Benchmarking (Strategic Management)?

Benchmarking

is a strategy tool used to compare the performance of the business processes and products with the best performances of other companies inside and outside the industry.

Benchmarking

is the search for industry best practices that lead to superior performance.

^[1]

Understanding the tool

Comparing your own business to a rival is essential when competing. Without it, you would never know how successful your performance is in a market or whether you perform one or another task better than your competitor does. For example, 85% customer satisfaction might look great for you or even compared to your industry’s average, but what if some other companies (not necessarily rivals) easily achieve 97% rate? In this situation, your 85% satisfaction rate doesn’t look that brilliant. To better understand your situation and improve company’s performance, the managers use benchmarking.
Some form of comparison in the companies was used, since 1800s, and mainly included product’s quality and feature comparison. This type of comparison was scarcely used and didn’t become a valuable management tool until late 1980s and 1990s, when Xerox introduced the process benchmarking technique.^[2] This type of comparison proved very beneficial and Xerox, AT&T and other companies began comparing the performance of their processes to the best standards in the industry. The following table shows how benchmarking evolved into a modern strategy tool:

Benchmarking history

1950-1975	Reverse engineering
1976-1986	Competitive benchmarking
1982-1986	Process benchmarking
1988+	Strategic benchmarking
1993+	Global benchmarking

Source: J. Blakeman, University of Wisconsin-Milwaukee^[3] According to Camp,^[1] benchmarking is simply “Finding and implementing the best business practices”. Managers use the tool to identify the best practices in other companies and apply those practices to their own processes in order to improve the company’s performance. Improving company’s performance is, without a doubt, the most important goal of benchmarking.

It’s a very important tool in strategic management, because it often reveals how well your organization performs compared to rivals.

Other uses of the tool:

• To reveal successful business processes. It is often unclear how successful companies achieve superior performance. By observing and scrutinizing such companies you can identify the processes, skills or competences that contribute to organization’s success and then apply the same practices to your own company.
• To facilitate knowledge sharing. The knowledge acquired about other businesses can be easily transferred to your own organization.
• To gain competitive advantage. The company can gain a competitive advantage if it applies the best practices from other industries to its own industry. For example, a small family owned farm selling its own agricultural products online could apply the same social media strategies as internet blogs to attract attention and gain new customers. This would be a new way to gain customers and may result in at least temporary competitive advantage.

Popularity

The tool is one of the most recognized and widely used tools of all the business strategy tools. The survey done by The Global Benchmarking Network^[4] reveals that adaptation of the tool in organizations vary from 68% for informal benchmarking to 49% and 39% for performance and best practice benchmarking, respectively. In addition, annual surveys from Bain & Company’s^[5] indicate similar results.
Source: Bain & Company^[5] The graph shows that, although, the satisfaction of the tool is high, the usage of it has declined since the heights in 1999. Still, benchmarking remained the 4th top used tool by businesses in the world in 2013.^[6]

Types

There are different types of benchmarking the managers can use. Tuominen^[7] and Bogan & English^[8] identified these 3 major types:

• Strategic benchmarking. Managers use this type of benchmarking to identify the best way to compete in the market. During the process, the companies identify the winning strategies (usually outside their own industry) that successful companies use and apply them to their own strategic process. It is also common to compare the strategic goals in order to spot new strategic choices.
• Performance benchmarking. It is concerned with comparing your company’s products and services. According to Bogan & English^[8] the tool mainly focuses on product and service quality, features, price, speed, reliability, design and customer satisfaction, but it can measure anything that has the measurable metrics, including processes. Performance benchmarking determines how strong our products and services are compared to our competition.
• Process benchmarking. It requires to look at other companies that engage in similar activities and to identify the best practices that can be applied to your own processes in order to improve them. Process benchmarking is a separate type of benchmarking, but it usually derives from performance benchmarking. This is because companies first identify the weak competing points of their products or services and then focus on the key processes to eliminate those weaknesses. For example, an organization using performance comparison identifies that their product ‘X’ is superior in features, manufacturing quality and design, but pricier than competitor’s product ‘Y’. Then the company determines, which processes add the most to the cost of the product and seek how to improve them by looking at similar, but less cost heavy processes in other companies.

Approaches

In addition to the types, there are four ways you can do benchmarking. It is important to choose the optimal way because it reduces the costs of the activity and improves the chances to find the ‘best standards’ you can rely on.

• Internal benchmarking. In large organizations, which operate in different geographic locations or manage many products and services, same functions and processes are usually performed by different teams, business units or divisions. This often results in processes performed very well in one division but poorly in another. Internal benchmarking is used to compare the work of separate teams, units or divisions to identify the ones that are working better and share the knowledge throughout the company to other teams to achieve higher performance. It is usually employed by the companies that have recently expanded geographically, but haven’t yet created proper knowledge sharing systems between divisions. If such systems are in place, there’s no need to use internal benchmarking to look for best practices.
• External or competitive benchmarking. Some authors use these terms interchangeably but there are a few differences between them. First, competitive benchmarking refers to a process when a company compares itself with the competitors inside its industry. Whereas external benchmarking looks both inside and outside the industry to find the best practices, thus, including competitive benchmarking.^[9] Second, competitive benchmarking, in my opinion, will only be used with performance benchmarking to compare your products and services. Strategic or process benchmarking won’t be viable options, because it’ll be very hard to find a competitor, who wants to share sensitive information with you and you’ll never outcompete your rival if you’ll be using his strategy or processes. Besides, external benchmarking is a more beneficial approach to use due to higher possibilities of finding the best practices.
• Functional benchmarking. Managers of functional departments find it useful to analyze how well their functional area performs compared to functional areas of other companies. It is quite easy to identify the best marketing, finance, human resource or operations departments, in other companies, that excel in what they do and to apply their practices to your own functional area. This way the companies can look at a wide range of organizations, even unrelated ones, and instead of improving separate processes, they can improve the whole functional areas.
• Generic benchmarking. According to Kulmala,^[9] it refers to comparisons, which “focus on excellent work processes rather than on the business practices of a particular organization”. For example, your company tries to improve its marketing capabilities and benchmarks itself against company ‘A’. While observing company’s ‘A’ marketing processes you also notice how well their human resources are managed using ‘big data’ analytics. This gives you an idea to implement the data collecting and analysis team in your own company to significantly improve its overall performance.
  The other example of generic benchmarking would be to compare your processes against generally accepted best standards. For example, every organization strives to become a learning organization, because such an organization is better equipped to overcome challenges and adapt to the market changes. By comparing your company to some general standards, which would indicate that your company is a learning organization, you would be using generic benchmarking.

The following diagram summarizes the types and approaches to benchmarking:

Advantages

• Easy to understand and use.
• If done properly, it’s a low cost activity that offers huge gains.
• Brings innovative ideas to the company.
• Provides you with insight of how other companies organize their operations and processes.
• Increases the awareness of your costs and level of performance compared to your rivals.
• Facilitates cooperation between teams, units and divisions.

Disadvantages

• You need to find a benchmarking partner.
• It is sometimes impossible to assign a metric to measure a process.
• You might need to hire a consultant.
• If your organization is not experienced at it, the initial costs could be huge.
• Managers often resist the changes that are required to improve the performance.
• Some of best practices won’t be applicable to your whole organization.

Using the tool

Benchmarking is used extensively by organizations, but no universal process of how to conduct it is established. Each organization designs its own way of using the tool. Before revealing some of the examples, we provide you with the guidelines^[3] to make the process easier.
Guidelines:

1. Only choose the products, services or processes, which perform poorly. Comparing the processes you are good at will be a waste of time and money, and won’t bring the desired results.
2. Define the specific metrics or processes to measure. Be careful not to choose too broad processes that can’t be measured as you won’t be able to compare it properly.
3. Prepare your company for change. Your organization must overcome the resistance to change to implement new best practices.
4. Choose the team that is qualified. Although benchmarking is easy to use, you shouldn’t pick up just anybody to do it. Include the people that will be responsible for implementing the changes and the people that are skilled at it.
5. Participate in benchmarking networks and use the appropriate software to facilitate the process. There are various benchmarking networks, where participating companies can find benchmarking partners or gather the data for the metrics they need. Such participation facilitates the process significantly by reducing the costs and time spent looking for the right data.
6. Look for the best standards and ideas even in unrelated areas. Many significant discoveries will be made by observing the companies that are completely unrelated to your organization.

Benchmarking Wheel

The benchmarking wheel model introduced in article “Benchmarking for Quality”^[10] is a 5 stage process that was created by observing more than 20 other models.
It’s fairly simple and comprises of following stages:

1. Plan. Assemble a team. Clearly define what you want to compare and assign metrics to it.
2. Find. Identify benchmarking partners or sources of information, where you’ll be able to collect the information from.
3. Collect. Choose the methods to collect the information and gather the data for the metrics you defined.
4. Analyze. Compare the metrics and identify the gap in performance between your company and the organization observed. Provide the results and recommendations on how to improve the performance.
5. Improve. Implement the changes to your products, services, processes or strategy.

Xerox Process

Xerox has popularized benchmarking and was one of the first companies to introduce the process of doing it. This 5-phase and 12-step process was created by Camp, R. the manager of Xerox responsible for benchmarking.^[3]
Most of the processes are similar to the examples above and can be applied to any company or non-profit organization that strives to achieve superior performance using benchmarking.

Example

Company ‘A’ has used performance benchmarking to compare its product ‘X’ with the competitor’s product ‘Y’ and found out that the product ‘X’ is priced slightly lower, but it also has fewer features than product ‘Y’. The company recognized that in order to win a larger market share and establish itself in the market, it has to increase the number of features in its product while keeping the price at the same level or even decreasing it.
To achieve this, the company ’A’ has set up a team that investigated product ‘X’ value chain analysis. The team identified that the activities adding the most to the cost are marketing and purchasing parts in an open market. The team also identified that by buying standards parts in the market, the company has little room to introduce new features as this would require customized parts for its product ‘X’. The next step was to assign the proper metrics to marketing and purchasing activities and gather the required data. The company joined the benchmarking network and in a few weeks gathered enough data to compare the performance of its processes.
The results indicated that the marketing activities could be improved significantly. The team recognized that many businesses in the industry were able to attract new customers profitably through heavy advertising online. Yet, further observations of the companies outside the industry showed that the average returns on advertising weren’t so huge compared to the returns when attracting customers through social media. Therefore, the team decided to rely on social media rather than advertising to attract more customers, while reducing its costs by 20%.
The next activity analyzed was the purchase of parts in the open market. While this was a convenient way to conduct the business it was costing more and didn’t allow customizing the product. The team identified that this activity could be improved by manufacturing the parts inside the company or by establishing long term relationships with suppliers. The collected data and the experience of other similar businesses showed that the best option would be to establish long term relationships with suppliers. It would cost less than manufacturing the parts inside the company or buying them in an open market. It would also allow ordering customized parts that were needed for the new features.
By engaging in benchmarking activities, the team has identified the gaps in company’s performance and introduced new ways to improve the current processes to achieve the higher performance.

Swot analysis(Strategic Mangement)?

Swot analysis

involves the collection and portrayal of information about internal and external factors which have, or may have, an impact on business.

^[2]

SWOT

is a framework that allows managers to synthesize insights obtained from an internal analysis of the company’s strengths and weaknesses with those from an analysis of external opportunities and threats.

^[3]

Understanding the tool

What is SWOT analysis? The answer to the question is simple: it’s a tool used for situation (business or personal) analysis! SWOT is an acronym which stands for:

Strengths: factors that give an edge for the company over its competitors.
Weaknesses: factors that can be harmful if used against the firm by its competitors.
Opportunities: favorable situations which can bring a competitive advantage.
Threats: unfavorable situations which can negatively affect the business.

Strengths and weaknesses are internal to the company and can be directly managed by it, while the opportunities and threats are external and the company can only anticipate and react to them. Often, swot is presented in a form of a matrix as in the illustration below:
Swot is widely accepted tool due to its simplicity and value of focusing on the key issues which affect the firm. The aim of swot is to identify the strengths and weaknesses that are relevant in meeting opportunities and threats in particular situation. ^[4]

Benefits

Swot tool has 5 key benefits:

• Simple to do and practical to use;
• Clear to understand;
• Focuses on the key internal and external factors affecting the company;
• Helps to identify future goals;
• Initiates further analysis.

Limitations

Although there are clear benefits of doing the analysis, many managers and academics heavily criticize or don’t even recognize it as a serious tool.^[2] According to many, it is a ‘low-grade’ analysis. Here are the main flaws identified by a research:^[2][5]

• Excessive lists of strengths, weaknesses, opportunities and threats;
• No prioritization of factors;
• Factors are described too broadly;
• Factors are often opinions not facts;
• No recognized method to distinguish between strengths and weaknesses, opportunities and threats.

How to perform the analysis?

Swot can be done by one person or a group of members that are directly responsible for the situation assessment in the company. Basic swot analysis is done fairly easily and comprises of only few steps:

Step 1. Listing the firm’s key strengths and weaknesses
Step 2. Identifying opportunities and threats

Strengths and Weaknesses

Strengths and weaknesses are the factors of the firm’s internal environment. When looking for strengths, ask what do you do better or have more valuable than your competitors have? In case of the weaknesses, ask what could you improve and at least catch up with your competitors?

Where to look for them?

Some strengths or weaknesses can be recognized instantly without deeper studying of the organization. But usually the process is harder and managers have to look into the firm’s:

• Resources: land, equipment, knowledge, brand equity, intellectual property, etc.
• Core competencies
• Capabilities
• Functional areas: management, operations, marketing, finances, human resources and R&D
• Organizational culture
• Value chain activities

Strength or a weakness?

Often, company’s internal factors are seen as both, strengths and weaknesses, at the same time. It is also hard to tell if a characteristic is a strength (weakness) or not. For example, firm’s organizational structure can be a strength, a weakness or neither! In such cases, you should rely on:
Clear definition. Very often factors which are described too broadly may fit both strengths and weaknesses. For example, “brand image” might be a weakness if the company has poor brand image. However, it can also be a strength if the company has the most valuable brand in the market, valued at $100 billion. Therefore, it is easier to identify if a factor is a strength or a weakness when it’s defined precisely.
Benchmarking. The key emphasize in doing swot is to identify the factors that are the strengths or weaknesses in comparison to the competitors. For example, 17% profit margin would be an excellent margin for many firms in most industries and it would be considered as a strength. But what if the average profit margin of your competitors is 20%? Then company’s 17% profit margin would be considered as a weakness.
VRIO framework. A resource can be seen as a strength if it exhibits VRIO (valuable, rare and cannot be imitated) framework characteristics. Otherwise, it doesn’t provide any strategic advantage for the company.

Opportunities and threats

Opportunities and threats are the external uncontrollable factors that usually appear or arise due to the changes in the macro environment, industry or competitors’ actions. Opportunities represent the external situations that bring a competitive advantage if seized upon. Threats may damage your company so you would better avoid or defend against them.

Where to look for them?

PESTEL. PEST or PESTEL analysis represents all the major external forces (political, economic, social, technological, environmental and legal) affecting the company so it’s the best place to look for the existing or new opportunities and threats.
Competition. Competitor’s react to your moves and external changes. They also change their existing strategies or introduce new ones. Therefore, the company must always follow the actions of its competitors as new opportunities and threats may open at any time.
Market changes. The most visible opportunities and threats appear during the market changes. Markets converge, starting to satisfy other market segment needs with the same product. New geographical markets open up allowing the firm to increase its export volumes or start operations in a new country. Often niche markets become profitable due to technological changes. As a result, changes in the market create new opportunities and threats that must be seized upon or dealt with if the company wants to gain and sustain competitive advantage.

Opportunity or threat?

Most external changes can represent both opportunities and threats. For example, exchange rates may increase or reduce the profits gained from exports. This depends on the exchange rate, which may rise (opportunity) or fall (threat) against the home country currency. The organization can only guess the outcome of the change and count on analysts’ forecasts. In such cases, when organization cannot identify if the external factor will affect it positively or negatively, it should gather unbiased and reliable information from the external sources and make the best possible judgement.

Guidelines for successful SWOT

The following guidelines are very important in writing a successful swot analysis. They eliminate most of swot limitations and improve it's results significantly:

• Factors have to be identified relative to the competitors. It allows specifying whether the factor is a strength or a weakness.
• List between 3 – 5 items for each category. Prevents creating too short or endless lists.
• Items must be clearly defined and as specific as possible. For example, firm’s strength is: brand image (vague); strong brand image (more precise); brand image valued at $10 billion, which is the most valued brand in the market (very good).
• Rely on facts not opinions. Find some external information or involve someone who could provide an unbiased opinion.
• Factors should be action orientated. For example, “slow introduction of new products” is action orientated weakness.

SWOT analysis example A

This is a basic example of the analysis:

SWOT analysis of Company "A"

Strengths	Weaknesses
Second most valuable brand in the world valued at $76 billion Diversified income (5 different brands earning more than $4 billion each) Strong patents portfolio (15,000 patents) Investments in R&D reaching 4 billion a year. Competent in mergers & acquisitions Have an access to cheap cash reserves Effective corporate social responsibility (CSR) projects Localized products Highly skilled workforce Economies of scale or economies of scope	Investments in R&D are below the industry average Very low or zero profit margins Poor customer services High employee turnover High cost structure Weak brand portfolio Rigid (bureaucratic) organizational culture impeding fast introduction of new products High debt level ($3 billion) Brand dilution (the firm has too many brands) Poor presence in the world's largest markets
Opportunities	Threats
Market growth for the main firm's product Growing demand for renewable energy New technology, that would drive production costs by 20% is in development Our country accession to EU Changing customer habits Disposable income level will increase Government's incentives for 'specific' industry Economy is expected to grow by 4% next year Growing number of people buying online Interest rates falling to 1%	Corporate tax may increase from 20% to 22% in 2013 Rising pay levels Rising raw material prices Intense competition Market is expected to grow by only 1% next year indicating market saturation Increasing fuel prices Aging population Stricter laws regulating environment pollution Lawsuits against the company Currency fluctuations

(If you need more examples for SWOT factors please visit our SWOT analyses examples)

Advanced SWOT

At the most, swot is considered to be only a reference to further analysis as it has too many limitations and cannot be used alone in the situation analysis. The previous guidelines identified in this article meet the most of swot limitations except one: “prioritization of factors”. An advanced swot goes a step further and eliminates this important drawback.
In a simple swot, strengths and weaknesses or opportunities and threats are equal to each other, therefore a minor weakness can balance a major strength. Without prioritization, some factors might be given too much or too little emphasis and the most relevant factors might simply be overlooked.
The aim of advanced swot is to identify the most significant factors of the analysis from all the items listed on it. How to perform it?

Step 1. Identify strengths, weakness, opportunities and threats.
Step 2. Prioritize them.

(The first step was discussed earlier so please refer to it when doing advanced swot analysis. See example B when reading further instructions.)

Prioritization

Strengths and weaknesses are evaluated on 3 categories:

• Importance. Importance shows how important a strength or a weakness is for the organization in its industry as some strengths (weaknesses) might be more important than others. A number from 0.01 (not important) to 1.0 (very important) should be assigned to each strength and weakness. The sum of all weights should equal 1.0 (including strengths and weaknesses).
• Rating. A score from 1 to 3 is given to each factor to indicate whether it is a major (3) or a minor (1) strength for the company. The same rating should be assigned to the weaknesses where 1 would mean a minor weakness and 3 a major weakness.
• Score. Score is a result of importance multiplied by rating. It allows prioritizing the strengths and weaknesses. You should rely on your most important strengths and try to convert or defend your weakest parts of the organization.

Opportunities and threats are prioritized slightly differently than strengths and weaknesses. Their evaluation includes:

• Importance. It shows to what extent the external factor might impact the business. Again, the numbers from 0.01 (no impact) to 1.0 (very high impact) should be assigned to each item. The sum of all weights should equal 1.0 (including opportunities and threats).
• Probability. Probability of occurrence is showing how likely the opportunity or threat will have any impact on business. It should be rated from 1 (low probability) to 3 (high probability).
• Score. Importance multiplied by probability will give a score by which you’ll be able to prioritize opportunities and threats. Pay attention to the factors having the highest score and ignore the factors that will not likely affect your business.

SWOT analysis example B

This swot example is adopted from the previous example and additionally includes prioritization. Highlighted cells point to the most significant factors affecting the organization.

Advanced SWOT of Company 'A' (1/2)

Strengths	Importance	Rating	Score
Second most valuable brand in the world	0.03	1	0.03
Diversified income	0.01	2	0.02
Strong patents portfolio (15,000 patents)	0.15	3	0.45
Investments in R&D reaching 4 billion a year	0.10	2	0.20
Competent in mergers & acquisitions	0.05	3	0.15
An access to cheap cash reserves	0.02	1	0.02
Effective corporate social responsibility (CSR) projects	0.03	1	0.03
Localized products	0.01	1	0.01
Highly skilled workforce	0.08	2	0.16
Economies of scale/economies of scope	0.02	3	0.06
Weaknesses	Importance	Rating	Score
Investments in R&D are below the industry average	0.03	2	0.06
Very low or zero profit margins	0.08	2	0.24
Poor customer services	0.10	2	0.20
High employee turnover	0.05	2	0.10
High cost structure	0.03	3	0.09
Weak brand portfolio	0.02	1	0.02
Bureaucratic organizational culture	0.03	1	0.03
High debt level ($3 billion)	0.03	1	0.03
Brand dilution (the firm has too many brands)	0.01	1	0.01
Poor presence in the world's largest markets	0.12	2	0.24

Advanced SWOT of Company 'A' (2/2)

Opportunities	Importance	Probability	Score
Market growth for the main business product	0.10	2	0.20
Growing demand for renewable energy	0.01	1	0.01
New technology is in development	0.13	1	0.13
Our country accession to EU	0.05	3	0.15
Changing customer habits	0.05	1	0.05
Disposable income level will increase	0.02	3	0.06
Government's incentives for 'specific' industry	0.03	2	0.06
Economy is expected to grow by 4% next year	0.01	2	0.02
Growing number of people buying online	0.08	3	0.24
Interest rates falling to 1%	0.02	3	0.06
Threats	Importance	Probability	Score
Corporate tax may increase from 20% to 22% in 2013	0.12	2	0.24
Rising pay levels	0.03	2	0.06
Rising raw material prices	0.09	3	0.27
Intense competition	0.07	1	0.07
Market is expected to grow by only 1% next year	0.05	3	0.15
Increasing fuel prices	0.01	3	0.03
Aging population	0.01	3	0.03
Stricter laws regulating environment pollution	0.01	1	0.01
Lawsuits against the company	0.02	1	0.02
Currency fluctuations	0.09	2	0.18

Value Chain Analysis(Strategoc Management)?

Value chain analysis (VCA)

is a process where a firm identifies its primary and support activities that add value to its final product and then analyze these activities to reduce costs or increase differentiation.

Value chain

represents the internal activities a firm engages in when transforming inputs into outputs.

Understanding the tool

Value chain analysis is a strategy tool used to analyze internal firm activities. Its goal is to recognize, which activities are the most valuable (i.e. are the source of cost or differentiation advantage) to the firm and which ones could be improved to provide competitive advantage. In other words, by looking into internal activities, the analysis reveals where a firm’s competitive advantages or disadvantages are. The firm that competes through differentiation advantage will try to perform its activities better than competitors would do. If it competes through cost advantage, it will try to perform internal activities at lower costs than competitors would do. When a company is capable of producing goods at lower costs than the market price or to provide superior products, it earns profits.
M. Porter introduced the generic value chain model in 1985. Value chain represents all the internal activities a firm engages in to produce goods and services. VC is formed of primary activities that add value to the final product directly and support activities that add value indirectly.
Although, primary activities add value directly to the production process, they are not necessarily more important than support activities. Nowadays, competitive advantage mainly derives from technological improvements or innovations in business models or processes. Therefore, such support activities as ‘information systems’, ‘R&D’ or ‘general management’ are usually the most important source of differentiation advantage. On the other hand, primary activities are usually the source of cost advantage, where costs can be easily identified for each activity and properly managed.

Firm’s VC is a part of a larger industry VC. The more activities a company undertakes compared to industry VC, the more vertically integrated it is. Below you can find an industry value chain and its relation to a firm level VC.

Using the tool

There are two different approaches on how to perform the analysis, which depend on what type of competitive advantage a company wants to create (cost or differentiation advantage). The table below lists all the steps needed to achieve cost or differentiation advantage using VCA.

Competitive advantage types

Cost advantage	Differentiation advantage
This approach is used when organizations try to compete on costs and want to understand the sources of their cost advantage or disadvantage and what factors drive those costs.	The firms that strive to create superior products or services use differentiation advantage approach.
Step 1. Identify the firm’s primary and support activities. Step 2. Establish the relative importance of each activity in the total cost of the product. Step 3. Identify cost drivers for each activity. Step 4. Identify links between activities. Step 5. Identify opportunities for reducing costs.	Step 1. Identify the customers’ value-creating activities. Step 2. Evaluate the differentiation strategies for improving customer value. Step 3. Identify the best sustainable differentiation.

Cost advantage

To gain cost advantage a firm has to go through 5 analysis steps:
Step 1. Identify the firm’s primary and support activities. All the activities (from receiving and storing materials to marketing, selling and after sales support) that are undertaken to produce goods or services have to be clearly identified and separated from each other. This requires an adequate knowledge of company’s operations because value chain activities are not organized in the same way as the company itself. The managers who identify value chain activities have to look into how work is done to deliver customer value.
Step 2. Establish the relative importance of each activity in the total cost of the product. The total costs of producing a product or service must be broken down and assigned to each activity. Activity based costing is used to calculate costs for each process. Activities that are the major sources of cost or done inefficiently (when benchmarked against competitors) must be addressed first.
Step 3. Identify cost drivers for each activity. Only by understanding what factors drive the costs, managers can focus on improving them. Costs for labor-intensive activities will be driven by work hours, work speed, wage rate, etc. Different activities will have different cost drivers.
Step 4. Identify links between activities. Reduction of costs in one activity may lead to further cost reductions in subsequent activities. For example, fewer components in the product design may lead to less faulty parts and lower service costs. Therefore identifying the links between activities will lead to better understanding how cost improvements would affect he whole value chain. Sometimes, cost reductions in one activity lead to higher costs for other activities.
Step 5. Identify opportunities for reducing costs. When the company knows its inefficient activities and cost drivers, it can plan on how to improve them. Too high wage rates can be dealt with by increasing production speed, outsourcing jobs to low wage countries or installing more automated processes.

Differentiation advantage

VCA is done differently when a firm competes on differentiation rather than costs. This is because the source of differentiation advantage comes from creating superior products, adding more features and satisfying varying customer needs, which results in higher cost structure.
Step 1. Identify the customers’ value-creating activities. After identifying all value chain activities, managers have to focus on those activities that contribute the most to creating customer value. For example, Apple products’ success mainly comes not from great product features (other companies have high-quality offerings too) but from successful marketing activities.
Step 2. Evaluate the differentiation strategies for improving customer value. Managers can use the following strategies to increase product differentiation and customer value:

• Add more product features;
• Focus on customer service and responsiveness;
• Increase customization;
• Offer complementary products.

Step 3. Identify the best sustainable differentiation. Usually, superior differentiation and customer value will be the result of many interrelated activities and strategies used. The best combination of them should be used to pursue sustainable differentiation advantage.

Example

This example is partially adopted from R. M. Grant’s book ‘Contemporary Strategy Analysis’ p.241. It illustrates the basic VCA for an automobile manufacturing company that competes on cost advantage. This analysis doesn’t include support activities that are essential to any firm’s value chain, thus the analysis itself is not complete.

Value Chain Analysis Example

Step 1 - Firm's primary activities
Design and engineering	Purchasing materials and components	Assembly	Testing and quality control	Sales and marketing	Distribution and dealer support
Step 2 - Toal cost and importance
$164 M less important	$410 M very important	$524 M very important	$10 M not important	$384 M important	$230 M less important
Step 3 - Cost drivers
Number and frequency of new models Sales per model	Order size Average value of purchases per supplier Location of suppliers	Scale of plants Capacity utilization Location of plants	Level of quality targets Frequency of defects	Size of advertising budget Strength of existing reputation Sales Volume	Number of dealers Sales per dealer Frequency of defects requiring repair recalls
Step 4 - Links between activities
High-quality assembling process reduces defects and costs in quality control and dealer support activities. Locating plants near the cluster of suppliers or dealers reduces purchasing and distribution costs. Fewer model designs reduce assembling costs. Higher order sizes increase warehousing costs.
Step 5 - Opportunities for reducing costs
Create just one model design for different regions to cut costs in designing and engineering, to increase order sizes of the same materials, to simplify assembling and quality control processes and to lower marketing costs. Manufacture components inside the company to eliminate transaction costs of buying them in the market and to optimize plant utilization. This would also lead to greater economies of scale.

PEST & PESTEL Analysis(Strategic Management)?

PEST analysis

is an analysis of the political, economic, social and technological factors in the external environment of an organization, which can affect its activities and performance.

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PESTEL model

involves the collection and portrayal of information about external factors which have, or may have, an impact on business.

^[2]

Understanding the tool

PEST or PESTEL analysis is a simple and effective tool used in situation analysis to identify the key external (macro environment level) forces that might affect an organization. These forces can create both opportunities and threats for an organization. Therefore, the aim of doing PEST is to:

• find out the current external factors affecting an organization;
• identify the external factors that may change in the future;
• to exploit the changes (opportunities) or defend against them (threats) better than competitors would do.

The outcome of PEST is an understanding of the overall picture surrounding the company.
PEST analysis is also done to assess the potential of a new market. The general rule is that the more negative forces are affecting that market the harder it is to do business in it. The difficulties that will have to be dealt with significantly reduce profit potential and the firm can simply decide not to engage in any activity in that market.

PEST variations

PEST analysis is the most general version of all PEST variations created. It is a very dynamic tool as new components can be easily added to it in order to focus on one or another critical force affecting an organization. Although following variations are more detailed analysis than simple PEST, the additional components are just the extensions of the same PEST factors. The analysis probably has more variations than any other strategy tool:

STEP = PEST in more positive approach.
PESTEL = PEST + Environmental + Legal
PESTELI = PESTEL + Industry analysis
STEEP = PEST + Ethical
SLEPT = PEST + Legal
STEEPLE = PEST + Environmental + Legal + Ethical
STEEPLED = STEEPLE + Demographic
PESTLIED = PEST + Legal + International + Environmental + Demographic
LONGPEST = Local + National + Global factors + PEST

Using the tool

The process of carrying out PEST analysis should involve as many managers as possible to get the best results. It includes the following steps:

• Step 1. Gathering information about political, economic, social and technological changes + any other factor(s).
• Step 2. Identifying which of the PEST factors represent opportunities or threats.

Gathering PEST, PESTEL and STEEPLED information

In order to perform PEST (or any other variation of it) managers have to gather as much relevant information as possible about the firm’s external environment. Nowadays, most information can be found on the internet relatively easy, fast and with little cost. When the analysis is done for the first time the process may take a little longer and as a beginner you may find yourself asking “What changes do I exactly look for in politics, economic, society and technology?” The following templates might be useful when gathering information for PEST, PESTEL and STEEPLED analysis.

NOTE: PEST covers all macro environment forces affecting an organization. Therefore, when doing PESTEL or STEEPLED analysis, legal, environmental, ethical and demographic factors may overlap with PEST factors.

PEST analysis template

Political factors	Economic factors
Government stability and likely changes Bureaucracy Corruption level Tax policy (rates and incentives) Freedom of press Regulation/de-regulation Trade control Import restrictions (quality and quantity) Tariffs Competition regulation Government involvement in trade unions and agreements Environmental Law Education Law Anti-trust law Discrimination law Copyright, patents / Intellectual property law Consumer protection and e-commerce Employment law Health and safety law Data protection law Laws regulating environment pollution	Growth rates Inflation rate Interest rates Exchange rates Unemployment trends Labor costs Stage of business cycle Credit availability Trade flows and patterns Level of consumers’ disposable income Monetary policies Fiscal policies Price fluctuations Stock market trends Weather Climate change
Socio-cultural factors	Technological factors
Health consciousness Education level Attitudes toward imported goods and services Attitudes toward work, leisure, career and retirement Attitudes toward product quality and customer service Attitudes toward saving and investing Emphasis on safety Lifestyles Buying habits Religion and beliefs Attitudes toward “green” or ecological products Attitudes toward and support for renewable energy Population growth rate Immigration and emigration rates Age distribution and life expectancy rates Sex distribution Average disposable income level Social classes Family size and structure Minorities	Basic infrastructure level Rate of technological change Spending on research & development Technology incentives Legislation regarding technology Technology level in your industry Communication infrastructure Access to newest technology Internet infrastructure and penetration

PESTEL analysis template

Political	Economic
Socio-cultural	Technological
+
Environmental (ecological)	Legal
Weather Climate change Laws regulating environment pollution Air and water pollution Recycling Waste management Attitudes toward “green” or ecological products Endangered species Attitudes toward and support for renewable energy	Anti-trust law Discrimination law Copyright, patents / Intellectual property law Consumer protection and e-commerce Employment law Health and safety law Data Protection

STEEPLED analysis template

Political	Economic
Socio-cultural	Technological
Environmental (ecological)	Legal
+
Ethical	Demographic
Ethical advertising and sales practices Accepted accounting, management and marketing standards Attitude towards counterfeiting and breaking patents Ethical recruiting practices and employment standards (not using children to produce goods)	Population growth rate Immigration and emigration rates Age distribution and life expectancy rates Sex distribution Average disposable income level Social classes Family size and structure Minorities

Identifying opportunities and threats

Gathering information is just a first important step in doing PEST analysis. Once it is done, the information has to be evaluated. There are many factors changing in the external environment but not all of them are affecting or might affect an organization. Therefore, it is essential to identify which PEST factors represent the opportunities or threats for an organization and list only those factors in PEST analysis. This allows focusing on the most important changes that might have an impact on the company.

PEST analysis example

The following table shows PEST analysis example. It lists opportunities and threats that are affecting a firm in its macro environment.

PEST analysis example

Political	Economic
Government has passed legislation which requires further reductions of CO2, HC and NC emissions for vehicles until 2015 New political forces, which are against tax reductions, may be elected in the next years’ elections Import restrictions will increase in 2013 Government is increasing its funding to ‘specific’ industry Government is easing regulations for employment Increasing tensions between our government and our major export partner’s government	GDP will grow by 3% in 2013 Availability of credit for businesses will slightly grow or remain unchanged in 2013. The same applies for the cost of credit in the 1 half of the year Unemployment is expected to decrease to 7% Inflation will fall to 3% or 2% in 2013 Corporate tax rate will decrease by 2% next year to 23% Dollar exchange rates are expected to decrease compared to euro Disposable income level will decrease Metal and oil prices will increase by 5% and 6% respectively in 2013
Socio-cultural	Technological
Positive attitude towards “green” vehicles Number of individuals and companies buying through the Internet is 67% and 45% respectively and is expected to grow Immigration is increasing Increasing attitude toward jobs with shorter work hours People tend to buy more domestic rather than foreign products People change their eating habits and now tend to eat healthier food	New machinery that could reduce production costs by 20% is in development Country’s major telecom company announced its plans to expand its internet infrastructure and install new optic fiber cables Driverless cars may be introduced in the near future “New” type of table will be introduced into the market next year

VRIO ANALYSIS (STRATEGIC MANAGEMENT)?

VRIO framework

is the tool used to analyze firm’s internal resources and capabilities to find out if they can be a source of sustained competitive advantage.

Understanding the tool

In order to understand the sources of competitive advantage firms are using many tools to analyze their external (Porter’s 5 Forces, PEST analysis) and internal (Value Chain analysis, BCG Matrix) environments. One of such tools that analyze firm’s internal resources is VRIO analysis. The tool was originally developed by Barney, J. B. (1991) in his work ‘Firm Resources and Sustained Competitive Advantage’, where the author identified four attributes that firm’s resources must possess in order to become a source of sustained competitive advantage. According to him, the resources must be valuable, rare, imperfectly imitable and non-substitutable. His original framework was called VRIN. In 1995, in his later work ‘Looking Inside for Competitive Advantage’ Barney has introduced VRIO framework, which was the improvement of VRIN model. VRIO analysis stands for four questions that ask if a resource is: valuable? rare? costly to imitate? And is a firm organized to capture the value of the resources? A resource or capability that meets all four requirements can bring sustained competitive advantage for the company.
Adopted from Rothaermel’s (2013) ‘Strategic Management’, p.91

Valuable
The first question of the framework asks if a resource adds value by enabling a firm to exploit opportunities or defend against threats. If the answer is yes, then a resource is considered valuable. Resources are also valuable if they help organizations to increase the perceived customer value. This is done by increasing differentiation or/and decreasing the price of the product. The resources that cannot meet this condition, lead to competitive disadvantage. It is important to continually review the value of the resources because constantly changing internal or external conditions can make them less valuable or useless at all.
Rare
Resources that can only be acquired by one or very few companies are considered rare. Rare and valuable resources grant temporary competitive advantage. On the other hand, the situation when more than few companies have the same resource or uses the capability in the similar way, leads to competitive parity. This is because firms can use identical resources to implement the same strategies and no organization can achieve superior performance.
Even though competitive parity is not the desired position, a firm should not neglect the resources that are valuable but common. Losing valuable resources and capabilities would hurt an organization because they are essential for staying in the market.
Costly to Imitate
A resource is costly to imitate if other organizations that doesn’t have it can’t imitate, buy or substitute it at a reasonable price. Imitation can occur in two ways: by directly imitating (duplicating) the resource or providing the comparable product/service (substituting).
A firm that has valuable, rare and costly to imitate resources can (but not necessarily will) achieve sustained competitive advantage. Barney has identified three reasons why resources can be hard to imitate:

• Historical conditions. Resources that were developed due to historical events or over a long period usually are costly to imitate.
• Causal ambiguity. Companies can’t identify the particular resources that are the cause of competitive advantage.
• Social Complexity. The resources and capabilities that are based on company’s culture or interpersonal relationships.

Organized to Capture Value
The resources itself do not confer any advantage for a company if it’s not organized to capture the value from them. A firm must organize its management systems, processes, policies, organizational structure and culture to be able to fully realize the potential of its valuable, rare and costly to imitate resources and capabilities. Only then the companies can achieve sustained competitive advantage.

Using the tool

Step 1. Identify valuable, rare and costly to imitate resources
There are two types of resources: tangible and intangible. Tangible assets are physical things like land, buildings and machinery. Companies can easily by them in the market so tangible assets are rarely the source of competitive advantage. On the other hand, intangible assets, such as brand reputation, trademarks, intellectual property, unique training system or unique way of performing tasks, can’t be acquired so easily and offer the benefits of sustained competitive advantage. Therefore, to find valuable, rare and costly to imitate resources, you should first look at company’s intangible assets.
Finding valuable resources:
An easy way to identify such resources is to look at the value chain and SWOT analyses. Value chain analysis identifies the most valuable activities, which are the source of cost or differentiation advantage. By looking into the analysis, you can easily find the valuable resources or capabilities. In addition, SWOT analysis recognizes the strengths of the company that are used to exploit opportunities or defend against threats (which is exactly what a valuable resource does). If you still struggle finding valuable resources, you can identify them by asking the following questions:

• Which activities lower the cost of production without decreasing perceived customer value?
• Which activities increase product or service differentiation and perceived customer value?
• Have your company won an award or been recognized as the best in something? (most innovative, best employer, highest customer retention or best exporter)
• Do you have an access to scarce raw materials or hard to get in distribution channels?
• Do you have special relationship with your suppliers? Such as tightly integrated order and distribution system powered by unique software?
• Do you have employees with unique skills and capabilities?
• Do you have brand reputation for quality, innovation, customer service?
• Do you do perform any tasks better than your competitors do? (Benchmarking is useful here)
• Does your company hold any other strengths compared to rivals?

Finding rare resources:

• How many other companies own a resource or can perform capability in the same way in your industry?
• Can a resource be easily bought in the market by rivals?
• Can competitors obtain the resource or capability in the near future?

Finding costly to imitate resources:

• Do other companies can easily duplicate a resource?
• Can competitors easily develop a substitute resource?
• Do patents protect it?
• Is a resource or capability socially complex?
• Is it hard to identify the particular processes, tasks, or other factors that form the resource?

Step 2. Find out if your company is organized to exploit these resources
Following questions might be helpful:

• Does your company has an effective strategic management process in organization?
• Are there effective motivation and reward systems in place?
• Does your company’s culture reward innovative ideas?
• Is an organizational structure designed to use a resource?
• Are there excellent management and control systems?

Step 3. Protect the resources
When you identified a resource or capability that has all 4 VRIO attributes, you should protect it using all possible means. After all, it is the source of your sustained competitive advantage. The first thing you should do is to make the top management aware of such resource and suggest how it can be used to lower the costs or to differentiate the products and services. Then you should think of ideas how to make it more costly to imitate. If other companies won’t be able to imitate a resource at reasonable prices, it will stay rare for much longer.
Step 4. Constantly review VRIO resources and capabilities
The value of the resources changes over time and they must be reviewed constantly to find out if they are as valuable as they once were. Competitors are also keen to achieve the same competitive advantages so they’ll be keen to replicate the resources, which means that they will no longer be rare. Often, new VRIO resources or capabilities are developed inside an organization and by identifying them you can protect you sources of competitive advantage more easily.

VRIO example

Google’s capability evaluated using VRIO framework

Google's VRIO capability

Excellent employee management
Valuable?	Rare?	Costly to Imitate?	Is a company organized to exploit it?
Yes	Yes	Yes	Yes
Result: sustained competitive advantage

Google’s ability to manage their people effectively is a source of both differentiation and cost advantages. Unlike other companies, which rely on trust and relationship in people management, Google uses data about its employees to manage them. This capability allows making correct (data based) decisions about which people to hire and the best way to use their skills. As a result, Google is able to hire innovative employees that are also very productive ($1 million in revenue per employee). Besides being valuable, it is also a rare capability because no other company uses data based employee management so extensively. Is it costly to imitate? It is costly to imitate, at least, in the near future. First, companies should build the highly sophisticated software, which is both costly and hard to do. Second, HR managers should be trained to make data based decisions and forget their old management methods. Is Google organized to capture value from this capability? Certainly, it has trained HR managers that know how to use the data and manage people accordingly. It also has the needed IT skills to collect and manage the data about its employees.

Porter’s five forces model?(strategic Management)

Porter’s five forces model

is an analysis tool that uses five industry forces to determine the intensity of competition in an industry and its profitability level.

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Understanding the tool

Five forces model was created by M. Porter in 1979 to understand how five key competitive forces are affecting an industry. The five forces identified are:
These forces determine an industry structure and the level of competition in that industry. The stronger competitive forces in the industry are the less profitable it is. An industry with low barriers to enter, having few buyers and suppliers but many substitute products and competitors will be seen as very competitive and thus, not so attractive due to its low profitability.

It is every strategist’s job to evaluate company’s competitive position in the industry and to identify what strengths or weakness can be exploited to strengthen that position. The tool is very useful in formulating firm’s strategy as it reveals how powerful each of the five key forces is in a particular industry.
Threat of new entrants. This force determines how easy (or not) it is to enter a particular industry. If an industry is profitable and there are few barriers to enter, rivalry soon intensifies. When more organizations compete for the same market share, profits start to fall. It is essential for existing organizations to create high barriers to enter to deter new entrants. Threat of new entrants is high when:

• Low amount of capital is required to enter a market;
• Existing companies can do little to retaliate;
• Existing firms do not possess patents, trademarks or do not have established brand reputation;
• There is no government regulation;
• Customer switching costs are low (it doesn’t cost a lot of money for a firm to switch to other industries);
• There is low customer loyalty;
• Products are nearly identical;
• Economies of scale can be easily achieved.

Bargaining power of suppliers. Strong bargaining power allows suppliers to sell higher priced or low quality raw materials to their buyers. This directly affects the buying firms’ profits because it has to pay more for materials. Suppliers have strong bargaining power when:

• There are few suppliers but many buyers;
• Suppliers are large and threaten to forward integrate;
• Few substitute raw materials exist;
• Suppliers hold scarce resources;
• Cost of switching raw materials is especially high.

Bargaining power of buyers. Buyers have the power to demand lower price or higher product quality from industry producers when their bargaining power is strong. Lower price means lower revenues for the producer, while higher quality products usually raise production costs. Both scenarios result in lower profits for producers. Buyers exert strong bargaining power when:

• Buying in large quantities or control many access points to the final customer;
• Only few buyers exist;
• Switching costs to other supplier are low;
• They threaten to backward integrate;
• There are many substitutes;
• Buyers are price sensitive.

Threat of substitutes. This force is especially threatening when buyers can easily find substitute products with attractive prices or better quality and when buyers can switch from one product or service to another with little cost. For example, to switch from coffee to tea doesn’t cost anything, unlike switching from car to bicycle.
Rivalry among existing competitors. This force is the major determinant on how competitive and profitable an industry is. In competitive industry, firms have to compete aggressively for a market share, which results in low profits. Rivalry among competitors is intense when:

• There are many competitors;
• Exit barriers are high;
• Industry of growth is slow or negative;
• Products are not differentiated and can be easily substituted;
• Competitors are of equal size;
• Low customer loyalty.

Although, Porter originally introduced five forces affecting an industry, scholars have suggested including the sixth force: complements. Complements increase the demand of the primary product with which they are used, thus, increasing firm’s and industry’s profit potential. For example, iTunes was created to complement iPod and added value for both products. As a result, both iTunes and iPod sales increased, increasing Apple’s profits.

Using the tool

We now understand that Porter’s five forces framework is used to analyze industry’s competitive forces and to shape organization’s strategy according to the results of the analysis. But how to use this tool? We have identified the following steps:

• Step 1. Gather the information on each of the five forces
• Step 2. Analyze the results and display them on a diagram
• Step 3. Formulate strategies based on the conclusions

Step 1. Gather the information on each of the five forces. What managers should do during this step is to gather information about their industry and to check it against each of the factors (such as “number of competitors in the industry”) influencing the force. We have already identified the most important factors in the table below.

Porter's Five Forces Factors

Threat of new entry
Amount of capital required Retaliation by existing companies Legal barriers (patents, copyrights, etc.) Brand reputation Product differentiation Access to suppliers and distributors Economies of scale Sunk costs Government regulation
Supplier power
Number of suppliers Suppliers’ size Ability to find substitute materials Materials scarcity Cost of switching to alternative materials Threat of integrating forward
Buyer power
Number of buyers Size of buyers Size of each order Buyers’ cost of switching suppliers There are many substitutes Price sensitivity Threat of integrating backward
Threat of substitutes
Number of substitutes Performance of substitutes Cost of changing
Rivalry among existing competitors
Number of competitors Cost of leaving an industry Industry growth rate and size Product differentiation Competitors’ size Customer loyalty Threat of horizontal integration Level of advertising expense

Step 2. Analyze the results and display them on a diagram. After gathering all the information, you should analyze it and determine how each force is affecting an industry. For example, if there are many companies of equal size operating in the slow growth industry, it means that rivalry between existing companies is strong. Remember that five forces affect different industries differently so don’t use the same results of analysis for even similar industries!
Step 3. Formulate strategies based on the conclusions. At this stage, managers should formulate firm’s strategies using the results of the analysis For example, if it is hard to achieve economies of scale in the market, the company should pursue cost leadership strategy. Product development strategy should be used if the current market growth is slow and the market is saturated.
Although, Porter’s five forces is a great tool to analyze industry’s structure and use the results to formulate firm’s strategy, it has its limitations and requires further analysis to be done, such as SWOT, PEST or Value Chain analysis.

Example

This is Porter’s five forces analysis example for an automotive industry.

Porter's Five Forces Evaluation

Threat of new entry (very weak)
Large amount of capital required High retaliation possible from existing companies, if new entrants would bring innovative products and ideas to the industry Few legal barriers protect existing companies from new entrants All automotive companies have established brand image and reputation Products are mainly differentiated by design and engineering quality New entrant could easily access suppliers and distributors A firm has to produce at least 5 million (by some estimations) vehicles to be cost competitive, therefore it is very hard to achieve economies of scale Governments often protect their home markets by introducing high import taxes
Supplier power (weak)
Large number of suppliers Some suppliers are large but the most of them are pretty small Companies use another type of material (use one metal instead of another) but only to some extent (plastic instead of metal) Materials widely accessible Suppliers do not pose any threat of forward integration
Buyer power (strong)
There are many buyers Most of the buyers are individuals that buy one car, but corporates or governments usually buy large fleets and can bargain for lower prices It doesn’t cost much for buyers to switch to another brand of vehicle or to start using other type of transportation Buyers can easily choose alternative car brand Buyers are price sensitive and their decision is often based on how much does a vehicle cost Buyers do not threaten backward integration
Threat of substitutes (weak)
There are many alternative types of transportation, such as bicycles, motorcycles, trains, buses or planes Substitutes can rarely offer the same convenience Alternative types of transportation almost always cost less and sometimes are more environment friendly
Competitive rivalry (very strong)
Moderate number of competitors If a firm would decide to leave an industry it would incur huge losses, so most of the time it either bankrupts or stays in automotive industry for the lifetime Industry is very large but matured Size of competing firm’s vary but they usually compete for different consumer segments Customers are loyal to their brands There is moderate threat of being acquired by a competitor

PEST analysis?(strategic Management)

PEST analysis

is an analysis of the political, economic, social and technological factors in the external environment of an organization, which can affect its activities and performance.

^[1]

PESTEL model

involves the collection and portrayal of information about external factors which have, or may have, an impact on business.

^[2]

Understanding the tool

PEST or PESTEL analysis is a simple and effective tool used in situation analysis to identify the key external (macro environment level) forces that might affect an organization. These forces can create both opportunities and threats for an organization. Therefore, the aim of doing PEST is to:

• find out the current external factors affecting an organization;
• identify the external factors that may change in the future;
• to exploit the changes (opportunities) or defend against them (threats) better than competitors would do.

The outcome of PEST is an understanding of the overall picture surrounding the company.
PEST analysis is also done to assess the potential of a new market. The general rule is that the more negative forces are affecting that market the harder it is to do business in it. The difficulties that will have to be dealt with significantly reduce profit potential and the firm can simply decide not to engage in any activity in that market.

PEST variations

PEST analysis is the most general version of all PEST variations created. It is a very dynamic tool as new components can be easily added to it in order to focus on one or another critical force affecting an organization. Although following variations are more detailed analysis than simple PEST, the additional components are just the extensions of the same PEST factors. The analysis probably has more variations than any other strategy tool:

STEP = PEST in more positive approach.
PESTEL = PEST + Environmental + Legal
PESTELI = PESTEL + Industry analysis
STEEP = PEST + Ethical
SLEPT = PEST + Legal
STEEPLE = PEST + Environmental + Legal + Ethical
STEEPLED = STEEPLE + Demographic
PESTLIED = PEST + Legal + International + Environmental + Demographic
LONGPEST = Local + National + Global factors + PEST

Using the tool

The process of carrying out PEST analysis should involve as many managers as possible to get the best results. It includes the following steps:

• Step 1. Gathering information about political, economic, social and technological changes + any other factor(s).
• Step 2. Identifying which of the PEST factors represent opportunities or threats.

Gathering PEST, PESTEL and STEEPLED information

In order to perform PEST (or any other variation of it) managers have to gather as much relevant information as possible about the firm’s external environment. Nowadays, most information can be found on the internet relatively easy, fast and with little cost. When the analysis is done for the first time the process may take a little longer and as a beginner you may find yourself asking “What changes do I exactly look for in politics, economic, society and technology?” The following templates might be useful when gathering information for PEST, PESTEL and STEEPLED analysis.

NOTE: PEST covers all macro environment forces affecting an organization. Therefore, when doing PESTEL or STEEPLED analysis, legal, environmental, ethical and demographic factors may overlap with PEST factors.

PEST analysis template

Political factors	Economic factors
Government stability and likely changes Bureaucracy Corruption level Tax policy (rates and incentives) Freedom of press Regulation/de-regulation Trade control Import restrictions (quality and quantity) Tariffs Competition regulation Government involvement in trade unions and agreements Environmental Law Education Law Anti-trust law Discrimination law Copyright, patents / Intellectual property law Consumer protection and e-commerce Employment law Health and safety law Data protection law Laws regulating environment pollution	Growth rates Inflation rate Interest rates Exchange rates Unemployment trends Labor costs Stage of business cycle Credit availability Trade flows and patterns Level of consumers’ disposable income Monetary policies Fiscal policies Price fluctuations Stock market trends Weather Climate change
Socio-cultural factors	Technological factors
Health consciousness Education level Attitudes toward imported goods and services Attitudes toward work, leisure, career and retirement Attitudes toward product quality and customer service Attitudes toward saving and investing Emphasis on safety Lifestyles Buying habits Religion and beliefs Attitudes toward “green” or ecological products Attitudes toward and support for renewable energy Population growth rate Immigration and emigration rates Age distribution and life expectancy rates Sex distribution Average disposable income level Social classes Family size and structure Minorities	Basic infrastructure level Rate of technological change Spending on research & development Technology incentives Legislation regarding technology Technology level in your industry Communication infrastructure Access to newest technology Internet infrastructure and penetration

PESTEL analysis template

Political	Economic
Socio-cultural	Technological
+
Environmental (ecological)	Legal
Weather Climate change Laws regulating environment pollution Air and water pollution Recycling Waste management Attitudes toward “green” or ecological products Endangered species Attitudes toward and support for renewable energy	Anti-trust law Discrimination law Copyright, patents / Intellectual property law Consumer protection and e-commerce Employment law Health and safety law Data Protection

STEEPLED analysis template

Political	Economic
Socio-cultural	Technological
Environmental (ecological)	Legal
+
Ethical	Demographic
Ethical advertising and sales practices Accepted accounting, management and marketing standards Attitude towards counterfeiting and breaking patents Ethical recruiting practices and employment standards (not using children to produce goods)	Population growth rate Immigration and emigration rates Age distribution and life expectancy rates Sex distribution Average disposable income level Social classes Family size and structure Minorities

Identifying opportunities and threats

Gathering information is just a first important step in doing PEST analysis. Once it is done, the information has to be evaluated. There are many factors changing in the external environment but not all of them are affecting or might affect an organization. Therefore, it is essential to identify which PEST factors represent the opportunities or threats for an organization and list only those factors in PEST analysis. This allows focusing on the most important changes that might have an impact on the company.

PEST analysis example

The following table shows PEST analysis example. It lists opportunities and threats that are affecting a firm in its macro environment.

PEST analysis example

Political	Economic
Government has passed legislation which requires further reductions of CO2, HC and NC emissions for vehicles until 2015 New political forces, which are against tax reductions, may be elected in the next years’ elections Import restrictions will increase in 2013 Government is increasing its funding to ‘specific’ industry Government is easing regulations for employment Increasing tensions between our government and our major export partner’s government	GDP will grow by 3% in 2013 Availability of credit for businesses will slightly grow or remain unchanged in 2013. The same applies for the cost of credit in the 1 half of the year Unemployment is expected to decrease to 7% Inflation will fall to 3% or 2% in 2013 Corporate tax rate will decrease by 2% next year to 23% Dollar exchange rates are expected to decrease compared to euro Disposable income level will decrease Metal and oil prices will increase by 5% and 6% respectively in 2013
Socio-cultural	Technological
Positive attitude towards “green” vehicles Number of individuals and companies buying through the Internet is 67% and 45% respectively and is expected to grow Immigration is increasing Increasing attitude toward jobs with shorter work hours People tend to buy more domestic rather than foreign products People change their eating habits and now tend to eat healthier food	New machinery that could reduce production costs by 20% is in development Country’s major telecom company announced its plans to expand its internet infrastructure and install new optic fiber cables Driverless cars may be introduced in the near future “New” type of table will be introduced into the market next year

Value chain analysis (VCA)?(strategic Management)

Definition

Value chain analysis (VCA)

is a process where a firm identifies its primary and support activities that add value to its final product and then analyze these activities to reduce costs or increase differentiation.

Value chain

represents the internal activities a firm engages in when transforming inputs into outputs.

Understanding the tool

Value chain analysis is a strategy tool used to analyze internal firm activities. Its goal is to recognize, which activities are the most valuable (i.e. are the source of cost or differentiation advantage) to the firm and which ones could be improved to provide competitive advantage. In other words, by looking into internal activities, the analysis reveals where a firm’s competitive advantages or disadvantages are. The firm that competes through differentiation advantage will try to perform its activities better than competitors would do. If it competes through cost advantage, it will try to perform internal activities at lower costs than competitors would do. When a company is capable of producing goods at lower costs than the market price or to provide superior products, it earns profits.
M. Porter introduced the generic value chain model in 1985. Value chain represents all the internal activities a firm engages in to produce goods and services. VC is formed of primary activities that add value to the final product directly and support activities that add value indirectly.
Although, primary activities add value directly to the production process, they are not necessarily more important than support activities. Nowadays, competitive advantage mainly derives from technological improvements or innovations in business models or processes. Therefore, such support activities as ‘information systems’, ‘R&D’ or ‘general management’ are usually the most important source of differentiation advantage. On the other hand, primary activities are usually the source of cost advantage, where costs can be easily identified for each activity and properly managed.

Firm’s VC is a part of a larger industry VC. The more activities a company undertakes compared to industry VC, the more vertically integrated it is. Below you can find an industry value chain and its relation to a firm level VC.

Using the tool

There are two different approaches on how to perform the analysis, which depend on what type of competitive advantage a company wants to create (cost or differentiation advantage). The table below lists all the steps needed to achieve cost or differentiation advantage using VCA.

Competitive advantage types

Cost advantage	Differentiation advantage
This approach is used when organizations try to compete on costs and want to understand the sources of their cost advantage or disadvantage and what factors drive those costs.	The firms that strive to create superior products or services use differentiation advantage approach.
Step 1. Identify the firm’s primary and support activities. Step 2. Establish the relative importance of each activity in the total cost of the product. Step 3. Identify cost drivers for each activity. Step 4. Identify links between activities. Step 5. Identify opportunities for reducing costs.	Step 1. Identify the customers’ value-creating activities. Step 2. Evaluate the differentiation strategies for improving customer value. Step 3. Identify the best sustainable differentiation.

Cost advantage

To gain cost advantage a firm has to go through 5 analysis steps:
Step 1. Identify the firm’s primary and support activities. All the activities (from receiving and storing materials to marketing, selling and after sales support) that are undertaken to produce goods or services have to be clearly identified and separated from each other. This requires an adequate knowledge of company’s operations because value chain activities are not organized in the same way as the company itself. The managers who identify value chain activities have to look into how work is done to deliver customer value.
Step 2. Establish the relative importance of each activity in the total cost of the product. The total costs of producing a product or service must be broken down and assigned to each activity. Activity based costing is used to calculate costs for each process. Activities that are the major sources of cost or done inefficiently (when benchmarked against competitors) must be addressed first.
Step 3. Identify cost drivers for each activity. Only by understanding what factors drive the costs, managers can focus on improving them. Costs for labor-intensive activities will be driven by work hours, work speed, wage rate, etc. Different activities will have different cost drivers.
Step 4. Identify links between activities. Reduction of costs in one activity may lead to further cost reductions in subsequent activities. For example, fewer components in the product design may lead to less faulty parts and lower service costs. Therefore identifying the links between activities will lead to better understanding how cost improvements would affect he whole value chain. Sometimes, cost reductions in one activity lead to higher costs for other activities.
Step 5. Identify opportunities for reducing costs. When the company knows its inefficient activities and cost drivers, it can plan on how to improve them. Too high wage rates can be dealt with by increasing production speed, outsourcing jobs to low wage countries or installing more automated processes.

Differentiation advantage

VCA is done differently when a firm competes on differentiation rather than costs. This is because the source of differentiation advantage comes from creating superior products, adding more features and satisfying varying customer needs, which results in higher cost structure.
Step 1. Identify the customers’ value-creating activities. After identifying all value chain activities, managers have to focus on those activities that contribute the most to creating customer value. For example, Apple products’ success mainly comes not from great product features (other companies have high-quality offerings too) but from successful marketing activities.
Step 2. Evaluate the differentiation strategies for improving customer value. Managers can use the following strategies to increase product differentiation and customer value:

• Add more product features;
• Focus on customer service and responsiveness;
• Increase customization;
• Offer complementary products.

Step 3. Identify the best sustainable differentiation. Usually, superior differentiation and customer value will be the result of many interrelated activities and strategies used. The best combination of them should be used to pursue sustainable differentiation advantage.

Example

This example is partially adopted from R. M. Grant’s book ‘Contemporary Strategy Analysis’ p.241. It illustrates the basic VCA for an automobile manufacturing company that competes on cost advantage. This analysis doesn’t include support activities that are essential to any firm’s value chain, thus the analysis itself is not complete.

Value Chain Analysis Example

Step 1 - Firm's primary activities
Design and engineering	Purchasing materials and components	Assembly	Testing and quality control	Sales and marketing	Distribution and dealer support
Step 2 - Toal cost and importance
$164 M less important	$410 M very important	$524 M very important	$10 M not important	$384 M important	$230 M less important
Step 3 - Cost drivers
Number and frequency of new models Sales per model	Order size Average value of purchases per supplier Location of suppliers	Scale of plants Capacity utilization Location of plants	Level of quality targets Frequency of defects	Size of advertising budget Strength of existing reputation Sales Volume	Number of dealers Sales per dealer Frequency of defects requiring repair recalls
Step 4 - Links between activities
High-quality assembling process reduces defects and costs in quality control and dealer support activities. Locating plants near the cluster of suppliers or dealers reduces purchasing and distribution costs. Fewer model designs reduce assembling costs. Higher order sizes increase warehousing costs.
Step 5 - Opportunities for reducing costs
Create just one model design for different regions to cut costs in designing and engineering, to increase order sizes of the same materials, to simplify assembling and quality control processes and to lower marketing costs. Manufacture components inside the company to eliminate transaction costs of buying them in the market and to optimize plant utilization. This would also lead to greater economies of scale.