What is External Analysis?
External analysis means examining the industry environment of the company, including factors such as competitive structure, competitive position, dynamics, and history. On a macro scale, external analysis includes macroeconomic, global, political, social, demographic, and technological analysis. The primary purpose of external analysis is to determine the opportunities and threats in an industry or any segment that will drive profitability, growth, and volatility.
Key Terms in External Analysis
To begin the discussion on external analysis, we must define two terms:
- Industry is a group of companies offering products or services that are close substitutes for each other. Examples of an industry include soft drinks, mobile phones, and sportswear.
- Market segments are distinct groups of customers within a market that can be differentiated from each other based on individual attributes and specific demands. Market segments can be separated by characteristics such as geography, demography, and behavior.
In order to conduct a thorough external analysis, the company needs to analyze its supply chain. A company’s supply chain is the system involved in converting a product or service from raw materials into finished goods and then transporting finished goods from the supplier to the consumer. All logistical issues and steps are part of the supply chain.
The image below shows a common supply chain for a manufacturing company: Raw materials are brought from the supplier. The raw materials are moved to the manufacturer to make completed goods. The completed goods are distributed and moved across separate retailers, and then from the retailers, they end up in the hands of consumers.
Consider the supply chain for a smartphone. Raw materials such as glass, lithium, and aluminum are obtained from suppliers. Manufacturers take these raw materials and build the smartphones at plants. The completed phones are then distributed and sold at retail locations (Best Buy, Walmart, Staples). The phones are then sold to consumers from these retail locations.
Supply Chain for e-Commerce
The supply chain for e-Commerce companies differs from the traditional supply chain of brick and mortar stores. As the following graphic shows, we begin with the e-Commerce domain. Consumers select the products they want to purchase, and the payment is dealt with through a third-party payment manager (i.e. PayPal). The selected products are moved to a warehouse wherein they are prepared for shipping. The products are shipped to customers who return to the same site and continue the cycle again. This is the common supply chain cycle for e-Commerce companies such as Amazon or Alibaba.
Strategic groups within an industry can be identified by factors such as:
- Choice of distribution channels
- Market segments
- Level of product quality
- Technological leadership
- The degree of vertical integration
- Pricing policy
A strategic group exists if the performance of a firm in an industry group is a function of group characteristics, controlling firm and industry characteristics. Customers tend to view products of companies in the same strategic group as direct substitutes for each other (Coke vs. Pepsi). Different strategic groups can have different relationships with each of the competitive forces. Thus, each strategic group may face a different set of opportunities and threats.
An initial step to identifying strategic groups is to build a strategic group map. A strategic group map plots clusters of rivals in a two-dimensional matrix using strategically relevant dimensions, which help identify the most probable competitively relevant companies. It is also useful for realizing mobility barriers that inhibit the repositioning of firms within industries from one strategic group to another.
We now move into a competitive analysis of the industry. Market structure and competitive environment are defining factors in the future success of a business. There are six key factors that determine the level of competition in an industry:
1. Intensity of industry rivalry
It measures the level of concentrations of rivals. Factors to determine the intensity of industry rivalry include product homogeneity, brand loyalty, and consumer switching costs.
2. Threat of potential entrants (Barriers to entry)
It measures the difficulty for newcomers to enter the industry. Factors to determine barriers to entry include brand loyalty, excess production capacity, and government regulation.
3. Bargaining power of buyers
It measures how much power consumers have in determining the prevailing price in a market. Buyers’ bargaining power is high when buyers are large and concentrated, and buyers’ price sensitivity is high when there are many industry competitors and substitutes.
4. Bargaining power of suppliers
It measures how much a supplier of materials is able to restrict the company’s business strategy. The bargaining power of suppliers is high when suppliers are large or concentrated. Purchasers’ price inelasticity is high when there are few alternative suppliers and when there are few substitute inputs.
5. Threat of substitute goods/services
It measures the chances that competing goods of a similar nature will threaten a company’s offerings. It is more likely to occur when switching costs are low or when substitutes offer superior price to performance characteristics.
6. Power of complementary good/service providers
It measures the level of impact of companies that produce complementary products on other firms. Complements add value to products in an industry. If complements are weak and unattractive they can become a threat that slows industry growth and limits profitability.
Industry Life Cycle
The industry life cycle describes the natural stages of an industry as time progresses. An industry life-cycle consists of start-up, growth, shakeout, maturity, and decline stages.
- Start-up is characterized by very low competition. Barriers to entry based on access to key technological know-how.
- Growth is characterized by the low threat from potential competitors due to rapid growth in demand.
- Shakeout is characterized by a rivalry between companies becoming intense; companies cut prices to increase demand.
- Maturity is characterized by the threat of potential entrants decreasing and product segmentation.
- Decline is characterized by fierce rivalry between established companies.
To round off external analysis, a company must conduct an examination of the Political, Economic, Social, and Technological landscape of the industry, otherwise known as a PEST analysis.
- Political: Issues such as international trade barriers and regulatory environment change.
- Economic: Issues such as interest rates, exchange rates, and inflation.
- Socio-demographic (Social): Issues such as population and age cohort changes.
- Technological: Issues such as scientific advances, R&D investment, and emerging technologies.
The main purpose of PEST analysis is to test for any major external shifts in the industry. Business plans and strategies need to be updated to conform to prevailing industry trends.
CFI is a leading provider of Financial Modeling & Valuation Analyst (FMVA)™ certification program for finance professionals. To help you advance your career, check out the additional resources below: