The significance of monitoring the business environment to estimate the potential impact on an organisation and the role of management accounting.
An example of PESTEL analysis using the agricultural industry with an associated learning activity.
Porter (1979) identified five forces that help shape an organisation’s strategy in what is frequently referred to as Porter’s Five Forces model. The model is useful in helping to understand how these forces will impact on the industry, and hence the profitability of the industry members. This article takes the pharmaceutical manufacturing industry as the basis of exploring how management accounting can be used to aid the analysis.
This covers the typical sources of external information from which environmental analysis can be undertaken, and illustrates how the management accountant can contribute to its collection and dissemination within the organisation.
This reviews scenario planning as a technique. A scenario is not a forecast, but a narrative of a possible future outcome. They are not a prediction of the future, but rather developed to enhance organisational learning about possible actions that can be taken in response to potential events and shocks to the business environment
Management accounting and changes in the business environment
One of the key aspects of successful strategic planning and the development of business strategy is being able to respond appropriately to changes in the business environment. Hence, the need to undertake environmental analysis. The most popular framework for undertaking an analysis of the general business environment is the PESTEL framework – political, economic, sociocultural, technological, environmental, and legal. Changes in the business environment can have significant financial implications for organizations. Therefore, an area where accountants can make a significant contribution to strategic management is in helping to determine the potential financial impact that changes in the business environmental could have on an organization. The key word here is ‘helping’. Accountants cannot do this on their own, but need to work very closely with other functional specialists, such as marketers, operations, research and development staff, and so on.
There are several changes that are currently receiving attention in the media. Two of these have wide ranging implications for many industry sectors. The two I am thinking of emanate from the increased awareness of sustainability and environmental issues, namely the use of fossil fuels and plastics.
Several governments around the world have announced future plans to ban the use of vehicles that use fossil fuel – indeed, some major cities already ban or make a charge for the use of fossil fuel vehicles in city centres. Consider the impact that a ban on the use of fossil fuels might have, not just on the industry for motor vehicles of all types, but on all the business sectors that are affected by the use of vehicles, or provision of the fuel. The impacts are spread across the energy industry, the transport sectors – commercial, private and public transport, delivery services, infrastructure in terms of the provision of charging points for electric vehicles, battery technology, and so on.
Many organizations have already developed, and are implementing, strategies to deal with this change. These courses of action need financing, and have significant cost implications, as well as generating the need to review pricing policies. Strategies also need to be evaluated and crystallized into operational plans and budgets, to facilitate monitoring and performance management.
The second big issue is that of reducing or, again banning, the use of single use plastics. Many organizations are now working on developing new forms of materials that can primarily be used in packaging and then recycled. Major supermarkets and manufacturers are actively announcing plans to combat the growing concerns about the use of single use plastics, but also note the desire, and sometimes contradictory, reluctance of the consumer to change habits. This is not just a research and development issue but also one of sensitive marketing and public relations, due to the necessity to work with the consumers to arrive at an acceptable compromise between the attributes of the packaging itself (product identification, product protection, convenience and product promotion), and the use of alternatives to plastic. This also has far reaching implications for supply chain management, the underlying cost structure, and pricing strategies. As with fossils fuels, there are significant cost implications, but also the opportunity to differentiate and gain a competitive advantage.
Strategic responses to both issues might include product development, entailing investment in research and development, or new plant and equipment; working closely with partner organisations in the supply chain to ensure sufficient margins are achieved and sustained; changes in logistical strategy, including storage and warehousing and infrastructure; changes to marketing channels; or changes to existing products and packaging.
These two issues are both created by the key driver for change of an increased awareness of sustainability. The potential impact on the business environment provides a useful illustration where the management accounting techniques of forecasting, investment appraisal, life cycle costing, pricing, target costing, and budgeting can be utilized to good effect in the formulation, evaluation, implementation, and review and control of strategic options. In short, they demonstrate Management Accounting in Support of Strategy.
Think of an industry - any industry, and identify a key driver for change in the environment. Now think of the potential impact this could have on the industry and determine various strategic options that organizations may consider to deal with the change. How can management accounting assist management in the strategic management process?
