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Every organization operates within a complex business environment, which encompasses both internal and external factors. These factors exert a significant influence on a company’s operations and, ultimately, its ability to achieve sustainable success.
The business environment is constantly evolving, presenting continuous opportunities and challenges. By strategically analyzing these factors, businesses can gain valuable insights to empower them to make informed decisions, develop effective strategies, and navigate toward long-term prosperity.
Classifying the business environment
Some classifications categorize the business environment differently. First, they divided them into two categories:
- Internal environment
- External environment
The internal environment is within the organization. It outlines the company’s strengths and weaknesses and is under the company’s control. An example is corporate culture.
Meanwhile, the external environment is outside the organization. Therefore, changes in external environment factors raise both opportunities and threats.
The external environment is beyond management’s control. The company cannot influence these external factors in the desired direction. Examples are changes in interest rates and government regulations. In this case, the company can only adapt to changes in the external environment to maximize opportunities and minimize threats.
Other classifications also include internal and external environments. However, they group the external environment into three levels:
- Natural physical environment
- Societal environment
- Task environment
The natural physical environment includes physical resources, climate, and wildlife. They represent the outer environment where changes expose the other two environments: societal and task environments.
Meanwhile, the societal environment includes the political, economic, social demographic, technological, and legal environments. Like the natural physical environment, they expose opportunities and threats to all companies rather than individuals.
The task environment includes the company and its external stakeholders, such as customers, suppliers, competitors, creditors, etc. Sometimes, it is also called the industry environment or competitive environment.
Then, another classification divides the external environment into two:
The external microenvironment affects the company’s ability to serve customers. Meanwhile, the external macroenvironment impacts survival, covering aspects such as politics, economics, social demography, legal, and technology.
Internal environment
Elements in the internal environment can affect a business, including:
- Human resources, such as employees and management, including formed culture, diversity, and leadership. Their skills, experience, and motivation directly impact their productivity and innovation potential.
- Physical resources such as equipment, facilities, and other infrastructure owned by the company. They are crucial for efficient production and service delivery.
- Financial resources such as funding and cash flow. Understanding them is essential for informed investment and strategic decision-making.
- Innovation and efforts to secure internal strengths from imitation, such as through patents, copyrights, and trademarks. Developing and protecting contributes to the long-term competitive advantage.
- Process management, which regulates how internal resources can be allocated effectively and efficiently according to the company’s strategy. Establishing efficient processes ensures optimal resource allocation and smooth day-to-day operations.
- Technology, including hardware and software, helps organizations carry out their business processes and operations. It plays a vital role in helping businesses operate efficiently and effectively.
Let’s take human resources as an example to explore how strategic the internal environment is for a company.
Human resources are related to the people who work in the organization. They include managers and employees. They shape the internal environment and influence the business through the following:
- Quality of work
- Productivity
- Innovation
- Motivation
- Industrial action
- Decision taken
Other factors related to human resources are also important and have an impact on the company. They include:
- Company culture
- Leadership style
- Diversity
Corporate culture is about how attitudes, beliefs, values, goals, and norms are seen and actualized around the workplace and shared by all employees in the organization. It can affect employee morale and productivity, both positively and negatively.
For example, great company culture is a pull factor for people to work or do business with the company. Therefore, it could affect recruiting efforts, sales, and profits.
Leadership is about influencing others to want to achieve the goals desired by the leader. The way the leader does this is known as the leadership style.
Leadership style influences business by influencing employee morale, productivity, motivation, and decision-making. Thus, the changes can directly affect the organization and its success.
Diversity is about accommodating people from different backgrounds. These differences can be related to social and ethnic background, personality, life experiences, skills, and competencies.
Diversity is important for increasing productivity by bringing people with different skills together to work. These differences also encourage creativity and problem-solving, which allows for more innovation within the company.
External environment
The external environment is beyond a company’s direct control but can present both opportunities and threats. Analyzing these factors using frameworks like PESTEL and Porter’s Five Forces equips us with a comprehensive understanding of the competitive landscape and the broader context in which businesses operate.
Let’s take the PESTEL framework first. It is short for:
- Political factors
- Economic factor
- Sociodemographic factors
- Technological factor
- Environmental factor
- Legal factor
Strategic management begins with PESTEL analysis, scanning which factors affect the company. Then, the company determines the opportunities and threats in each factor and how significant its exposure is to changes in these factors.
For example, banks are highly exposed to changes in interest rates (economic factors), while manufacturers are less exposed. Thus, interest rates are strategic for banks rather than for manufacturers.
