UNDERSTANDING YOUR OPERATING ENVIRONMENT

UNDERSTANDING THE NEAR EXTERNAL ENVIRONMENT

In previous blogs, I have introduced the idea that Businesses operate in Three Environments – The Far External, The Near External, and the Internal.

Here, I am going to examine the Near External Environment, and how it affects our ability to be successful in business. For this I will be using a very famous model (in business academic circles anyway) proposed by Michael Porter* – The Five Forces Model.

Porter believes that for any business or organisation, there are five main factors that put pressure on a business and affect its likelihood of success. These are:

• Market Competition,

• Customer Power,

• Supplier Power,

• Threat of new Entrants,

• Threat of Substitutes.

 We can go through each one of these in turn, starting with the most obvious –

Market Competition.

This relates to the competition you are up against to obtain and retain customers for your product or service. So if you are a hairdresser, your competition is other hairdressers. Porter believes that the key to surviving this competition is to identify, develop and maintain Competitive Advantage. This is an aspect of your product or service offering that is difficult for the competition to replicate or acquire, and which makes you more attractive to customers. The possibilities for achieving Competitive Advantage are dependent on the market you are in, and the imagination of the company. In short it is the thing or things that you do differently or better when compared to the competition. For example, what do you think the Competitive Advantage of Ferrari is. Or Porsche?

To go back to the Hairdresser example – what might their advantage be? Perhaps it is that all of their stylists trained at Vidal Sassoon – and no one else in the area has those types of stylists. Or perhaps it’s that they provide a crèche for children while parents are being seen to.

Whatever your industry or market, it is very helpful to identify something that you can do that is different or better than your competitors, and which (very importantly) will attract and help to retain customers.

Customer Power.

This relates to the size of the company in relation to the size of the market. It also relates to the ability of the customer to switch from one company to another to acquire the thing they want. Consider Supermarkets. In terms of size, Tesco’s is very large and takes up a large part of the market. It is therefore less worried about ONE customer leaving and going somewhere else. However, it is very easy for customers to switch. So to be successful, Tesco has to try and decide how it is going to try to satisfy a large number of different customers with different needs and wants who can switch relatively easily – customers with little loyalty to the firm. So they sell lots of variety, both of product types and product identities (Brands).

On the other hand consider Rolls Royce Engines, who make engines for aeroplanes. There are very few companies who do this, but also very few customers (aeroplane builders). So Rolls Royce engines make few products, but all the products are very carefully tailored to suit the very few customers who order them.

Supplier Power.

Like Customer power in reverse, this tries to analyse the power of suppliers over the customer. For example, if you are the only petrol Station on the M1 within 50 miles all round, you can pretty much dictate prices (within reason). So if you are the only Train Operator between A and B, you can control pricing and, since the customer has little choice but to use you if they want to take the train, you also dictate service levels. But of course, no Government would allow that, would they?

Threat of New Entrants  

While you may know how many competitors you have, and who they are, you also need to be aware of how likely it is that someone else will enter the market.

The easiest way to think about this is: remember how easy or difficult it was for you to enter the market and start trading. That’s how easy it’s going to be for someone else. It depends on how much money it takes to set up, any special technology that must be mastered, any special licenses that are needed, and so on. So entering the market of window cleaning is fairly easy, entering the market of making aeroplanes is very difficult.

Finally, the Threat of Substitutes.

Often overlooked, even by leading business figures, it is very important in business. Basically, in order to understand this threat – and it is a big one, you need to really understand the Need or Want that you are satisfying for your customers. Then ask yourself: How could my customers satisfy this need or want without my product service offering or one like it.

For example, Coke – its main competitor is Pepsi, but that is not a substitute, it’s a competitor. In order to understand substitutes we need to understand Need or Want. So for Coke, its customers want something that will ease their thirst. Tap water does that, so tap water is a substitute product.

Now consider cars. Suppose you are Ford. Your Competitors are Volkswagen, Vauxhall, Toyota, etc. But they are not your substitute threat. If you ask yourself: “What is the need or want that is satisfied by Ford?” We can say “A means of getting from A to B”. Buses do that, so do bikes, so do trains, so do aeroplanes. So these are the substitute threats.

Now, you might reply to the question of need or want: “A means of getting into work, so that I can sit at a computer all day and do paperwork”. In other words “A way of me being able to work”. But computers do that. Hence, why so many people work from home. They do not need a car because they do not need to travel.  So the Internet is a Substitute Threat for cars in meeting this customer need.

The lesson here is that advances in technology often allow substitutes to take over from established markets. When Henry Ford started making cars for the masses, the established market was horses. The substitute was cars.

The same with typewriters. It used to be if you wanted to send an official letter, you typed it using metal keys and ink, onto paper and sent by post. Now, there is no need for ink or paper. We still type, but the product is not physical– the substitute for typewriters was a computer.

Remember Amazon from a previous blog? – they are a substitute for Bookshops. Kindle is a substitute for Book Printers.

Consider a Barber. He cuts hair. For men. This is a service. 40 years ago there were very few substitute threats. Now, I can buy a home hair trimmer for the price of a decent haircut, and give myself a number 3 every month. No barber. A product has replaced a service.

Artists replaced by photographers and cameras and photographic film. Kodak Film replaced by digital cameras. Digital cameras replaced by mobile phones. Mobile phones replaced by?????

The reason I am spending so long on this one is because it is so important. While businesses often spend time deciding who their competition is and how they are going to out-compete them, they can often miss the substitute offering. If you can work out what the substitute might be, perhaps you can get in on the action. This aspect of business training – to look beyond what is immediately obvious – is essential and often overlooked.

Now some of you might be saying – “That’s all very well and good, but it’s based on hindsight, seeing something after the fact”. Except that businesses can do it and do it successfully. Kindle is replacing books. That might be a problem for Amazon who sell books, except that Amazon and Kindle are one and the same. Amazon saw the technological advances, saw the threat of electronic books as a substitute for real ones, and saw an opportunity to get in on the ground floor. Not only that, but you don’t need warehouses to store electronic books, which makes Amazon’s Kindle e-book operation more profitable AND cheaper to customers. Everyone wins – except people who print books.

*Michael Porter is a Professor at Harvard University Business School. A leading business academic and consultant to large companies, he has written several books on Business and is highly regarded in his field.

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