A motor vehicle at an electric charging point.
The agricultural sector has been in the news during recent years for many reasons, not least because of the severe weather conditions that farmers have faced, but also due to the growing awareness of genomic technology and sustainability issues. The agricultural industry provides a good example of how a PESTEL analysis could help organisations develop their strategy.
The PESTEL analysis can be undertake at a very high level but then more focused analysis that prioritises the potential trends and changes in the environment can be done in relation to a specific organisation. Part of the analysis would be to assess how the environmental trends may affect your organisation, as opposed to the competitors, and to develop a strategy accordingly.
Many governments around the world are committing to reducing the impact of climate change and signing up to setting targets for a reduction in Greenhouse Gases (GHGs). This opens up opportunities to invest in markets for new low emission products and services. Climate change and the carbon footprint can also be linked to a sociocultural trend of consumers being more aware of the impact of GHGs, but also changing their diet to what they see as a more sustainable and healthy diet. This might herald a switch away from the need for less meat and dairy products. The potential change is strengthened by advice provided by government agencies which promote the idea of healthy living, and linking this to health care polices.
Government policy toward agriculture differs around the world, which potentially impacts on import and export markets in world food production. Changes in government policy need to be monitored and the potential impact on the business assessed at regular intervals. Government policy towards genetically modified (GM) crops differs from country to country and, via trade agreements, will impact on the food products available on global markets. For example, certain products do not meet the food standards, or animal welfare standards, of the UK and are not permitted to be imported. This affects the willingness of industry members to invest in GM. Indeed, if consumers are uncertain about the long term safety of GM it may strengthen the resolve of some farmers not to become involved in developing GM crops. The interrelationship between government policy and public opinion cannot be ignored when setting future strategy, and changes in attitudes, and consumer acceptance, as well as government policies, need to be monitored closely.
Food security - the state of having reliable access to a sufficient quantity of affordable, nutritious food, is also becoming a growing issue, particularly in the light of severe weather conditions and the difficulty of guaranteeing crop yields. This not only impacts on food availability and prices, but also creates problems of food production and feeding the world in the future, which is a much wider issue exercising governments in various parts of the world. The issue of food security has a direct impact on the availability of certain products and hence consumer markets, but also affects the price farmers pay for feedstuffs for livestock and their ability to be self-sufficient. During periods of extreme weather farmers are having to pay more for foodstuffs, whilst consumers and large powerful supermarket chains put downward pressure on the end price of the product. So input costs increase, but there is significant pressure for prices to stay the same, with the resultant reduction in margins.
Food labelling is becoming a major concern of consumer pressure groups, such that governments are encapsulating enhanced requirements in legislation so that additional information is required to be shown. This impacts on the support industries such as packaging, the food processing companies, and retailers. The information required is not just the ingredients and nutritional information, but information regarding origin, placing the onus and the burden of proof on the farmer, and the processing companies and retailers, to track and monitor the supply chain more closely, not just of product, but of feedstuffs as well, for example, grain fed or grass fed beef, and was it GM grain? The costs of compliance, ensuring the product can be tracked throughout the whole process, is increasing.
Land use is an issue that governments are using as an incentive, for example, to pay subsidies to farmers to take land out of production for periods of time to increase biodiversity, but at the same time demanding more productivity per hectare of land in production. Another aspect of this is that the demand for biofuels is increasing, providing another market for products, such as grain and oil crops, and creating a dilemma between food or fuel production. Farmers are also supplementing income from creating recreational and amenity areas on land.
Conservation groups are placing pressure on governments and the farming industry to reverse the trend of farming on a large scale as large fields are not conducive to wildlife, but the size of the machinery to make farming efficient and cost effective requires large fields, creating a dilemma for the farming community.
In many countries state funding and support of agriculture is being reduced, making it more difficult for small farmers to survive in business. Conversely, in some instances, governments follow protectionist policies to protect the domestic producers.
Exchange rates impact on export and imports, not just of food products, but of feedstuff for animals which impacts on the cost of input and hence margins.