The external environment includes the task environment in addition to the factors above. It’s basically a competitive environment. Which factors influence the competitive environment? Porter’s Five Forces provides a good framework for analyzing it.
Political factor
The political environment is concerned with government or public affairs. It covers topics such as government decisions and policies. Other factors include political stability, corruption, the rule of law, and institutional strength.
Political changes can expose businesses to uncertainty through their impact on the:
- Government policy
- Legal framework
- Regulation and deregulation
- Foreign trade policy
Political stability is vital for business. If politics is unstable, it will lead to more frequent changes in policies and regulations, which exposes companies to uncertainty. It may, for instance, discourage businesses from investing.
Economic factor
The economic environment relates to the economic conditions in which a business operates. Frequently observed factors include:
- Economic growth
- Inflation rate
- Interest rate
- Exchange rate
- Unemployment rate
Changes in these factors expose the business to opportunities and risks. They can directly impact companies, such as operating costs, and indirectly impact other stakeholders, such as consumer spending attitudes.
For example, lower interest rates encourage businesses to invest at lower costs. Likewise, low interest rates encourage consumers to take out loans to finance purchases of durable goods such as cars and houses.
Economic factors are also related to the policies taken by the government to influence the economy. The examples are:
- Fiscal policy deals with changes in taxes and government spending.
- Monetary policy is related to the money supply and interest rates.
Sosiodemographic factor
These factors deal with population and its changes. Meanwhile, demographic structure refers to its composition associated with aspects such as:
- Gender
- Age
- Education
- Work
- Income
- Family size
- Ethnicity
- Religion
The population and its composition change over time due to changes in the:
- Birth rate
- Death rate
- Immigration rate
Demographics matter to the business. Some companies use demographic variables to segment markets. First, they grouped consumers based on age, gender, marital status, family size, income, or education. Then, they select a specific segment as a target.
In addition, population structure is a business consideration when expanding overseas. For example, companies target countries with a predominant working age as their market. These countries offer high demand potential and a productive workforce.
In addition to population and its structure, sociodemographic factors also include:
- Lifestyle
- Attitude
- Culture
- Tastes and preferences
- Demographic structure
The factors above change from time to time, which influences the strategy and way businesses market their products. Take shifts in preference as an example. McDonald’s did not initially offer salads or frappes. Instead, the company focuses on the classic hamburger and fries combo. Then, however, customers’ preferences changed, and they wanted healthier food.
McDonald’s then responded to these changes and adapted. As a result, companies are starting to offer healthy alternatives, such as salads, fruit, and oatmeal.
Technological factor
Technological changes affect not only products and how they are marketed but also various aspects, including business models, production processes, and communication channels. For example, information technology contributes to reducing operating costs and time, operating efficiency, and being a key managerial tool in business decision-making.
Technological advancements and disruptions, such as artificial intelligence, automation, and big data analytics, can revolutionize entire industries and create new business models. They can also present opportunities for companies. Embracing them can give companies a competitive edge by developing new products and services, improving operational efficiency, and reaching new customer segments.
However, technology can also pose threats. E-commerce is a great example. It has forced conventional retailers out of business. Some may adapt but may still lag behind e-commerce retailers.
Environmental factor
Environmental factors include weather, climate, air, water, soil, natural resources, flora, fauna, etc. The two aspects, namely:
- Natural physical environment
- Green credentials
The natural physical environment includes all factors, such as weather and nature. Air, natural vegetation, lakes, and oceans are also included, and they significantly affect human life and business activities.
For example, damaged forest vegetation has had a significant impact on global warming. Furthermore, it is responsible for the recent increase in natural disasters. In addition, it results in real effects such as floods and landslides. These disasters cause infrastructure damage, which disrupts logistical activities.
Meanwhile, green credentials are related to sustainability. It covers topics like pollution and recycling. This aspect has become increasingly crucial for businesses as it exposes not only the company directly but also other stakeholders.
For example, governments around the world are enacting stricter regulations to address climate change and resource depletion. This can increase compliance costs for businesses, such as paying carbon taxes or investing in pollution control equipment. Failure to adapt risks fines or even operational shutdowns.
Like other factors, environmental factors also present opportunities. For example, investing in energy efficiency, waste reduction, and water conservation can lead to long-term cost savings. Companies can also explore renewable energy sources like solar or wind power to reduce their reliance on fossil fuels and fluctuating energy prices.
