CHAPTER THREE

ENVIRONMENTAL ANALYSIS

The Nature of an External Audit

The external environment analysis considers factors that are beyond the control of the
organization and either brings an opportunity or pose threats to the organizations.
The purpose of an external audit is to develop a finite list of opportunities that could benefit a
firm and threats that should be avoided.
As the term finite suggests, the external audit is not aimed at developing an exhaustive list of
every possible factor that could influence the business; rather, it is aimed at identifying key
variable 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.
Most firms face external environments that are highly turbulent, complex, and global –conditions
that make interpreting them increasingly difficult. The cope with what are often ambiguous and
incomplete environmental data and to increase their understanding of the general environment,
firms engage in a process called external environment analysis. Those analyzing the external
environment should understand that completing this analysis is a difficult, yet significant,
activity.
The Industrial Organization (I/O) View
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.
Porter’s Five-Forces Model, is an example of the I/O perspective, which focuses upon analyzing
external forces and industry variables as a basis for getting and keeping competitive advantage.
Competitive advantage is determined largely by competitive positioning within an industry,
according to I/O advocates.
The Process of Performing an External Audit

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Step one, gather information: from internet, libraries, suppliers, salesperson, customers and
competitors.
Step two, Evaluate information: obtaining prioritized list of selected factors. Managers to rank
from most important to least important opportunity/threat.

The firm’s choice of direction and action (strategy), its organizational structure, and its internal
processes are influenced by a host of external factors. These factors, which constitute the
external environment, can be divided into three interrelated subcategories: factors in the remote
environment, factors in the industry environment, and factors in the operating
environment. The success of the firm’s strategy is also affected by the realistic analysis of its
internal capabilities and its consistency with conditions in the external environment.
Macro Environment
Social
Technology
Economic
Ecologic
Political

Industry Environment
Entry Barrier
Supplier Power
Buyer Power
Substitute Availability
Competitive Rivalry

Operating Environment

Competitive Forces

The Firm

Figure : A firm’s External Environment

Remote Environment and STEEP Factors

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The remote environment comprises factors that originate beyond, and usually irrespective of,
any single firm’s operating situation. It presents firms with opportunities, threats, and constraints,
but rarely does a single firm exert any meaningful reciprocal influence. There are five forces in
the firm’s remote environment with the popular acronym STEEP factors, which stands for
Social, Technological, Economic, Ecological, and Political factors.

A. Social Factors
The social factors that affect a firm involve the beliefs, values, attitudes, opinions, and lifestyles
of persons in the firm’s external environment; as developed form cultural, demographic,
religions, educational, and ethnic conditioning.
Like other forces in the remote external environment, social forces are dynamic. As social
attitudes change, so does the demand for various types of clothing, books, and so on. The
constant change in social environment is the result of efforts of individuals to satisfy their desires
and needs by controlling and adapting to environmental factors.
Several changes have occurred in the social environment. One of the most profound social
changes in recent years has been the entry of large numbers of women into the labor market.
Those social changes affected business in the following areas:
 Hiring and compensation policies and resource capabilities of employers.
 Expanded demand for a wide range of products and services necessitated by women’s
absence form the home. For instance convenience foods, microwave ovens, and day-
care centers are results of such changes.

B. Technological Factors
Awareness of technological changes that might influence the industry is important to the firm in
order to avoid obsolescence and promote innovation. Creative technological adaptations can
suggest possibilities for: new products, improvements in existing products, and improvements in
manufacturing and marketing techniques.
A technological break through can have a sudden and dramatic effect on a firms environment. It
may generate sophisticated new markets and products of significantly shorten the anticipated life
of a manufacturing facility.

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Firms in a turbulent growth industries must strive for an understanding both of existing
technological advances and the probable future advances that can affect their products and
services. In other words, they need to foresee advancements and estimate their impact on an
organization’s operations through technological forecasting.

C. Economic Factors
Economic factors concern the nature and direction of the economy in which a firm operates.
Because consumption patterns are affected by the relative affluence of various market segments,
in its strategic planning each firm must consider economic trends in the segments that affect its
industry. As far as economic factors are concerned, the firm must consider the general
availability of credit, the level of disposable income, the propensity of people to spend, prime
interest rates, inflation rates, and trends in the growth of the gross national product (GNP).

