Harvard Business Review, 137–156.

[2] Odell, K. 2011, February 22. Portuguese-influence d Australian chicken burger chain, Oporto, comes to

SoCal. Eater LA . Retrieved from

http://la.eater.com/archives/2011/02/22/portuguesein fluenced_australian_chicken_burger_chain_oporto_comes

_to_socal.php

[3] Bianco, B., & Zellner, W. 2003, October 6. Is Wal-Mart too powerful? Bloomberg Businessweek. Retrieved

fromhttp://www.businessweek.com/magazine/content/03_40/b3852001_mz001.htm

Saylor URL: http://www.saylor.org/books Saylor.org

3.4 Mapping Strategic Groups

LEARNING OBJECTIVES

1. Understand what strategic groups are.

2. Learn three ways that analyzing strategic groups is useful to organizations.

The analysis of the strategic groups in an industry can offer important insights to executives. Strategic

groups are sets of firms that follow similar strategies to one another. [1]More specifically, a strategic

group consists of a set of industry competitors that have similar characteristics to one another but

differ in important ways from the members of other groups.

Understanding the nature of strategic groups within an industry is important for at least three

reasons. First, emphasizing the members of a firm’s group is helpful because these firms are usually

its closest rivals. When assessing their firm’s performance and considering strategic moves, the other

members of a group are often the best referents for executives to consider. In some cases, one or

more strategic groups in the industry are irrelevant. Subway, for example, does not need to worry

about competing for customers with the likes of Ruth’s Chris Steak House and P. F. Chang’s. This is

partly because firms confront mobility barriers that make it difficult or illogical for a particular firm to

change groups over time. Because Subway is unlikely to offer a gourmet steak as well as the

experience offered by fine-dining outlets, they can largely ignore the actions taken by firms in that

restaurant industry strategic group.

Second, the strategies pursued by firms within other strategic groups highlight alternative paths to

success. A firm may be able to borrow an idea from another strategic group and use this idea to

improve its situation. During the recession of the late 2000s, midquality restaurant chains such as

Applebee’s and Chili’s used a variety of promotions such as coupons and meal combinations to try to

attract budget-conscious consumers. Firms such as Subway and Quiznos that already offered low-

priced meals still had an inherent price advantage over Applebee’s and Chili’s, however: There is no

tipping expected at the former restaurants, but there is at the latter. It must have been tempting to

executives at Applebee’s and Chili’s to try to expand their appeal to budget-conscious consumers by

experimenting with operating formats that do not involve tipping. Saylor URL: http://www.saylor.org/books Saylor.org

Third, the analysis of strategic groups can reveal gaps in the industry that represent untapped

opportunities. Within the restaurant business, for example, it appears that no national chain offers

both very high-quality meals and a very diverse menu. Perhaps the firm that comes the closest to

filling this niche is the Cheesecake Factory, a chain of approximately 150 outlets whose menu

includes more than 200 lunch, dinner, and dessert items. Ruth’s Chris Steak House already offers

very high quality food; its executives could consider moving the firm toward offering a very diverse

menu as well. This would involve considerable risk, however. Perhaps no national chain offers both

very high quality meals and a very diverse menu because doing so is extremely difficult.

Nevertheless, examining the strategic groups in an industry with an eye toward untapped

opportunities offers executives a chance to consider novel ideas.

KEY TAKEAWAY

xExamination of the strategic groups in an industry provides a firm’s executives with a better

understanding of their closest rivals, reveals alternative paths to success, and highlights untapped

opportunities.

EXERCISES

1. What other colleges and universities are probably in your school’s strategic group?

2. From what other groups of colleges and universities could your school learn? What specific ideas could be

borrowed from these groups?

[1] Hunt, M. S. 1972. Competition in the major home appliance industry 1960–1970 . (Unpublished doctoral

dissertation). Harvard University, Cambridge, MA; Short, J. C., Ketchen, D. J., Palmer, T., & Hult, G. T. 2007. Firm,

strategic group, and industry influences on performance. Strategic Management Journal, 28, 147–167.

Saylor URL: http://www.saylor.org/books Saylor.org

100

3.5 Conclusion

This chapter explains several considerations for examining the external environment that executives

must monitor to lead their organizations strategically. Executives must be aware of trends and

changes in the general environment, as well as the condition of their specific industry, as elements of

both have the potential to change considerably over time. While PESTEL analysis provides a useful

framework to understand the general environment, Porter’s five forces is helpful to make sense of an

industry’s profit potential. Strategic groups are valuable for understanding close competitors that

affect a firm more than other industry members. When executives carefully monitor their

organization’s environment using these tools, they greatly increase the chances of their organization

being successful.

EXERCISES

1. In groups of four or five, use the PESTEL framework to identify elements from each factor of the general

environment that could have a large effect on your future career.

2. Use Porter’s five forces analysis to analyze an industry in which you might like to work in the future.

Discuss the implications your results may have on the salary potential of jobs in that industry and how

that could impact your career plans.