Business environment

CHAPTER 2 – BUSINESS ENVIRONMENT

 

AIMS OF THE CHAPTER
The first chapter showed how the design of a strategy depends on the organisation’s purpose, its external environment and its internal features.  This chapter discusses the concept of a business environment – while the following chapter looks at an organisation’s internal features. 

The business environment includes all the external factors that affect an organisation, but which it cannot control.  The most important factors of a business environment include the overriding economic system, the industry in which the organisations chooses to work, and the market that it serves.  Although an organisation cannot change these, it can choose the area in which it works, and it particularly wants to choose an attractive industry and market.  

The aim of this chapter is to describe the environment in which an organisation works.  More specific aims are to:

• Understand the importance of a business environment

All organisations must work within their business environment, which consists of all the external factors that affect its operations, but which it cannot control.  This is a very complex concept, with many competing stakeholders.  Managers have to asses their environment, and then design a strategy that allows the organisation to work successfully within it. 

• Describe the factors that form an environment

The environment is a complex combination of the economic system, political system, legal restraints, society, industry, labour relations, customer expectations, markets, competition, technology, culture, history, infrastructure, state of the economy, shareholder demands, natural environment, labour conditions, and so on.  We can classify these factors into five categories of the physical environment, political and legal factors, economic factors, social and socio-cultural factors, and technological factors.  Alternatively we can consider inherent or macro factors that give the infrastructure and framework, and competitive or micro factors that are set by the industry and market.

• Appreciate the economic context of operations.

The type of economic system is probably the dominant factor in an organisation’s macro environment, as it defines the basic relationships between supply and demand.  We assume that most organisations work in some kind of market economy.  Then economic analyses give a lot of essential information about costs, supply, demand, competition, and so on.

• Discuss the concept of an industry and the features that make it attractive to an organisation.

An industry is a group of organisations that use similar resources to make equivalent products to satisfy the same customer demand.  When planning its products, an organisation implicitly makes a choice about the industry it works in.  many features can make an industry attractive, including the size of market, financial performance, type of products, point in their life cycles, number and features of customers, patterns of demand, state of competitors, basis of competition, resource requirements, efficiency, economies of scale, levels of technology, seasonal variations, entry and exit barriers, relations in the supply chain, risks, and so on.

• Discuss the concept of a market and the features that make it attractive to an organisation.  

The market is the set of customers who buy – or might buy – a particular type of product.  As a rule, organisations do not like working in markets that are aggressively competitive.  This means that in more attractive markets Porter’s five competitive forces are all weak – in other words, there is little competition from existing organisations, weak suppliers and customers, and low chance of substitute products and new entrants.  But the market does not have to look like this, and a well-designed strategy can allow an organisation to succeed in even the most hostile market. 

• Consider the ways that managers respond to changes in the environment.

There are continuous changes in the environment and managers have to make appropriate responses.  In effect, they have to assess potential events in the future, and then make decisions based on the likelihood of these events occurring, and the consequences if they do occur.  Several analyses can help here, particularly decision rules and expected values (or utilities).  Then the chapter lists nine possible reactions, ranging from ignoring potential changes (particularly if they are unlikely to happen or if the consequences are minor) to moving to another environment (if changes are very likely to happen and have serious consequences).

DISCUSSION QUESTIONS

• What factors should managers consider in their organisation’s environment? 

In principle, they should consider every external factor that is likely to affect performance.  This can be a very broad group indeed, so it is realistically impossible to consider every factor.  Normally managers concentrate on a small number of factors that they think are most important.  These typically centre on questions of the industry and market.  

• Do you agree with the view that business should not be concerned with ethics, as any action that is sufficiently harmful will be illegal, and any action that is legal must be acceptable?  

This is a view that is quite widely held – anything legal is permissible.  However, most people disagree and say that companies should behave responsibly and ethically as well as just legally.  As individuals we do things because they are ‘right’ – at least most of us do – and we should expect organisations to behave in the same way. 