D. Ecological Factors
The term ecology refers to the relationship between human beings, other living things and air,
soil, and water that support them. Threats to life-supporting ecology caused principally by
human activities in an industrial society are commonly referred to as pollution. Specific
concerns under ecological environment include global warming, loss of habitat and biodiversity,
and pollution of air, water, and land.
The global climate has been changing for years. However, it is non evident that humanity’s
activities are accelerating tremendously.
 A change in atmospheric radiation, due to ozone depletion, causing global warming.
 Solar radiation that is normally absorbed into the atmosphere reaches the earth’s surface,
heating the soil, water, and air.
 Loss of habitat and biodiversity refer to the extinction of important flora and fauna is
occurring at a rapid rate due to disturbance of the natural habitat by the human activities.
 Air pollution is created by dust particles and gaseous discharges that contaminate the air.
 Water pollution occurs principally when industrial toxic wastes are dumped or leak into
the waterways.
 Land pollution is caused by the need to dispose of ever-increasing amounts of waste.

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Many large businesses are realizing that their decisions must no longer ignore environmental
concerns. Every activity is linked to thousands of other transactions and their environmental
impact. Therefore, corporate environmental responsibility must be taken seriously and
environmental policy must be implemented to ensure a comprehensive organizational strategy.
Such firms are called ‘Eco-efficient’ business since they produce more useful goods and services
while continuously reducing resource consumption and pollution.

Reasons for businesses to be ‘Eco efficient’

 Customers demand for cleaner products.
 Environmental regulations are increasingly more stringent.
 Employees prefer to work for environmentally conscious firms.
 Financing is more readily available for eco-efficient firms.
 Government provides incentives to environment friendly firms.
E. Political Factors
The direction and stability of political factors is a major consideration for managers in
formulating company strategy. Political factors define the legal and regulatory parameters within
which firms must operate.

Political constraints are placed on firms through:

 Fair-trade decisions
 Tax programs
 Minimum wage legislation
 Pollution and pricing policies
 Employee protection acts
 Protection of consumers and general public.

Although most of laws and regulations are commonly restrictive, some political actions are
designed to benefit and protect firms through patent laws, government subsidies, and product
research grants.

Industry Analysis

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Analysis of industry and competitive conditions is the starting point in evaluating a company’s
strategic situation and market position. The nature and degree of competition in an industry
hinge on five forces: the threat of new entrants, the bargaining power of suppliers, the
bargaining power of buyers, the threat of substitute products and services, and the rivalry
among existing firms. To establish a strategic agenda for dealing with the existing contending
firms and to grow despite them, a company must understand how they work in its industry and
how they affect the company in its particular situation.
Industry conditions differ so much that leading companies in unattractive industries can filed if
hard to earn respectable profits, while even weak companies in attractive industries can turn in
good performance. Industry and competitive analysis utilizes concepts and techniques to get a
clear fix on changing industry conditions and on the nature and strength of competitive forces. It
is a way of thinking strategically about an industry’s overall situation and drawing conclusions
about whether the industry is an attractive investment for company funds.

The framework for industry and competitive analysis hangs on developing probing answers to
the following seven questions.
1) What are the chief economic characteristics of the industry?
2) What factors are driving charges in the industry, and what impact will they have?
3) What competitive forces are at work in the industry, and how strong are they?
4) Which companies are in the strongest or weakest competitive positions?
5) Who will likely make what competitive moves next?
6) What key factors will determine competitive success or failure?
7) How attractive is the industry in terms of its prospects for above - average profitability?

The collective answers to these questions boils understanding of a firm’s surrounding

environment and form the basis for matching strategy to changing industry conditions and to
competitive forces,

A. Threats of Entry

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New entrants to an industry bring new capacity, the desire to gain market share and often
substantial resources. The seriousness of the threat of entry depends on the barriers present and
on reaction from existing competitors that the entrant can expect.