Interest rates can be an important factor, particularly due to the volatility of farm revenues from year to year, being somewhat determined by crop yields, and commodity prices, such that farmers may need short term finance to bridge between years, as well as long term investment funds to invest in new technologies, and so on. The competition and market pressures from consumers, and the large buyers of farm produce, increases the degree of competition and larger farms are often better placed to compete than small farmers, due to the incidence of economies of scale.
Smaller farmers have developed the ‘farm shop’ to sell directly to local markets from the farm itself, providing another channel to market. This can reduce the costs of getting the product to market, and also aid the issue of proof of origin, as consumers are able to see where the food if produced.
The skill levels required are changing within the sector, particularly as high intensity farming using technology is being introduced more widely. In the UK the potential impact of leaving the European Union is making it more difficult for farms, such as fruit farms, to obtain sufficient labour to pick the crops. This may be mitigated by introducing technology to the process, but this often requires a change in growing methods to accommodate the machinery as well as the initial investment funds.
Consumers are becoming more diet conscious and demanding healthy eating options. This is also fuelled by government policy.
Sustainability issues are more relevant than ever before, with consumers concerned about animal husbandry, particularly of imported produce, the use of pesticides, and GM crops.
The growth of organic foods and local produce, where the origin can be guaranteed, is increasing in some parts of the world. However, conversely some farmers that went ‘organic’ have reverted back to ‘normal’ farming techniques, as the cost of organic produce is more expensive and the realised demand from consumers did match expectations, and was not enough to cover the costs.
There is a growing acceptance of genomic technology by some governments as a means of feeding the world in the future, but this links with the concerns of consumers and health issues.
The use of science to drive up yields is a key part of agriculture with the growing adoption of precision farming, particularly in western countries. This requires the investment in modern machinery and data analytics. Driverless tractors and the use of GPS to manage the application of fertilizers, pesticides and so on are becoming more prevalent in big farming.
The use of trade deals or trade wars often cover agriculture products. This is supported by comments made under the heading of political, as government policy that is crystallised into legislation can have an impact on the sector. For example, the common agricultural policy in Europe places restrictions on certain activities, as well as protecting parts of the industry from outside competition.
Government licenses for the testing of GM crops, minimum wages legislation, legislation covering labelling requirements, and the control of origin, and so on, need to be monitored. The requirement to track the origin of products increases the need to monitor the supply chain and undertake evaluation and monitoring of suppliers. This can have serious consequences for producers who are responsible for the compliance through the supply chain. The horsemeat scandal in the UK several years ago, where burgers advertised as beef burgers were found to contain horsemeat, was partly due to a lack of control over the supply chain.
Climate change and the vagaries of the weather is the most obvious aspect here, which illustrates that not everything is controllable, or factors that the members of the industry are able to influence. Governments can be lobbied, but there is nothing that can be done to influence the weather in the short term. Perhaps climate change can be influenced in the very long term.
Sustainability issues have been covered elsewhere, but the need for a sustainable food supply into the future is acknowledge by all governments and all members of the sector.
Water management is a key topic in some parts of the world, as is soil quality, along with soil erosion and land management. The use of science and technology to improve production in certain parts of the world, and how to finance the implementation of strategies to improve methods and production yields, is a constant dilemma that is reviewed regularly by bodies such as the African Congress on Conservation Agriculture and various other bodies around the world.
Imagine that you are a farmer in your country of origin. Your farm is of medium size and has elements of arable and animal husbandry. How might the trends in the environment affect your business in the future, and how might management accounting aid in the review of your current strategy and in the development of the future strategy?
Tractors working in a field representing the agricultural industry
Understanding the forces that impact on organisational strategy – an example using the Pharmaceutical industry
Porter (1979) identified five forces that help shape an organisation’s strategy in what is frequently referred to as Porter’s Five Forces model. The model is useful in helping to understand how these forces will impact on the industry, and hence the profitability of the industry members. This article takes the pharmaceutical manufacturing industry as the basis of exploring how management accounting can be used to aid the analysis.