• Some people say that organisations do not succeed by fitting their strategy to opportunities in an existing environment, but by developing strengths to create entirely new opportunities.  What does this mean?  

The traditional view says that the environment is fixed, so organisations must adopt their own operations to succeed within this environment.  Some more aggressive competitors say that this gives conformity, and if managers are innovative enough they can actually change the environment and create new opportunities, industries and markets.  For example, when Amazon.com started selling books through their Website they did not compete in an existing environment, but developed a completely new product and market – thus changing the business environment.  

• Economic analyses, like the models for supply and demand, are usually so simplified that they are of little practical value to organisations.  Do you think this is true? 

Not really.  It is true that economic models are simplified views of reality – but so is every other kind of model.  The point of a model is not that it is a perfect reproduction of reality, but that it gives information that can help managers make decisions.  Based on this criterion, economic models can be very useful.

• What is the difference between an industry and a market? 

An industry is a group of organisations that use similar resources to make equivalent products to satisfy the same customer demand.  The market is the set of customers who buy – or might buy – a particular type of product.  So the industry focuses on supply, while the market focuses on demand.

• An organisation has to match its operations to both the industry that it works in and the market that it satisfies.  How can it satisfy both of these requirements?  

This needs a balance – and achieving this balance is one of the most difficult jobs of management.  If they put too much emphasis on the market, they may not satisfy their internal requirements; if they put too much emphasis on their own operations, they may not satisfy the market.  This becomes easy when the two requirements are aligned – and we shall see in later chapters that high quality products or fast delivery give benefits to both customers and suppliers.  Often, though, there is some conflict between requirements, and then finding the best balance is more difficult.  The trend in recent years has been increasingly to put more emphasis on customer requirements – with the implication that it is easier to adjust internal operations than find new customers.

• Organisations only succeed by satisfying market requirements.  Does this mean that marketing is the only really import function?

No.  It is easy to satisfy customers if you put unlimited resources into customer satisfaction, with no regard for the internal operations.  A car manufacturer could satisfy customers by supplying a car with higher specifications and quality than a Rolls Royce, but charging less than a Hyundai.  But it could only do this until it went out of business.  And there are many more aspects of the external environment to consider than the market.  The aim of an organisation is to balance all of the external requirements – including the market – with all of the internal requirements.

• If you ask senior managers what they do, they say that they analyse circumstances to design and implement strategies.  If you watch what they do, they spend most time reviewing past performance and justifying their previous decisions.  Why is this? 

There are really two aspects to this question.  The first is a matter of the image that managers want to portray.  They want to be seen as productive and leading their business into the future rather than mulling over past events.  So they inevitably emphasise their role in plotting future directions and moving the business forward.  Also, they do not want to be seen as irrational, subjective decision makers, so they emphasise rational analyses and the formal procedures they use to make decisions.  Unfortunately, this image may be far from reality, where managers often make decisions in quite irrational ways.  And this leads to the second factor, which arises from management rewards that are based on the performance of their organisations.  But management is not an exact science where people look for the single best solution, and performance depends on many factors, only some of which are directly controlled by managers.  So they have to convince everyone that their decisions were the best ones in the prevailing circumstances.

 

 

IDEAS IN PRACTICE
AstraZeneca
Aim: to outline the way that one major company manages some interactions with its environment

One view of the environment considers a set of stakeholders, each of which puts pressure on the company to work in certain ways and tries to constrain its activities.  Pharmaceutical companies are particularly prone to such pressures – including financiers trying to get a return on their enormous research expenditure, governments setting maximum prices for health services, generic manufacturers making competing products, customers trying to reduce prices, pressure groups aiming for cheap products for developing countries, society looking for cures for every type of illness, and so on.  These different stakeholders try to push AstraZeneca – and every other pharmaceutical company – in different directions. 

