The business environment influences business success. The changes expose both opportunities and risks to the business. Thus, companies must be able to adapt to these changes by exploiting opportunities while minimizing risks.
Types of 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. They outline the company’s strengths and weaknesses and are under the company’s control. An example is corporate culture.
Meanwhile, the external environment is outside the organization. Therefore, changes in factors in the external environment raise both opportunities and threats.
External environment beyond management 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 dissect 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:
- External microenvironment
- External macroenvironment
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.
The external environment and its impact
The external environment includes several factors, which we categorize into:
- Political factors
- Economic factor
- Sociodemographic factors
- Technological factor
- Environmental factor
- Legal factor
We abbreviate them as PESTEL.
Strategic management begins with PESTEL analysis by scanning which factors affect the company. Then, the company determines the opportunities and threats in each factor and how significant the company’s exposure is to changes in these factors.
For example, banks have high exposure to changes in interest rates (economic factors). In contrast, manufacturers have lower exposure. Thus, interest rates are strategic for banks rather than for manufacturers.
In addition to the factors above, the external environment includes the task environment. It’s basically a competitive environment. Which factors influence the competitive environment? We can check that from Porter’s five forces model.
The political environment is concerned with government or public affairs. It covers topics such as decisions and policies taken by the government. 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.
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 both opportunities and risks to the business. They can directly impact companies, such as operating costs, and indirectly on 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.
As it grows, the economy creates more income and jobs for households. Thus, during economic growth:
- Consumers have more money to spend on goods and services
- The demand for the product increases
- Businesses can earn more revenue
- Businesses invest in capital goods to increase production and generate more revenue
Conversely, during a recession, economic growth falls. As a result, the unemployment rate increases, and household income decreases.
- Consumers spend less
- Demand for goods and services falls
- Businesses face pressure on their profits as revenues fall
- Companies must take efficiency measures to reduce stress on their bottom line
The inflation rate represents how high the prices of goods and services are rising. High inflation rates have an impact on the following:
- Decrease in consumer purchasing power
- Nominal wage increase
During high inflation, consumers see their money as less valuable as prices for goods and services rise. So they get less stuff than before for the same dollar amount.
Expectations play an important role in consumer spending decisions. For example, if consumers expect future inflation rates to rise, they shop now before prices rise. On the other hand, if they expect the inflation rate to decrease, they will delay spending for lower prices in the future.
Then, high inflation can also have an impact on operating costs. Workers will demand higher wages during this period to compensate for decreased purchasing power. As a result, wage costs rise.
So is a reduction in the inflation rate better? A lower inflation rate is reasonable, for example, from 5% to 2%. This shows the price rising more moderately. We call this situation disinflation.
However, suppose the inflation rate is in the negative zone (called deflation). In that case, this negatively affects the business and results in the following:
- Delay in purchases by consumers. As prices drop, they want to get cheaper in the future and hold off on buying.
- Decrease in business revenue. A decrease in price causes a reduction in revenue dollars by the business. Despite selling the same volume, businesses earn less money than before.
- Debt deflation. Weakening revenues affect the company’s ability to pay debts.
An increase in interest rates results in the following:
- Borrowing costs are more expensive, which impacts investment and consumption decisions;
- Businesses and households receive more interest on money held in banks;
- Consumers prefer to save rather than spend;
- Consumers delay buying durable goods, such as cars, which rely on loans;
- Businesses invest less due to high costs and weak consumer demand.
A decrease in interest rates results in the following:
- Cheap credit is more widely available, encouraging businesses and consumers to apply for loans;
- Loan-financed consumer spending increases;
- Savings only result in lower returns;
- Consumers are more willing to spend money on goods and services;
- Businesses are willing to invest because costs are lower and demand tends to increase.
Depreciation occurs when the domestic currency becomes less valuable in exchange for foreign currency. Thus, we must spend more domestic currency to get one foreign currency.