The five forces are:
· Threat of new entrants to the industry
· Bargaining power of suppliers
· Bargaining power of buyers
· Degree of competitive rivalry in the industry
· Threat of substitute products or services to the output of the industry.
Threat of new entrants to the industry
The threat of new entrants is determined by the strength of the barriers to entry that exist for new entrants. The pharmaceuticals industry is dominated by several large players that enjoy significant economies of scale and are able to spend large amounts of money on research and development. They also command a significant hold over distribution channels and can afford to invest huge sums in marketing to support the development of a strong brand for their products.
The industry is also subject to regulatory policies related to patent protection and approval of new products by agencies, such as the Food and Drug Administration (FDA) in the US, the Medical and Healthcare products Regulatory Agency (MHRA) in the UK, the Central Drug Standard Control Organization in India (CDSCO), and the China Food and Drug Administration (CFDA) in China, to name a few of the regulatory bodies in the world. There are also advisory agencies, such as the National Institute for Health and Care Excellence (NICE) in the UK that advises the National Health Service (NHS) and can influence which pharmaceutical products are made available to the public through the NHS. In some countries the price is regulated by government bodies.
There would appear to be a prima facie case to suggest that there are significant barriers that might deter new entrants to the industry, and in the 1970s and 1980s this would have had a significant impact on limiting new start-ups in the industry. However, with the development of biotechnologies, and the rise of the generic product producers that provide the same product as the original patented drug once the patent has expired, some of the barriers are not as strong as they used to be.
For example, in the case of new start-up in the industry, the large returns that can be made on successful products means that a team of researchers are able to raise funds from venture capital sources to finance the development of new products. The new companies pose no real threat to the large companies, as one of the main exit strategies of the start-up investors is to sell out to the large pharmaceutical companies once the product has gone through the initial development phases, however, it is now easier to enter the industry than it was in the 1980s.
The patent protection, typically of 20 years duration, which provides the opportunity for high profits to recoup the development costs of a product, does not provide the length of benefit previously enjoyed by companies some 20 years ago. It can take up to 8 years, (some would say 13 – 15 years) to obtain the data from clinical trials necessary to gain FDA approval in the USA, which leaves little time to recoup the development costs. Once a product has lost its patent protection it can lose up to 80% of its brand name sales, as generic products flood the market. As a result, large pharmaceutical companies have been known to apply for new patents linked to the products to extend the protection and to fight generic companies in the courts to stop them producing a generic version of the product. In retaliation generic companies sue to try to invalidate these extra patents. It is argued that this legal tit for tat slows down new product innovations and a solution might be to allow patents to begin after the approval has been granted. However, due to competitive rivalry, companies often file patents at the earliest opportunity to stop competitors from stealing a potential idea before it is fully developed. This also eats into the time available to recoup investment.
Understanding an industry cannot be achieved based on a static analysis of factors affecting the industry at a point in time, or over a particular year. The changes identified may be cyclical in nature, or temporary. Therefore the analysis needs to be undertaken over a period of time, ideally a full business cycle. The length of a business cycle is debatable but the nature of the pharmaceuticals industry suggests that the analysis needs to be undertaken over a lengthy period of time. This is due to the long R & D phase, the length of the patent protection, the fact that products can be re-positioned or re-purposed, that is, where a drug is used to treat a different disease, which can extend its product lifecycle, and the impact of generic products on profitability. Indeed, this links to PESTEL analysis in that factors within the general environment could impact on the forces affecting the industry, such as, government policies on health care, aging populations affecting demand for certain products, or technological changes that enable the development of new treatments, and so on.
It is not possible to respond to every change in the environment and simply creating a list of qualitative factors does not really aid strategy development. Management accounting can help to put some numbers to the issues so that the significance of the changes and emerging trends can be understood in terms of the potential impact on the achievement of the organisation’s strategy. This aids some degree of prioritisation to be undertaken so that a suitable response can be developed if necessary.