AstraZeneca cannot change these pressures, so it has to accept them and work within their constraints.  To help with this, the company has developed a series of formal procedures for dealing with its environment.  These appear as core values that affect all aspects of operations, and ensure that it can ‘set, promote and maintain high standards of corporate responsibility worldwide’.  They clearly state that  ‘Our challenge is to sustain improvement in our environmental performance as we continue to grow our business’.  These values also appear in a Corporate Responsibility Priority Action Plan which shows how the company responds to a series of key issues. 

 

Balakrishnan and Sons
Aim: to outline a specific example of a supply and demand analysis

Balakrishnan and Sons can get good estimates of its own costs for a product, and has to decide whether this would be attractive in the prevailing environment.  Surveys of potential customers can give reasonable forecasts for likely demand at various prices.  It is more difficult to assess likely supply, but estimates can be found from the past performance of competitors.  So for each level of demand the company can estimate its own costs, likely total sales, and share of this market lost to competitors.

The company really needed to sell 10,000 units to maintain a selling price of €26.  But demand at the proposed price would be around 7,000 – which would give spare capacity and higher unit costs.  If they raised the price demand would fall even lower, and more competitors would appear; if they lowered the price they would sell more and competition would decline – but they would not cover production costs.  In this case, the sensible decision was not to develop the product.

Baileys
Aim: to give an example of the way that a major company responds to its environment – and can even change it

In the 1970s, Diageo noticed an opportunity in its Dublin operations to take advantage of a local surplus of milk – using this in an entirely new cream liqueur that they called Baileys.  This proved so successful over the next 20 years that it used all the surplus milk around Dublin, and began to create a shortage.  The operations of Diageo were so large that they changed the features of their environment – and particularly affecting the economics of local dairy farming.  Their next stage was carefully planned, and consisted of steps to increase the efficiency of farmers, raising their productivity and lowering costs.  Their impact on the environment went wider, ranging from social changes as agriculture became more attractive, to competitive forces as customers increased demand for different types of drinks.

Huang Sho Lan Industries
Aim: to show how a scoring model is used to assess the attractiveness of an industry

It is easy to say that managers look for attractive industries and markets, but the environment is so complex and there are so many conflicting factors, that it is difficult to compare alternatives and say exactly which is the most attractive.  Several analyses can help with this, and scoring models are one of the most robust and straightforward.  They give a way of comparing alternatives, giving a quantitative view of essentially qualitative factors and put decisions on a more objective footing. 

Scoring models are widely used in many different circumstances, and here a company has used one to assess a new market.  By itself, the figures only give limited information – but perhaps a score of 885 out of 3,000 suggests that the market is not particularly attractive.  The result is much more useful for comparing different markets.

Decisions under strict uncertainty
Aim: to introduce the idea of strict uncertainty and decision rules

The characteristic of strict uncertainty is that we know which events might happen, but cannot put realistic probabilities on their happening.  Then there is no obvious ‘best’ policy and managers have to use their judgement.  To help, they often use some type of simple decision rule. 

In this case, we have two events with the following costs (in millions of Euros).

Event	New competitor enters market	New competitor does not enter market
Increase promotion now	0.2	0.2
Do not increase promotion now	0.0	1.0

Three common decision rules are:

• Laplace – choose the option with the lowest average cost, which is to increase promotion now.
• Wald – find the highest potential cost for each event (€200,000 for increasing promotion now, and €1 million for not increasing promotion).  Then choose the event with the lowest of these potential costs, which is to increase promotion now
•  Hurwicz – which calculates for each event

α ´ lowest cost + (1 – α) ´ highest cost
where α is a constant between zero and one which reflects management attitude towards risk.  If we set α = 0.5, this gives:
increase promotion now:               0.5 ´ 0.2 + 0.5 ´ 0.2 = 0.2
do not increase promotion now    0.5 ´ 0 + 0.5 ´ 1  = 0.5
Then we choose the lowest of these notional costs, which is to increase promotion now.

Other rules are possible, but in this case there seems a clear consensus for increasing promotion now as the safer option.