Focusing on sustainability can also lead to innovation in product design, manufacturing processes, and resource management. Companies that develop eco-friendly products and services can differentiate themselves from competitors and attract a growing market of environmentally conscious consumers.
Lastly, consumers are increasingly looking to support companies with strong environmental practices. By demonstrating a commitment to sustainability, businesses can enhance their brand image and reputation, leading to increased customer loyalty and brand advocacy.
Legal factor
The legal environment deals with the laws and regulations passed by the government. The government promulgates laws and regulations to regulate business conduct and encourage businesses to behave ethically and socially responsibly.
Changes to those regulations can force businesses to change how they operate to comply with the new ones. For example, the government raised the minimum wage. Companies must comply even if it will increase their operating costs.
Legal aspects cover various areas, including:
- Consumer protection
- Employment
- Competition
Consumer law protects consumers from low-quality products and bad business practices. It regulates aspects like:
- Products and services
- Return
- Repair and replacement
- Delivery
Labor law aims to protect employees from exploitation. It governs aspects like:
- Recruitment
- Wages/salaries
- Discrimination
- Health and safety at work
Competition law promotes fair competition and prohibits anti-competitive agreements, decisions, and practices. It covers aspects like:
- Monopoly
- Uncompetitive practices such as predatory pricing
- Mergers and acquisitions
- Collusive practice
- Price fixing
- Cartel
Non-compliance with regulations can have negative impacts such as:
- Damaged business reputation
- Facing lawsuits and courts
- Rejection by stakeholders
Task environment
The task environment is related to various factors in the company’s market. For example, it may be related to market structure, industry cycles, and the extent to which forces such as competitors, buyers, suppliers, new entrants, and substitutes affect a company’s profitability and competitive advantage. Unlike the previous factors, changes to the task environment only impact companies in the same industry and not in other industries.
Market structure refers to the composition and relationships between elements in the market. It includes aspects such as:
- Number of companies
- Number of consumers
- Company size
- Differentiation
- Barriers to entry and exit
- Competitive strategy (price or non-price competition)
- Market power
The most frequently cited market structures are perfect competition, monopolistic competition, oligopoly, and monopoly.
Meanwhile, the industry life cycle refers to the stages in which an industry/market evolves from the initial phase to the decline phase. It is divided into stages:
- Embryo
- Growth
- Shakeouts
- Mature
- Decline
Each stage has implications for profitability and market competition. Therefore, the strategy for success will also be different for each stage.
Lastly, Porter’s Five Forces framework helps analyze the competitive landscape within a specific industry. By understanding these five forces, companies can identify their competitive position and develop strategies to achieve a sustainable competitive advantage.
- Threat of new entrants: The ease with which new companies can enter an industry can intensify competition and reduce profitability for existing players. Factors influencing it include barriers to entry (e.g., high capital requirements, complex regulations) and brand loyalty of existing customers.
- Bargaining power of suppliers: The power suppliers have to influence prices and terms can squeeze a company’s profit margins. It depends on factors such as the number of suppliers available, the uniqueness of the supplier’s product or service, and the switching costs for a company to change suppliers.
- Bargaining power of buyers: Buyers’ ability to negotiate prices and demand higher-quality products or services can also impact profitability. Factors influencing buyer power include the number of buyers in the market, the concentration of large buyers, and the availability of substitutes for the company’s product or service.
- Threat of substitutes: If close substitutes exist, it can limit a company’s pricing power and market share. Companies need to be aware of substitute products or services and innovate to differentiate their offerings and maintain customer loyalty.
- Competitive rivalry: The intensity of competition among existing players within an industry determines the overall profitability. It depends on factors such as the number and size of competitors, the level of product differentiation, and the switching costs for customers to choose a competitor’s product or service.
Changes in the business environment
The business landscape is constantly shifting, presenting both exciting opportunities and unforeseen challenges for companies. These changes can impact a company directly, through its operations, or indirectly, through its stakeholders.
- Direct impacts occur when changes in the business environment affect a company’s operations. For example, a shift in consumer preferences towards organic food directly affects a supermarket chain’s demand for these products, potentially impacting sales.
- Indirect impacts affect business stakeholders, which ultimately impact the company. For example, a trade war can indirectly affect a clothing manufacturer. While the manufacturer itself might not be directly involved, rising costs of imported materials from their suppliers can lead to higher production costs and ultimately impact their pricing and sales.
In one case, changes in the business environment might affect individual firms. For example, the government is spurring growth on the supply side and providing incentives to companies willing to operate in designated areas.