For example, in relation to the impact of generic products, using management accounting techniques to monitor the organisation’s own products through the process from R & D to sales and profits during, and after, patent protection can aid the understanding of the impact that generic companies have on the organisation’s performance. This not only provides comparative data that can be used to build up experience of lifecycle costs and profitability of a product, but also provides information that aids decisions, such as the costs and benefits of taking legal action to protect the patent. It is all too easy to get trapped in to believing that the patent must be protected at all costs, but ploughing millions of dollars into the legal system could actually divert significant resources away from R & D. It may prove more profitable in the long run to ensure a good pipeline of new products is forthcoming from a well-funded R & D function.
Pricing of products to maximise the contribution towards development cost, and fixed costs and profit during the patent protection period is another obvious area where management accounting can aid the development of strategy and resource allocation decisions. The pricing decision can be critical as setting a high price, whilst desirable as a means of recouping development costs during the patent protection period, can result in regulatory and advisory bodies, such as NICE in the UK, not recommending the product for public availability via the National Health Service, or insurance companies not being willing to pay for the drug under insurance. Deals are often done to provide the product at a discounted rate, as this not only builds up goodwill with key buyers, but also aids the development of a success rate for the branded product before generic producers jump into the market once the patent expires. Pricing, therefore, can be a key decision in stimulating demand, so, price sensitivity, brand recognition, substitute products, competitor response (including generic producers), psychological factors, and so on, are all significant factors that need to be taken into account when setting the pricing strategy. It is far more complicated than just covering product costs.
Techniques such as risk-adjusted net present value, decision trees and real options are useful in valuing products, although the long timeframe involved, and the high attrition rate of new products make this a difficult area to forecast with any accuracy. Building up experience over time and comparing the actual outcomes with expected outcomes is a highly valuable learning exercise that should be undertaken as a matter of course. This makes forecasting of sales and costs for new products more reliable as more experience is gained, even to the extent of being able to assess issues, such as the quality of project management, and the impact of new technologies on success rates. The cost of capital and discount rates used, as well as the timeframe considered, can also have a significant impact on the evaluation of new products. It is, therefore, always advisable, and good practice, to undertake some form of sensitivity analysis to ask the, what if? style questions.
Acquiring a good understanding of your own costs and processes provides a benchmark which can be used to assess competitors and understand the likelihood of new entrants being able to enter the market. Knowing the costs and expertise required enables an informed judgement to be made of any potential threat. Also understanding the cost base, such as, how much volume is required before a manufacturing plant becomes viable, what level of financing is required to develop a new product, what level of sales is required to operate a logistical network efficiently and cost effectively. Assessing these factors quantitatively and monitoring them over a period of time, can help to assess the immediate and potential threat from new entrants. Even if low at present it does not mean it will not change in the future.
Bargaining power of suppliers
The raw materials for the manufacture of pharmaceutical products are primarily commodity products in the chemical industry. There are numerous sources of the raw material and chemical components that make up pharmaceutical products from which these can be acquired, and therefore suppliers have little power over the manufacturers of drugs. Even the price of rarer materials can be mitigated by purchasing a range of more common raw materials at negotiated discounted prices from the same supplier. The packaging companies often have a mutual dependence on the pharmaceutical companies for their business, so have little bargaining power. There are also multiple suppliers of the capital equipment required to manufacture drugs and undertake research activities. This means that switching costs are low, which makes it difficult for suppliers to lock the pharmaceutical companies into their particular products. In fact the balance of power in the negotiation probably lies more with the pharmaceutical companies than with the suppliers. Many of the larger pharmaceutical companies have their own manufacturing plants that manufacture basic materials and chemical components, and therefore do not need to engage with the whole of the external supply chain.
Vendor analysis and monitoring raw material costs by supplier can provide an early indication of any potential shift in the negotiating position of suppliers. Vendor comparison across a range of performance indicators can help to keep suppliers in check, particularly if operated in conjunction with an approved supplier list.