For example, the dollar against the euro changed from EUR1.0 per US dollar to EUR0.93 per US dollar. Americans see their currency depreciate as they get 0.93 euros when exchanging their one dollar, less than the previous 1.0 euros.
Depreciation hurts business because:
- Imports have become more expensive. Businesses face rising costs if they rely on input from abroad. American companies have to spend more dollars buying inputs from European markets.
- Businesses have to collect more domestic currency to pay debts. In other words, depreciation causes the foreign debt burden to increase. This only applies if they generate domestic currency income but have foreign currency debt.
Depreciation has a positive impact on business because:
- Competitive pressure from imported goods decreases as they become more expensive when sold to the domestic market. Higher prices discourage consumers from buying imported goods, encouraging them to switch to domestic products.
- Exported goods become cheaper in destination countries, increasing their competitiveness and demand. In addition, exporters can generate more income from exchange differences when their foreign currency earnings are translated into domestic currency.
Meanwhile, appreciation is when the domestic currency is more valuable when exchanged abroad. For example, the dollar against the euro changed to EUR1.02 per US dollar from EUR0.9 per US dollar. Americans see their currency appreciate because they can get more euros for a dollar.
Appreciation has the opposite effect of depreciation.
- Imported goods become cheaper. Thus, businesses get imported raw materials and inputs cheaper.
- The demand for imported goods increases when they arrive in the domestic market. This intensifies the competition.
- Export goods become more expensive for foreign buyers. Finally, it lowers their competitiveness in foreign markets.
- Debt servicing is cheaper when businesses want to pay off their foreign debt. They need less domestic currency and convert it into foreign currency to pay debts.
The labor market is tight when the unemployment rate is low because people have found jobs. In addition, households are seeing improvements in their income prospects, prompting them to spend more. As a result, the demand for the product increases.
During this period, however, businesses faced fewer potential workers from which to choose. As a result, they have to compete with each other for quality workers. Consequently, offering higher competitive wages becomes a way to attract workers.
Operating costs increased as wages rose. This forces businesses to increase selling prices to compensate for increased costs and to maintain profits.
Conversely, when high unemployment rates, households see their income prospects deteriorate, forcing them to be thrifty. As a result, demand for goods and services weakens as consumers spend less.
However, high unemployment rates mean businesses have more potential workers to choose from. As a result, they tend to keep wages low.
Demographics deals with population and its changes. Meanwhile, demographic structure refers to its composition associated with aspects such as:
- Family size
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. This is because these countries offer high demand potential. Besides, they also provide a productive workforce.
In addition to population and its structure, sociodemographic factors also include:
- 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 changes affect not only products and how they are marketed. But it also involves 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.
Several examples illustrate how changes in technology have transformed businesses, including:
- Innovations in information and communication technology make business processes and communications faster and more efficient. It facilitates people to stay connected despite different locations, allowing them to work in separate geographical areas for a project.
- Strong research and development (R&D) have driven innovation in various business areas related to products, business processes, or production techniques. The results are 3D printers, smartphones, electric cars, and self-driving cars.
- Changes in demand for a company’s products can occur due to changes in technology. For example, the introduction of the laptop resulted in low demand for personal computers.
- Technology also contributes to changes in production processes. For example, computerization and automation reduce the number of workers needed to work in factories. Companies can produce standardized output on a mass scale with little human intervention.
- Big data allows managers to access more accurate data, which enables them to plan and make better decisions.
- E-Commerce allows people to shop anywhere and anytime through their smartphones. They no longer need to visit a retail store.
Environmental factors include weather, climate, air, water, soil, natural resources, flora, fauna, etc. They expose the business, but the impact varies between industries.
Insurance, for example, has significant exposure to environmental changes. Climate change increases natural disasters and catastrophic risks, which can lead to substantial losses and claims.
Environmental factors include two aspects, namely:
- Natural physical environment
- Green credentials
The natural physical environment includes all factors, such as weather and nature. In addition, air, natural vegetation, lakes, and oceans are also included, significantly affecting 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 are responsible for 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, the government continues to demand that businesses operate in environmentally friendly. Likewise, deep environmental concern encourages consumers to deal only with environmentally friendly companies.