Analyzing the business environment
Companies analyze internal and external environments as they affect business. Commonly used tools include:
- PESTEL analysis
- SWOT analysis
- Strategic group analysis
PESTEL analysis
PESTEL analysis provides a framework for examining a company’s external environmental conditions. As presented previously, it scans for factors such as:
- Political: Government regulations, tax policies, trade agreements.
- Opportunity: New government funding for green technology companies.
- Threat: Increased import restrictions impacting a company’s supply chain.
- Economic: Inflation rates, interest rates, economic growth.
- Opportunity: Expanding into new markets during economic booms.
- Threat: Rising production costs due to inflation.
- Sociodemographic: Population growth, demographics, consumer preferences.
- Opportunity: Developing products for a growing aging population.
- Threat: Changing consumer tastes rendering existing products obsolete.
- Technological: Technological advancements, innovation cycles.
- Opportunity: Utilizing new technologies to improve efficiency.
- Threat: Disruptive technologies render existing business models obsolete.
- Environmental: Environmental regulations, climate change.
- Opportunity: Developing sustainable packaging solutions.
- Threat: Increased costs due to stricter environmental regulations.
- Legal: Laws, regulations, intellectual property rights.
- Opportunity: Benefitting from new patents or trademarks.
- Threat: Lawsuits or compliance issues impacting operations.
As in the example above, each factor exposes both opportunities and threats to the business. However, not all aspects are relevant to the company. Therefore, the company must sort it out, considering the following:
- Impact on the company
- Chance of occurrence
External factors are strategic if they significantly impact the company, either positively or negatively, and have a high chance of occurring.
SWOT analysis
SWOT analysis, which stands for Strengths – Weaknesses – Opportunities – Threats analysis, is helpful for mapping which external environmental factors are the most significant, considering the company’s internal environment. The results serve as a management guide for developing strategy.
- Strengths: Advantages over competitors and are the foundation for building competitive advantage. For example, the company has a flexible organizational structure, an innovation culture, and strong brand equity.
- Weaknesses: Negative internal factors which can lead to a competitive disadvantage. Examples are limited capacity, obsolete production machines, or high financial leverage.
- Opportunities: Potential areas to be exploited to grow the business and increase future profits. For example, a decrease in interest rates and increased consumer spending.
- Threats: Negative external factors which impede or jeopardize the company’s future success. Examples are intense market competition and rapid technological changes.
The matrix in the SWOT analysis has four quadrants, namely:
- Strength – Opportunity (S-O): using internal strengths to exploit opportunities in the external environment. For example, a company leverages its innovative culture to push more new products during high economic growth.
- Strength – Threat (S-T): using internal strength to overcome external threats. For example, the company leverages its innovative culture during a recession to focus internally by increasing efficiencies across operations.
- Weakness – Opportunity (W-O): improving internal weaknesses using external opportunities. For example, companies reduce financial leverage during low-interest rate environments by replacing expensive debt securities with less expensive ones.
- Weakness – Threat (W-T): adopting a defensive approach to minimize external threats to internal weaknesses. For example, a company with high financial leverage reduces debt financing during a high-interest-rate environment and switches to equity or internal cash.
Strategic group analysis
Strategic group analysis helps a company identify its closest competitors and the factors on which they compete. By understanding their strategic groups, companies can make informed decisions about where to position themselves in the market.
Like the stakeholder map, companies create strategic groups using two main variables. Then, they identify and place competing firms in the matrix.
Strategic group analysis can be applied to various industries. Let’s consider the fast-food industry again. Here, several variables can be used to define strategic groups:
- Product price: Value menus vs. premium offerings.
- Product quality: Focus on affordability vs. higher-quality ingredients.
- Market segments served: Targeting families, young adults, health-conscious consumers, etc.
- Operation area: Fast-casual restaurants with table service vs. traditional quick-service counters.
- Product line breadth: Limited menus vs. extensive variety.
- Geographical reach: National chains vs. regional or local operations.
- Distribution channels used: Primarily dine-in vs. offering drive-thru, delivery, or mobile ordering options.
By analyzing these variables, companies in the fast-food industry can identify their closest competitors and the factors on which they compete. This understanding allows them to make informed decisions about their own positioning:
- A new fast-food chain might choose to compete on price and convenience by offering a limited menu of affordable items through drive-thru and mobile ordering, similar to existing value menu chains.
- Another entrant might focus on a specific market segment, such as health-conscious consumers, offering a wider menu variety with fresh, high-quality ingredients at a slightly higher price point. This entrant could potentially operate in areas with higher foot traffic and offer dine-in options.