Monitoring the general environment for movements in commodity prices and events outside the control of the suppliers can help to determine whether cost rises are the result of inefficiencies in supplier operations, or events which the suppliers cannot control, which may result in a price rise. For example, a shortage of supply of a particular raw material due to natural phenomenon will affect the whole industry. This will inform the negotiation stance adopted by the supplier and the buyer. Understanding the effect of natural phenomena on the costs of the industry also feeds into competitor analysis, as it is highly likely that the competitor costs will rise as well. However, if the cost increase is due to supplier inefficiencies it signals that a potential change of supplier may be required. As switching costs are relatively low it puts the buyer in the stronger negotiating position. This highlights the need to understand the dynamics of the suppliers’ industry sector, in this case the market for raw materials, as well your own (manufacturing), and indeed the buyers’ industry sector.
Bargaining power of buyers
Buyers in the pharmaceutical industry include distributors to the retail trade, health maintenance organisations (HMOs) that arrange or provide managed care for insurance companies, private individuals, hospitals, and other entities, which may include government agencies. The end patient often has very little input, although recent changes in more developed countries are now encouraging more patient participation in their medical care. Bodies such as the National Institute for Health and Care Excellence (NICE) can also influence purchasing decisions. The large private health providers, insurance companies and government funded health care systems and advisory bodies, such as NICE, are able to exert some downward pressure on prices and choose between alternative treatments, thus putting pressure on the margins earned from pharmaceutical products. More general trends in the environment, such as aging populations, obesity, and a focus on education and prevention rather than cure, will also impact on which products are in demand, or where the price sensitivity of certain products may be susceptible to change. This has implications for R & D effort in targeting potentially lucrative areas of health care where demand may be high, or where competitive advantage can be achieved, providing the opportunity of earning higher profits.
Monitoring customer profitability can be an early indicator of any potential increase in buyer power. Sales force personnel often lose track of the overall trend in selling prices, particularly if key account managers only deal with certain customers. A trend that is identified from internal data may be an early indication of a more general trend in the industry. It is therefore, as important to monitor internal trends and to assess these in the light of industry wide data, as they may provide a signal of wider changes in the industry, and forewarned is forearmed.
Relationships with health care professionals, such as doctors, can also influence purchasing decisions and incentives. For example, the use of discounts and trial periods are common, but these need to be carefully monitored and costed as profits can so easily be given away in the pursuit of volume. The cost of branding can be a significant factor in the success of the product, particularly when linked to the effectiveness of the product in the treatment of patients. Huge sums can be spent on marketing so again careful monitoring needs to be in place and sensible methods of setting marketing budgets adopted. An objective setting approach may be preferable in which marketing budgets are set with specific objectives in mind on a campaign by campaign basis, but often large companies adopt a percentage of sales revenue as an overall marketing budget. The danger here is that the link between marketing and performance is lost, or it is not possible to track the impact of the marketing activities, which deprives the organisation of valuable information that can be fed into future decision making.
The earlier discussion on pricing is also relevant here, as is understanding tuge HHuge he potential impact of generic products on profitability, particularly as medical professionals can choose to switch to a generic product once it becomes available. The negotiation of supply contracts can help to create some element of switching costs, but professional buyers in HMOs, government agencies, hospitals, and over-the-counter retail organisations will be aware of the implications of long term or exclusive supply contracts.
The pharmaceuticals industry is characterised by high levels of competition, in both R & D activity and new patents, attracting leading researchers and fighting for market share. The development of a strong brand image can be an important aspect of competitive advantage, particularly in the fight against generic producers. The other forces also impact on the degree of competitive rivalry, such as the threat of new entrants. Although smaller companies enter the market the larger firms are often looking to acquire these to gain access to intellectual property of new products, whilst the new entrants are often looking to sell the business to a larger firm once a product is in development. The impact of supplier power and buyer power can also affect the margins earned by the industry, which also affects the competitive rivalry. However, in the case of the pharmaceutical industry competitive rivalry is more focused on market share and the need to maintain a vibrant and innovative product portfolio. This can be achieved organically or via merger and acquisition. The area of mergers and acquisitions is an obvious area where the particular skill set of accountants can be usefully employed.