Expected values
Aim: to introduce the ideas of risk, expected values and decision trees

The characteristic of decision making under risk is that we can give a reasonable probability to the likelihood of an event occurring.  Then we can calculate an expected value from:
EV = Probability of an event occurring ´ value of the outcome when it occurs
It follows that managers should be most concerned over events that have a high probability and/or a particularly serious outcome. 

Here the directors of the company could calculate expected values for their alternatives, and use these to identify a reasonable course of action.  Of course, the final decision is made by managers in the light of all available information – only one part of which comes from the expected value.  And they have to remember that the expected value does have weaknesses, in that it uses subjective estimates for probabilities, forecasts of future conditions, linear values of money, gives the expected return over the long-term, and ignores attitudes towards risk.  Sometimes an expected utility can give a clearer picture.

 

CASE STUDY – ROYAL DUTCH / SHELL GROUP
It might be a broad statement, but oil companies do not seem to generate much goodwill.  They are generally seen as making excessive profits, causing pollution through spills, depleting scarce natural resources, wasting gas by flaring it, damaging natural environments through exploration and recovery – and generally being poor corporate citizens.  Because of this reputation, the leading companies go out of their way to improve their image.  Shell shows how this works in a major company as it works ‘in partnership with industry, government and society to deliver what is expected of us – economically, socially and environmentally’.  They also have rigorous Business Principles and their annual report reviews environmental and social performance.

• What are the main elements in Shell’s business environment?

In common with all other organisations, we can classify the factors in Shell’s business environment as physical environment, political and legal factors, economic factors, social and socio-cultural factors, and technological factors.  Because of the nature of its primary operations in oil, the physical environment is likely to be more important than in many other industries.  Oil exploration and recovery is done in remote areas, with major impact on the natural surroundings. 

Having said this, major elements in Shell’s business environment are still the economic environment (which depends on the country of operations) and the industries and markets that it chooses to work in.  Most people probably imagine Shell as a leading company in the oil industry.  However, it has diversified and describes itself as working in the broader energy industry.  Within this, it works in different segments for oil, oil products, electricity, solar power, renewable resources, energy efficiency, efficiency advice, and so on.  It also works in the related industries, such as petrochemicals and transport.

The problem with trying to describe Shell’s business environment is that it is a huge organisation that works virtually everywhere, and whose global operations can be affected by almost anything that happens.  

• How would you summarise the environmental concerns facing Shell?  What strategies does it have to deal with these concerns?

Again, we have to say that Shell is such a huge organisation, that it is concerned by almost every possible environmental factor.  The illustrations given in the book mention some of Shell’s current projects and their difficulties.  From these, we can deduce some of Shell’s broader concerns.  For example, its Nigerian operations have a significant effect on the physical environment; this brings contacts no only with local communities, but also with governments, international organisations and pressure groups.  These operations also have political considerations arising from the style of governments – and this, in turn, determines the distribution of benefits.  If this distribution seems unfair, Shell has to consider social factors top ensure that local communities get a reasonable share of benefits.

We could keep developing these ideas and reinforce them with suggestions from the other illustrations – but it is already clear that Shell work in a very complex environment.  Their way of responding is based on strategies that define formal procedures and guidelines for all operations.  These strategies do not just appear but are carefully crafted – the company consider each type of problem, then develops a response, and incorporates this in strategies for the future.  It is impossible to list all aspects of their strategy, which is broad and often hazy.  But we can infer some points, such as social responsibility, concern for their environment in its broadest sense, high ethical standards, integrity, diversification, political neutrality, safe and healthy operations, profitability, responsibility to stakeholders, open communications, fair competition, and so on.

• How does the environment of oil companies compare with that of major companies in other industries?

In principle, the problems met by the oil industry are similar to those in other industries.  They have to put more emphasis on certain areas, such as the physical environment, but similar questions are raised in, say, the transport industry, pharmaceuticals, or nuclear energy.  Perhaps the single distinguishing feature about oil is its size and scope.  It is the largest international industry, and operates in every area of the world.