Diagnosis of the External Environment
Rex C. Mitchell, Ph.D.
"Awareness of the environment is not a special project to be undertaken only when warning of change becomes deafening." (Kenneth R. Andrews)

In the ongoing process of strategic management, the organization is considered as an "open system" that affects and is affected by its environment. It is important to maintain an accurate and current awareness of important aspects of and trends in the organization's external environment.

Many major companies have lost dominance or gone out of business because of their failure to recognize and adapt to changes in their environments, or by failing to be leaders in making necessary changes. For example, Royal and Underwood were market leaders in typewriters, but had no part in making word processors or their extension to personal computers. Maytag had a dominant number one position in manufacturing wringer-type washing machines during the first half of the 20th Century, but suffered a disastrous fall in market share from about 50% to 8% in just a few years after WWII, due to a "substitute" product introduced by a newcomer, Bendix.

In 1968, Switzerland dominated the world of watchmaking, with over 65% of the unit sales in the world and more than 85% of the profits. They were constant innovators and on the cutting edge of research in all aspects of their watches. By 1980 their world market share had collapsed to less than 10%, and 50,000 of the 62,000 watchmakers had lost their jobs. What happened? A profound change in the external competitive environment, a change in the fundamental rules of watchmaking. Everything the Swiss were good at -- making gears and bearings and mainsprings, etc. -- was irrelevant to the new way. The irony was that this disaster was totally avoidable. The Swiss themselves invented the electronic quartz movement at their research institute in Neuchatel, Switzerland. Yet, when the Swiss researchers presented this revolutionary new idea to the Swiss manufacturers in 1967, it was rejected. It couldn't possibly be the watch of the future! So sure were the manufacturers of that conclusion that they let their researchers showcase their "useless" invention at the World Watch Congress that year. Seiko took one look, and the rest is history.

"It is not the strongest of the species that survive, nor the most intelligent, but the ones most responsive to change." (Charles Darwin)

The key point is that an organization needs to be in tune with its often turbulent external environment. There must be a strategic fit between what the environment wants and what the organization has to offer (also a strategic fit between what the organization needs and what the environment can provide.) However, since there is so much happening in the external universe, we have to be selective and smart in scanning:

It is customary and convenient to break up the external environment into two parts: the competitive (or task) environment and the general environment (sometimes called societal environment or macroenvironment). These are discussed below.


Most of the external environment factors important to an organization are in its industry/competitive environment. Industries differ widely in their characteristics. This means that a company with multiple lines of business in multiple countries has to analyze and deal with the complexities of many different country-industry environments. For each, the industry and competitive analysis should develop insightful answers to seven questions (after T&S, i.e., Thompson & Strickland, 2005):

  1. What are the industry's dominant features, especially economic ones?
  2. What is competition like and how strong are each of the competitive forces?
  3. What is causing the industry's competitive structure and business environment to change?
  4. Who are the major competitors and what are their relative competitive strengths?
  5. What strategic moves are rivals likely to make next?
  6. What are the key factors for competitive success?
  7. Is the industry attractive and what are the prospects for above-average profitability?

The primary model for diagnosing the industry/competitive environment is Michael Porter's 5-force model, which is very useful in the business world, as well as in the classroom. The model involves identifying and evaluating key components of five forces that drive industry competition. It is important to evaluate the relative strength/importance of the forces and focus particularly on the important forces.

  1. Rivalry Among Existing Firms
    This involves the direct competition in an industry, what is casually considered as the "competitive environment," although Porter helped us appreciate that the competitive environment is not confined to this force. However, this is almost always an important force and usually the strongest of the five forces. It deserves proportionate attention in the competitive analysis. Some of the major factors that produce more intense rivalry are (adapted from H&W, 2004; T&S, 2005, and other sources):
    • Slow Market/Industry Growth Rate: in a rapidly growing market, there tends to be "enough to go around." However, a slow growth or declining market, typical of a mature industry, sets up price wars and other efforts to take business away from competitors.
    • Capacity Surpluses: excess capacity pushes both prices and profitability down, especially when there are substantial fixed costs and/or high exit barriers.
    • Number & Size of Competitors: rivalry tends to increase when there are relatively few competitors who are about equal in size and capabilities; they tend to watch each other carefully and respond quickly to competitor actions.
    • Diverse & Relatively New Competitors: new entrants/rivals with different ideas on how to compete are likely to unknowingly challenge each other (adding to the intentional challenges). Further, relatively new competitors haven't tested each other and the competitive boundaries and are more likely to take more drastic actions, especially when a strong company outside the industry has acquired a weak company in the industry and wants to (and can afford to) try to transform their new acquisition.
    • Product/Service Differentiation is Low (i.e., products/services are standardized and regarded as commodities) if customers view the products or services as commodities, competitors are forced to make more extreme competitive moves on pricing, promotion, etc.
    • High Exit Barriers: when it is difficult for a firm to leave the industry, the competitors are forced to stay and compete with "whatever it takes." - e.g., when fixed costs and asset specialization are high, strategic stakes are high

