What is External Environment Analysis? Definition, Tools, & Importance

What is External Environment Analysis?

External environment analysis or external analysis is the process of analyzing external factors of an organization to understand uncertainty and achieve competitiveness.

The main objective of analyzing external environment factors is to be aware of likely opportunities and threats. The external environment greatly holds potential opportunities for the firm, if analyzed successfully and aligned strategies with, the firm will enjoy enormous benefits.

On the other hand, if the firm can not mitigate the threats arising from the external environment every step it takes would not give reasonable results.

External environment analysis focuses on macro-environmental forces which are external to the firm and indirectly affect the firm’s operations and performance. Analyzing factors such as political, economic, customers, suppliers, social, technological, competitors, media, legal, ecological, and global, it predicts future possible events in which the firm would be.

Since external environment factors are uncontrollable by managers it has been a critical task for every manager to get a competitive advantage, be ahead of competitors, and get market leadership. The organizations which continuously analyze this environment have a better chance to compete in the competition than others.

What is External Environment?

The external environment of a business refers to the environment which is external to a firm. The environment is out of the control of the managers.

To deal with uncertainty and achieve strategic attractiveness firms must be aware of the elements of the external environment. The elements sometimes provide opportunities and sometimes threats, so managers must understand which is good for the firm and which is not and make decisions accordingly.

The external environment is composed of operating and remote environments.

General/Remote/Macro Environment

The general environment is composed of factors that are broad and affect the industries and the firms competing with each other. The general environment should be scanned, monitored, forecasted, and assesses to recognize and evaluate opportunities and threats to the firm.

The general environment has the following components.

  • Economic environment
  • Political environment
  • Legal environment
  • Socio-cultural environment
  • Technological environment
  • Physical/Natural environment
  • Global environment

Operating/Task Environment

The task environment of a business is composed of factors that are directly related to the competitive position of a firm. It consists of different stakeholders who have a direct or indirect interest in the performance of the business.

The components of the task environment are,

  • Customers
  • Competitors
  • Distributors
  • Government
  • Suppliers
  • Creditors
  • Media
  • Pressure Groups

Techniques/Tools of External Environment Analysis

The main techniques used to analyze the external environment are mentioned below.

  • PESTLEG Analysis
  • Scenario Planning
  • Industry and Competitive Analysis

PESTLEG Analysis

PESTLEG is the acronym for political, economic, sociocultural, technological, legal, environmental, and global factors. PESTLEG analysis involves the analysis of general environment factors that we mentioned above.

These factors are uncontrollable to the firm. They are analyzed to identify the environmental trends and assess possible opportunities or threats.

The following components are analyzed in PESTLEG analysis.

Political Factors – Political factors are those actions imposed by the government that affects businesses. Such as understanding whether the country follows a democratic political ideology or totalitarian.

Economic Factors – Economic factor consists of GDP, employment rate, income level, and so on by which you have to decide whether the people have the payment capacity to buy your products.

Socio-Cultural Factors – Factors like beliefs, traditions, views, values, attitudes, habits, preferences, and so forth greatly affect people’s choices of purchase and their living style.

Technological Factors – Today, the pace of technological advancement is very high. To be competitive you should use advanced technology and understand how it affects the organization’s performance.

Legal Factors – It includes a nation’s laws, business laws, constitution, law administration, etc.

Environmental FactorsManagement must be aware of changing physical climates and restrict the activities hurting the physical environment.

Global Environment – Global environment is the collection of global phenomena such as global market, global competition, global culture, global opportunities, and global threats.

Scenario Planning

In the event that conventional forecasting methods are unable to foresee the change in the environment, scenario planning is utilized for environmental analysis. It is a methodical technique for businesses to consider the future. It is created by researching potential environmental effects on a specific business.

It provides a thorough and believable analysis of potential future changes to an organization’s business environment. It is based on classifications of significant environmental effects and changes drivers, for which there is a great deal of uncertainty.

It can be used to explore and learn the future and form a corporate strategy. It helps to link the likely future uncertainties to the decisions that are made today. It is a planning method that works by understanding the nature and impact of the most uncertain and important driving forces affecting the future.

Industry and Competitive Analysis

An industry is a group of firms producing products that are close substitutes. The industry environment is considered to be made up of Porter’s five forces – threats of new entrants & product substitutes, bargaining power of suppliers & buyers, and competitive rivalry.

As compared to the PESTLEG analysis the industry environment has a more direct impact on the firm’s performance.

Threats of New Entrants – This concerns the ability of new firms to enter the industry. If the entry cost is very high there is little threat of new competitors entering the industry and vice versa.

Threats of Substitutes Products – This concerns when there are more substitute products in the market, the competition will be intense, the product price will fall down, and customers easily switch vendors. If such happens it poses a strong threat to a firm.

Bargaining Power of Suppliers – Suppliers exert pressure over firms on prices and quality of the products. Suppliers have more power when there is a large & monopoly supplier, few substitutes, powerful brand, etc.

Bargaining Power of Buyers – Buyers always wish to have products of high quality but at low prices. Buyers have more power when there are a large number of buyers, a large number of suppliers, low switching costs, etc.

Competitive Rivalry – It concerns the competitors to increase market share over your firm. When there is a high competition you should opt for quality, low price, differentiation, or search for a new market.

Importance of External Environment Analysis

Why external environment analysis is critical? From the above discussion, we can clearly say that external environment analysis gives information about the potential trends and changes in the external environment.

As a manager, you should always be aware of what is happening and what possibly will happen on the factors that could affect your business operations. Its further importance may be pointed out as,

Identification of Opportunities

External environmental analysis is a must-used tool to identify likely opportunities for firms from the external environment. Opportunities are the situations if a company exploits them effectively, the company will definitely be benefited.

You should continuously analyze the likely opportunities and make new, modify, or abandon strategies to exploit the arising opportunities.

Identification of Threats

Along with opportunities, it also helps to identify what are likely threats. These are negative indicators for your firm and they hinder your goals achieving.

The likely threats should be identified, and after identifying you should make plans on how to get rid of or mitigate the threats.

Fit for Big Companies

Small companies are happy with their local customers. But for big companies only local customers might not cover their investment.

From huge investments to get maximum return, big companies require to have a huge amount of customers. In such a scenario, they must have to identify a new market, existing markets need, new trends, new strategies, and so forth.

Adapt Change

It is obvious that external environment analysis gives us a clear view of changing trends in the markets and business practices. This information is critical to follow to go with the changing business practices.

Competitive Advantage

A thorough analysis of external environmental factors helps us to understand what customers are using and towards what products they are heading. How their consumption habits are changing.

It helps us to serve customers more efficiently than the competitors gaining a competitive advantage over them.

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