There are five major sources of barriers to entry:

1. Economies of Scale
Economies of scale deter by forcing the aspirant either to come in on larger scale or to accept a
cost disadvantage. Economics of scale also can act as hurdles or barriers in distribution,
utilization of the sales force, financing, and nearly any other part of a business.

2. Product Differentiation
Brand identification creates a barrier by forcing entrants to spend heavily to overcome customer
loyalty. Advertising, customer service, being first in the industry, and product differences are
among the factors fostering brand identification.

3. Capital Requirement
The need to invest large financial resources in on order to compete in the market creates a barrier
to entry. Capital is necessary not only for fixed facilities but also for customer credit, inventories,
and absorbing start-up losses.

4. Access to Distribution Channels

A new product must displace others from the market through price breaks, promotions, intense
selling efforts, and some other means. However, the more limited the wholesale or retail
channels are the tougher that entry into that industry will be.
Sometimes this barrier is so high that, to surmount it, a new firm must create its own distribution
channel.

5. Government Policy

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The government can limit or even foreclose entry to industries, with such controls as license
requirements and limit on access to raw materials. The government also can play a major indirect
role by affecting entry barriers through such controls as air and water pollution standards and
safety regulations.

B. Bargaining Power of Suppliers

Suppliers can exert bargaining power on participants of an industry by raising prices or reducing
the quality of purchased goods and services. Powerful suppliers, thereby, can squeeze
profitability out of an industry for unable to recover cost increases in its own prices.
The power of each important supplier group depends on a number of characteristics of its market
situation and on the relative importance of its sales to the industry compared to its overall
business.

A supplier group is powerful if:

 It is dominated by a few companies and is more concentrated than the industry it sells.
 Its products are unique or at least differentiated.
 It poses a credible threat of integrating forward into the industry’s business.
 The industry is not an important customer of the supplier group.

As indicated above, the supplier group will be powerful if its product is unique. This is so
because buyers’ cost of switching or changing suppliers raises as its product specifications ties it
to particular suppliers.

C. Bargaining Power of Buyers

Like the supplier group customers also pose threat to the industry. They can force down prices,
demand for higher quality products or more services, and play competitors off against each other.

A buyer group is powerful if:

 It is concentrated or purchases in large volumes
 The products it purchases from the industry are standard or undifferentiated.

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  The products it purchases are components of its products and represent a significant
fraction of its cost.
 It earns low profits, which create great incentive to lower its purchasing costs.
 The industry’s product is unimportant to the quality of the buyer’s products or services.
 It poses a credible threat of integrating backward product.

Buyers group poses the above threats in that when the product is a major component or
significant fraction of the buyers’ product, the buyer is likely to shop for a favorable price and
buy selectively. The less profitable the buyer is, the more price sensitive it would be. Similarly,
where the quality of the buyers product is not as such affected by the industry’s product, buyers
are generally more sensitive to price and pose a threat to the industry.

D. Threat of Substitute Products and Services

Substitutes pose threat to the industry’s product in that substitute products or services limit the
potential of an industry by placing a ceiling on the prices it can charge. Unless it can upgrade the
quality of the product or differentiate it through marketing, the industry will suffer in earnings
and possibly in growth. The more attractive the price-performance trade off offered by substitute
products, the higher the threat it poses on the industry’s profit potential.

Substitutes often come rapidly into play if some development increases competition in their
industries and causes price reduction or performance improvement.

E. Rivalry among Existing Firms

Rivalry among existing competitors takes the familiar form of jockeying for position using
tactics like price completion, product introduction, and advertising.

Rivalry among existing firms becomes intense when the following factors are present:
 Competitors are numerous or are roughly equal in size and power.
 Industry growth is slow, enhancing fights for market share.
 The product lacks differentiation or switching costs.
 Exit barriers are high and keep the companies competing even though they earn low
profit or losing.

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  Fixed costs are high or the product is perishable, creating a strong temptation to cut
prices.
 The rivals are diverse in strategies, origins, and personalities
Competitive Forces
An important part of an external audit is identifying rival firms and determining their strengths,
weaknesses, capabilities, opportunities, threat, objectives, and strategies.