  2. Potential New Entrants
    There are two main factors to consider relative to this force: the likelihood of a new entrant and the seriousness of a potential entry. This is a relatively important force only when both factors are reasonably high.
    • A new entrant is more likely when there are low customer switching costs and low barriers to entry. Some of the possible barriers to entry are: major or special resources in existing firms (economies of scale, finances, technology, proprietary knowledge, experience curve advantages, brand identification, etc), capital requirements, differentiated products or services, limited access to raw materials and distribution channels, regulatory restrictions, tariffs and international trade restrictions.
    • The seriousness of a potential entry is high when a potential entrant brings (or could bring) some special characteristics that are not already present or not easily matched by existing competitors, e.g., greater financial resources, special technology, unusual access to distribution channels and/or government favor, synergy with the entrant's other lines of business.

    In addition, the following factors increase the likelihood of new entrants:
    • Product differentiation is low
    • Brand identification is low
    • Incumbents' control of access to raw materials and distribution are low

  3. Substitute Products or Services
    This competitive force becomes stronger as the probability of an effective substitute becomes higher (not just a hypothetical threat).The potential threats from substitutes come in two varieties
    • Existing products (or services) from other industries that could satisfy the same need as a product in our industry under analysis (e.g., tea as a substitute for coffee, email as a substitute for the U.S. Postal Service and other companies in an industry providing overnight document delivery)
    • New products (or services) that did not exist previously, but that offer major improvements over existing ones. These might originate within or outside the industry. In addition to the three examples mentioned earlier (word processors over typewriters, automatic washers over wringer-types, and quartz crystal over mechanical watches), consider the many generations of media for recording sound, each of which substituted for and generally eliminated its predecessors (Edison wax cylinders, acoustic & later electric 78 rpm records, 45 rpm records, 33 rpm records, wire recorders, reel-to-reel tape, 8-track tapes, cassette tapes, CDs, DVDs, computer and Internet-based music files...)

    In addition, the following factors increase the likelihood or threat of substitutes:
    • The industry is attractive (e.g., profitable and growing)
    • Alternatives are readily available
    • Some alternatives have especially attractive characteristics
    • Improvements in price-performance of alternatives is high
    • Customer switching costs are low

  4. Bargaining Power of Suppliers
    This force becomes stronger when suppliers are more powerful and have more options than the firms in the industry who purchase from them. Some of the factors that produce such a condition are:
    • There are few suppliers and demand is high relative to supply
    • The suppliers have many customers and options for selling their pr
    • oducts
    • Products are unique and suppliers have specialized knowledge, technology, facilities, workers, government approvals, access to key materials, locations, access)
    • The suppliers' products/services are very important in the output of the target industry firms
    • Switching costs for industry firms are high
    • Suppliers are larger and have greater resources than the industry firms
    • The purchasing industry buys only a small portion of the suppliers' goods/services
    • Suppliers could integrate forward

  5. Buyers
    Notwithstanding the adage, "the buyer is always right," there is more to be considered in analyzing this competitive force, and it is not necessarily a strong force. This force is an analogue of the supplier force, in the sense that the industry firms are the buyers for their suppliers, and the industry firms are the suppliers for their buyers. Consequently, some of the factors that result in significant buyer power are:
    • There are few buyers and demand is low relative to supply (e.g., because there are many firms in the industry competing for limited buyer purchases)
    • The buyers have many sources and options for buying products
    • Products are not unique (little differentiation) and companies have little of specialized knowledge, technology, facilities, workers, government approvals, access to key materials, location]
    • Switching costs for buyers are low
    • Buyers are larger and have greater resources than the industry firms
    • The buyers' group buys a major portion of the industry's goods/services
    • Some close-substitute products are available
    • Buyers' ability to integrate backward is high.


Although usually only a few factors and trends in the general environment will be of much importance, it is important to scan, analyze, and evaluate this broader macroenvironment to identify and understand any factors and trends of importance. It is useful to think of four main aspects of the general environment, to remind ourselves to look in all these categories, listed with some examples of potentially important variables and trends:

These four dimensions of the general environment are listed above in roughly descending order of rapidity of change (in the USA at this time). Technological changes can be very rapid. While political-legal changes can be while rapid in some other countries, they usually have fair advance warning and lead times in the USA. Economic swings, again, are relatively slow in this country. Finally, social-cultural changes are the slowest of the four.

| Strategic Mgt. Resources | Diagnosis | Home |
* Or press the BACK button on your browser to return to your (different) access point *
Last modified May 23, 2009 Copyright 2000-2009 Rex Mitchell