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
Consumer law protects consumers from low-quality products and bad business practices. It regulates aspects like:
- Products and services
- Repair and replacement
Labor law aims to protect employees from exploitation. It governs aspects like:
- Health and safety at work
Competition law promotes fair competition and prohibits anti-competitive agreements, decisions, and practices. It covers aspects like:
- Uncompetitive practices such as predatory pricing
- Mergers and acquisitions
- Collusive practice
- Price fixing
Non-compliance with regulations can have negative impacts such as:
- Damaged business reputation
- Facing lawsuits and courts
- Rejection by stakeholders
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 factors above, 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
- 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:
Each stage has implications for profitability and competition in the market. Therefore, the strategy for success will also be different for each stage.
Porter’s five forces refer to five factors to explain competition and answer why specific industries have higher profitability than other industries. These five factors are:
- Rivalry among existing companies
- Barriers to entry
- Threat of substitution
- Bargaining power of suppliers
- Bargaining power of buyers
The internal environment and its impact
Elements in the internal environment can affect a business, including:
- Human resources, such as employees and management, including formed culture, diversity, and leadership.
- Physical resources such as location, equipment, and facilities owned by the company.
- Financial resources such as funding, leverage levels, cash balances, and income diversification.
- Innovation and efforts to secure internal strengths from imitation, such as through patents, copyrights, and trademarks.
- Process management, which regulates how internal resources can be allocated effectively and efficiently according to the company’s strategy.
- Technology, including hardware and software to help organizations carry out their business processes and operations.
Let’s take a deeper look at the human resource factor.
Human resources relate 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
- 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
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. Meanwhile, the way the leader does it 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 together. In addition, these differences also encourage creativity and problem-solving, which allows for more innovation within the company.
Impacts of changing business environment
Changes in the business environment expose opportunities and risks. It affects the company through two channels:
Direct impacts occur when changes in the business environment affect a company’s operations. For example, changes in consumer taste directly affect product demand – and, therefore, company sales.
Indirect impacts affect business stakeholders, which ultimately impact the company. For example, exchange rate depreciation may indirectly affect a consulting firm. But instead, it impacts their suppliers, such as office equipment manufacturers.
Office equipment manufacturers face rising costs as imported raw materials become more expensive. If they pass on the increased costs to the selling price, it ends up affecting the consulting firm.
Then, 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.
Or, the impact could apply to all companies in the same industry. For example, changes in tastes and preferences – such as increases in interest in health and the environment – impact the demand for certain products and, therefore, all firms in the market.
Finally, changes in the business environment can also expose all companies in various industries to opportunities and risks. For example, an increase in corporate profits tax will impact more than just one or two companies. But it affects all companies in the economy.
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 provides a framework for examining a company’s external environmental conditions. It scans for factors such as:
- Political factors
- Economic factor
- Sociodemographic factors
- Technological factor
- Environmental factor
- Legal factor
These factors expose both opportunities and threats to the business. However, not all aspects are relevant to the company. Therefore, the company must sort it out.
Scanning the external environment using PESTEL analysis requires companies to consider 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, 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.
Steps in a SWOT analysis include:
- Scanning the company’s external environment
- Mapping opportunities and threats in the external environment
- Sorting opportunities and threats by their strategic level
- Scanning the internal environment
- Mapping the company’s strengths and weaknesses
- Putting opportunities, threats, strengths, and weaknesses into a matrix
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 most direct competitors and should be considered first when formulating strategy. Through this analysis, companies will also understand on what basis they compete.
Like the stakeholder map, companies map strategic groups onto a matrix using two main variables. Then, they identify and place competing firms into the matrix.
Variables can vary between businesses, for example:
- Product price
- Product quality
- Market segments served
- Operation area
- Product line breadth
- Geographical reach
- Distribution channels used