Internal Environment Analysis

The nature of an internal audit

The Institute of Internal Auditors has determined the internal audit as an insurance activity and
independent consulting, designed to add value and improve an organization’s objectives. It also
helps the company in achieving its objectives, and this improves the effectiveness of risk
management, control, and governance. It objectively examines, evaluates, and reports on the
adequacy of internal control as a proper use, economic and effective use of resources.

Understanding opportunities from external environment is nothing unless there is internal

capacity that enables to exploit opportunities on time. Hence, having understood the impact of
the external environment, the next step is analyzing internal factors. The internal environment
analysis is conducted in order to know the strengths and weaknesses of the organization.
Mangers often start their internal analysis with questions like “How well is the current strategy
working?” “What is our current situation?” or “What are our strengths and weaknesses?”.

Particularly, the internal environment analysis involves the following:

 Mission Statement - a statement that states the reason why an organization exists. It tells
what the company is providing to society. A well-convinced mission statement defines
the fundamental, unique purpose that sets a company apart from other firms. It identifies
the scope of the company’s operation in terms of products offered and markets served. It
puts into word no only what the company is now, but also what it wants to become. It
promotes a sense of shared expectation in employees and communicates a public image

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 to important stakeholder groups in the company’s task environment. A mission statement
reveals who is the company is and what it does.
 Objectives - are end results of planned activity. They state what is to be accomplished by
whom and should be quantified if possible. The achievement of corporate objective
should result in the fulfillment of the company’s mission. Some of the areas in which a
company might establish its objectives are:
o Profitability or net income
o Efficiency or low cost
o Reputation (being considered as top of all firm)
o Contribution to employees (employees security or wage adjustment)
o Contribution to society (tax paid, participation in charities, providing needed products
or services)
o Market leadership (market share)
o Technological leadership (innovativeness)
o Survival (avoiding bankruptcy).

 Policies - are broad guideline for decision making that links the formulation of strategy
with its implementation. Companies use policies to make sure that employees through the
firm make decisions and take actions that support the corporation’s mission, its objectives
and its strategies.

 Resources - consists of both human and non human resource. The profiles of the
employees with their number need to be analyzed and compared with the anticipated
activity. The materials resource such as machineries and their obsolescence can help in
evaluating the organization’s internal strength and weakness.

 Procedures - are a system of sequential steps or techniques that describe in detail how a
particular task or job is to be done. They typically detail the various activities that must
be carried out for completion of a corporation’s program.

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Key Internal Forces
It is not possible in a strategic-management text to review in depth all the material presented in
courses such as marketing, finance, accounting, management, management information systems,
and production/operations; there are many subareas within these functions, such as customer
service, warranties, advertising, packaging, and pricing under marketing.
The essential features of an effective internal audit department are as follows:
(1) Independence, professional skills, and staff training;
(2) Relationships;
(3) Planning, control, records, verifications;
(4) Assessment, reporting, and monitoring.
This is a management responsibility to determine the degree of the internal control and not to
depend on internal audit as a substitute for these checks. It is the responsibility of management to
maintain internal control system and ensure that resources are directed properly. This, of course,
will include a responsibility for preventing and detecting fraud. If an internal auditor discovers
fraud or any negligence, they should report their suspicions to the appropriate management level.
Independence
This is achieved through organizational status of internal auditing. It is clear that it must have the
freedom to function effectively. Management support is essential and internal audit should
determine its own policies, in consultation with management. The head of internal audit should
have direct access to the freedom to report to all executives and employees of the company. The
main attribute of independence is the ability to report the highest level of company management.
Every internal auditor should have an objective attitude and be able to exercise independent
judgment, express opinions, and make recommendations, without any pressure scale.
Personnel and Training
Guidelines for Auditing Practices Board (APB) declare that:
1. Effectiveness of internal audit depends largely on the quality, training, and experience of
its staff. The goal should be the appointment of appropriate personnel, taking into
consideration the personal qualities and potential. After that, you must take steps to
ensure the necessary experience, training, and continuous professional training;
2. Internal Audit Unit should be managed by the internal audit staff that should be qualified
and should have extensive experience in internal audit and management. They must plan

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 and control direct motivation of available resources, ensuring that the objectives and
responsibilities of internal audit are accomplished;
3. The full range of the duties may require personnel audit to attract a variety of disciplines.
Internal audit effectiveness can be increased by using specialized staff, especially
technical nature of internal audit activities;
4. Internal Audit Unit should employ personnel with different levels of skills,
qualifications, and experience, in order to meet the requirements of each task of internal
audit.

