Strategic Analysis: External and Internal Environment
Why analysis comes before choice
The previous chapter defined strategy as fundamentally concerned with the relationship between a firm and its environment. This chapter supplies the tools for actually studying that environment, on both sides — the external conditions the firm does not control, and the internal resources and capabilities it does. Strategic choices, examined in the next chapter, cannot be made soundly without this analysis first, which is exactly why this is the heaviest-weighted single chapter in the Strategic Management half: nearly every scenario-based SM question, regardless of which later chapter it nominally belongs to, expects a candidate to be able to reach for these tools.
PESTLE: scanning the macro-environment
Before analysing an industry specifically, a firm must first scan the broader macro-environment within which every industry operates. PESTLE structures this scan into six categories: Political factors, such as government stability, taxation policy and trade regulation; Economic factors, such as interest rates, inflation, exchange rates and the business cycle; Social factors, such as demographic shifts, cultural attitudes and lifestyle trends; Technological factors, such as the pace of innovation and the emergence of disruptive technology; Legal factors, such as employment law, consumer protection law and industry-specific regulation; and Environmental factors, such as climate policy, sustainability expectations and resource scarcity.
PESTLE's value lies in ensuring a systematic scan across all six categories rather than an ad hoc list of whatever factors happen to come to mind, and a strong PESTLE answer for a given scenario names the specific factor within each relevant category and states its specific implication for the firm in question, rather than listing generic factors with no connection drawn to the specific business being analysed.
Porter's five forces: analysing industry attractiveness
Where PESTLE scans the broad macro-environment, Porter's five forces framework analyses the structure and attractiveness of a specific industry, examining five forces that together determine the intensity of competition, and therefore the average level of profitability, within that industry.
Threat of new entrants is high where barriers to entry are low — where capital requirements are modest, where existing firms enjoy no significant economies of scale advantage over a new entrant, where switching costs for customers are low, and where access to distribution channels is not restricted — since low barriers mean new competitors can enter relatively easily whenever the industry appears attractively profitable, eroding that profitability over time as supply expands to meet demand.
Bargaining power of suppliers is high where suppliers are concentrated relative to the buying industry, where the product supplied is differentiated or has no ready substitute, where switching to an alternative supplier would be costly, and where suppliers face little threat of the buying industry integrating backward to produce the input itself — under these conditions, suppliers can extract more favourable prices and terms from firms in the industry, compressing the margins those firms can retain.
Bargaining power of buyers is high where buyers are concentrated or purchase in large volumes relative to sellers, where the product purchased is undifferentiated and switching suppliers is easy, where buyers have good information about alternatives and pricing, and where buyers face a credible threat of integrating backward to produce the product themselves — under these conditions, buyers can negotiate lower prices and better terms, again compressing the margins available to firms in the industry.
Threat of substitute products or services is high where products or services from a different industry can serve the same underlying customer need, particularly where those substitutes offer an attractive price-performance trade-off — this force constrains how high firms in the industry can price without losing customers to an entirely different category of product serving the same need, a threat that is often easy to overlook precisely because a substitute is, by definition, not a direct competitor within the same industry.
Rivalry among existing competitors is intense where there are numerous competitors of roughly similar size, where industry growth is slow, so firms must compete for share of a static or shrinking market rather than simply growing alongside overall demand, where products are undifferentiated, so competition centres on price, and where exit barriers are high, keeping unprofitable competitors from leaving the industry and continuing to add to competitive pressure.
A structurally attractive industry, under this framework, is one where all five forces are comparatively weak — high entry barriers, low supplier and buyer power, few attractive substitutes, and moderate rivalry — allowing firms within it to sustain healthier margins than an industry where several forces are strong. A firm applying this framework to a scenario should identify which forces are strong and which are weak specifically, explain why given the facts described, and state the implication this structure has for the firm's likely profitability and strategic options, exactly the identification-development-conclusion pattern the method chapter established.