Planning, Control, and Registration

The internal audit guidelines declare the main goals of the internal audit planning as follows:
 To define the priorities and the creation of cost-effective to achieve the objectives of the
audit;
 To assist in the direction and control of audit work;
 To assist in providing the attention in critical aspects of the audit work;
 To assist in providing that the work is performed in accordance with predetermined
objectives.
According to the instructions, the stages of audit planning are as follows:
 To identify the organization’s objectives;
 To define the objectives of the internal audit;
 To consider relevant changes in legislation and other external factors;
 To get a thorough understanding of the organization’s systems, structure, and operations;
 To identify, appreciate the risks degree to which the organization is exposed;
 To consider changes in structure of the organization;
 To consider the strong knowledge and weaknesses in the internal control system;
 To consider the management concerns;
 To determine the type of audit, e.g. systems, verification, or value for money;
 To estimate the necessary staff resources.

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Assessment of Internal Control Systems
It is advised and recommended a based approach system on internal audit, which means that the
internal auditor is a control expert. APB guidance for internal auditors clearly emphasizes that
the controls should ensure that the processes meet the objectives of the systems. The main
objectives of the system of internal control, according to the instructions are as follows:
 To ensure the compliance of management policies and directives in order to achieve the
organization’s
 objectives;
 To protect the assets;
 To ensure the relevance, reliability, and integrity of information;
 To ensure compliance with the statutory requirements.
During the assessment of internal control systems, internal auditor should consider the effect that
all the controls have on each other as well as related systems. As part of the planning process, the
internal auditor should identify the full range of systems within the organization. For the systems
that will be examined, the internal auditor should establish appropriate criteria to determine
whether controls are adequate and help achieve the objectives of the system.

The Process of Performing an Internal Audit

The process of performing an internal audit closely parallels the process of performing an
external audit. Representative Managers and employees from throughout the firm need to be
involved in determining a firm’s strengths and weaknesses. The internal audit requires gathering
and assimilating information about the firm’s management, marketing, finance/accounting,
production/operations, research and development (R&D), and management information systems
operations.

The Resource-Based View (RBV) approach to competitive advantage contends that internal
resources are more important for a firm than external factors in achieving and sustaining
competitive advantage. In contrast to the I/O theory presented in the previous chapter,
proponents of the RBV view contend that organizational performance will primarily be
determined by internal resources that can be grouped into three all-encompassing categories:
physical resources, human resources, and organizational resources.

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Physical resources include all plant and equipment, location, technology, raw materials,
machines; human resources include all employees, training, experience, intelligence, knowledge,
skills, abilities; and organizational resources include firm structure, planning processes,
information systems, patents, trademarks, copyrights, databases, and so on. RBV theory asserts
that resources are actually what helps a firm exploit opportunities and neutralize threats.

The Functional Approach

Accordingly, the key internal factors are a firm’s basic capabilities, limitations, and
characteristics. The following lists are typical internal factors, some of which would be the focus
of internal analysis in most firms.
MARKETING
 Firm’s products & services = breadth of product line
 Market share or sub market shares
 Channels of distribution &number, coverage and control
 Product & service image, reputation, and quality
 Pricing strategy and pricing flexibility
 After sale service and follow-up.

FINANCE AND ACCOUNTING

 Ability to raise short-term capital
 Ability to raise long-term capital - debt & equity
 Tax considerations
 Leverage position
 Working capital & flexibility of capital structure.

PRODUCTION / OPERATJ0NS / TECHNICAL

 Raw materials with cost and availability
 Inventory control systems
 Location of facilities
 Economics of scale
 Patents, trademarks, and similar legal protection

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  Research and development - Technology & innovation

PERSONNEL
 Management team
 Employee’s skill and morale
 Employee turnover and absenteeism
 Efficiency and effectiveness of personnel policies

QULAITY MANAGEMENT
 Relationship with suppliers & customers
 Procedures for monitoring quality

INFORMATION SYSTEMS
 Timeliness and accuracy of information
 Ability of people to use the information provided

ORGANIZATION AND MANAGEMENT

 Organizational structure & culture
 Organizational communication system
 Use of systematic procedures and techniques
Firms are not likely to evaluate all of the factors listed above. To develop a revised strategy,
managers would prefer to identify the few factors on which its success is most likely to depend.
Strategists examine a firm’s past performance to isolate key internal contributors to favorable or
unfavorable results. Analysis of past trends in a firm’s sales, cost, and profitability is of major
importance in identifying its strategic internal factors.

The identification of strategic internal factors requires an external focus. A strategist’s efforts to
isolate key internal factors are assisted by analysis of industry conditions and trends and by
comparisons with competitors. Changing conditions in an industry can lead to the need to
reexamine a firm’s internal strengths and weaknesses in light of newly emerging determinants of
success in that industry.

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The functional approach to internal analysis focuses managers on basic business functions
leading to a more objective, relevant analysis that enhances strategic decision making regardless
of situational differences.

The Value Chain analysis

Values chain analysis is based on the assumption that a business’s basic purpose is to create
value for uses of it products or services. In this analysis, managers divide the activities of their
firm is to sets of separate activities that add value. Their firm is viewed as a chain of value-
creating activities stating with procuring new materials or inputs and continuing through design,
component production, manufacturing and assembly, distribution, sales, delivery, and support of
the ultimate user of its products or services. Each of these activities can add value and each can
be a source of competitive advantage. Value chain analysis divides a firm’s activities into two
major categories, primary activities and support activities, as shown in the following figure.
Primary activities are those that directly contribute to production of good or services and
organization’s provision to customer. Support activities are those that aid primary activities, but
do not they add value. Primary activities are those involved in the physical creation of the
product, marketing and transfer to the buyer, and after-sale support. Support activities assist the
primary activities by providing infrastructure of inputs that allow them to take place on an
ongoing basis.

Conducting the Value Chain Analysis

The initial step in value chain analysis is to divide a company’s operations into specific activities
or business processes, usually grouping them similarly to the primary and support activity
categories as you have seen in figure above. Within each category, a firm typically performs a
number of discrete activities that may represent key strengths or weaknesses.
The next step is to attempt to attain costs to each discrete activity. Each activity in the value
chain incurs costs and ties up time and assets. Value chain analysis requires managers to sign
costs and assets to each activity, thereby providing the basis to estimate costs to each activity.
The result provides managers with a very different way of viewing costs than traditional cost
accounting procedures would produce.

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General Competences/capabilities
They are assets like industry-specific skills, relationships and organizational knowledge which
are largely intangible and invisible assets. Competences and capabilities will often be internally
generated, but may be obtained by collaboration with other organizations.
Certain competences are likely common to competing businesses within a global industry or
strategic group.

Core Competences or Distinctive Capabilities

Core competences or distinctive capabilities are combinations of resources and capabilities
which are unique to a specific organization and which are responsible for generating its
competitive advantage.

Internal Factor Evaluation (IFE) Matrix

Strength and weakness analysis
As discussed earlier the internal capabilities are the strengths and weaknesses of the firm. They
are defined as follows:
A. Strengths
Strength is a resource, skills, or other advantages relative to competitors and the needs of the
markets a firm serves or expects to serve. Strength is a distinctive competence when it gives the
firm a comparative advantage in the market place. Strengths may exist with regard to:
 Financial resources,
 Corporate image,
 Market leadership, and
 Buyer-supplier relations.
B. Weakness
Weakness is a limitation or deficiency in resources, skills, or capabilities that seriously impedes a
firm’s effective performance.
Weakness may exist with regard to:
 Production facilities,
 Financial resources,
 Management capabilities,

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 Marketing skills, and
 Brand image.

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