SWOT analysis: bringing external and internal analysis together
SWOT analysis structures a firm's strategic position along four categories: Strengths and Weaknesses, which are internal to the firm — resources, capabilities and characteristics the firm itself possesses, some of which give it an advantage and some of which put it at a disadvantage relative to competitors; and Opportunities and Threats, which are external to the firm — favourable and unfavourable developments in the environment that the firm does not control but must respond to.
SWOT is valuable specifically because it deliberately combines external analysis, drawing on tools such as PESTLE and Porter's five forces, with internal analysis of the firm's own resources and capabilities, and the strongest use of a SWOT framework goes beyond simply populating four separate lists to actively match them against each other — asking how the firm's specific strengths can be deployed to capture a specific identified opportunity, how a specific weakness might be exposed by a specific identified threat, and what strategic response each such matching implies. A SWOT analysis presented as four disconnected lists, with no cross-referencing between the internal and external categories, misses the framework's real strategic value and reads, precisely as the method chapter warned, as an unstructured recitation rather than genuine analysis.
Internal analysis: resources, capabilities and core competence
Where the frameworks above analyse the external environment, internal analysis asks what the firm itself has to work with, and this half of strategic analysis is examined through a distinct vocabulary.
Resources are the specific assets a firm possesses — tangible resources such as plant, equipment, finance and location, and intangible resources such as brand reputation, patents, organisational knowledge and relationships. Resources on their own, however, do not automatically confer advantage; a firm's capabilities are its capacity to deploy resources effectively, typically in combination, to achieve a desired outcome, and it is capability, the ability to actually make productive use of resources, rather than the mere possession of resources, that more directly determines competitive performance.
A core competence is a specific capability, or a bundle of related capabilities and resources, that is genuinely difficult for competitors to imitate, that contributes significantly to the value customers perceive in the firm's offering, and that can potentially be leveraged across multiple products or markets. A core competence is the internal-analysis counterpart to a structurally attractive industry position identified through Porter's five forces — where the five forces framework asks whether the external industry structure is favourable, core competence analysis asks whether the firm itself possesses something genuinely difficult for competitors to replicate that can be turned into a durable, defensible advantage within whatever industry structure it operates in.
For a resource or capability to genuinely qualify as a source of sustainable competitive advantage, it is commonly assessed against criteria resembling VRIN — is it Valuable, genuinely contributing to customer value or cost efficiency; is it Rare, not widely possessed by competitors; is it Inimitable, genuinely difficult for competitors to replicate or acquire, whether due to complexity, causal ambiguity about exactly why it works, or the time and cost required to build an equivalent; and is it Non-substitutable, with no readily available alternative capability that could achieve the same effect. A resource or capability that is valuable and rare but easily imitated by a determined competitor confers, at best, a temporary advantage, not a sustainable one, which is precisely why the inimitability and non-substitutability criteria matter as much as the more obvious value and rarity criteria.
Value chain analysis
Value chain analysis, closely related to internal analysis, breaks a firm's activities down into a sequence of primary activities — inbound logistics, operations, outbound logistics, marketing and sales, and service — and support activities — firm infrastructure, human resource management, technology development and procurement — that together underlie the value the firm's finished product or service ultimately delivers to the customer. Analysing the firm activity by activity along this chain helps identify specifically where value is being created, and where cost is being incurred, allowing a firm to identify which specific activities are genuine sources of competitive advantage worth investing in and protecting, and which activities might be candidates for cost reduction, outsourcing or reorganisation without damaging the firm's overall value proposition.
Bringing external and internal analysis together
The tools in this chapter are deliberately complementary rather than redundant: PESTLE scans the broad macro-environment; Porter's five forces analyses the specific industry structure within that macro-environment; SWOT brings external opportunities and threats together with internal strengths and weaknesses; and resource, capability, core competence and value chain analysis dig into precisely what internal strengths a firm actually has and whether they are genuinely durable. A well-analysed scenario in this subject typically draws on more than one of these tools together, since a firm's strategic position is never adequately captured by any single framework in isolation — exactly the kind of multi-framework fluency the next chapter's strategic choices, and the following chapter's implementation and evaluation, are built to assume.