It is not just the assessment of individual forces that needs to be made. It is equally important, if not more so, to gain an understanding of how a change in one force may impact on another. For example, a breakthrough in new technology may impact on the development of innovative products, and as in the case of biotechnology encourage smaller firms to enter the market intent on developing new products which are manufactured by other firms, essentially creating a new industry sector which changes the business model. This could in turn impact on the supply market and the cost base of large manufacturers, increase the number of alternative products, and potentially impact on buyer power, and ultimately profits margins, not to mention the potential impact on competitive rivalry.
Competitor analysis is important, not just in terms of their product sales and market share, but in monitoring their R & D capability, number of patents filed, their ability to raise finance to feed the R & D process, their success rate in launching new products, and their profitability and return to investors.
Threat of substitutes
One aspect of the pharmaceuticals industry is that it can be segmented in to different categories. For example: chemically derived products, biologically derived products, and prescription products and over-the-counter products. There are also innovation derived products, which are new products developed via R & D, and generic products, which are products that are the same as the innovative products, but not sold under the original brand name. Generic products can be produced after the expiration of a patent, and are usually cheaper than the branded product. There are also companies that specialise in research, such as contract research organisations (CROs), and those that specialise in manufacturing known as contract manufacturing organisations (CMOs). What are considered as substitutes is therefore debateable depending on how one views the industry. For example, an innovative pharmaceutical company may view generic companies as substitutes for its output. For the purposes of this analysis substitutes are defined as any other means of providing the benefits of pharmaceutical products. This may include natural remedies and other forms of alternative medicines, which are becoming more socially acceptable.
The threat from generic producers, which could equally be consider under threat of new entrants or competitive rivalry, is now always present but can be mitigated via patent protection. However, once the patent has expired the sales and profitability of the branded drug are likely to reduce. Therefore, building up a database of past experience can be invaluable in estimating the likely impact of the generic products on any new products emerging from their patent protection. This emphasises the importance of good product portfolio management and ensuring that a well balanced portfolio is maintained.
The threat from alternative medicines (substitutes) is low due to the size of the pharmaceuticals market and the fact that patients do not normally seek an alternative to the prescription drugs. This largely leaves the alternative medicines within the over-the-counter range of products and health supplements, some of which are now produced by the larger pharmaceutical companies. Monitoring the financial performance of alternative providers and the growth in the segment of the market can inform future strategy development. For example, evaluating the potential impact on industry sales via trend analysis, or evaluating the cost of the organisation entering the market segment via product development, as some larger pharmaceutical companies have already done.
It can be seen that there are a number of aspects within the industry analysis where accountants are able to make a significant contribution. The understanding of how the forces and environmental changes will impact on the industry is important for strategy formulation, but equally understanding how those forces and changes will impact on your organisation compared to the competition. Therefore, some form of competitor analysis alongside the analysis with respect to the organisation is required. This then feeds into the SWOT analysis, as strengths and weaknesses are technically relative to the competition. Also the industry analysis enables and assessment of the impact of changes in the general environment on the industry and also helps to identify not just the threats, but also the opportunities.
Porter, M.E. March-April, 1979, How competitive forces shape strategy, Harvard Business Review, 57 (2), pp.137-45.
Young lady in white lab coat and face mask examining the contents of a test tube
Sources of external information
There are numerous sources of information that can be used to undertake an analysis of the business environment relevant to an organisation, but it is important to test the validity, reliability and credibility of the sources used. Cross checking information from different sources and being constantly alive to the possibility of ‘fake news’ are useful habits to adopt. While information can reduce uncertainty there is a danger of too much information, creating information overload, such that the really significant changes get lost in the sheer volume of information. Therefore, gathering information for its own sake is not a good idea, but constantly scanning the environment for events, actions and trends that will impact on the current strategy provides more focus to the activity. It is beneficial if the act of environmental scanning is merged into the normal activities and responsibilities of those persons in the organisation that are in a position to access the information.
The typical sources where this is possible is through contact with customers and suppliers, manufacturers, intermediaries and retailers, with which the members of the organisation come into regular contact. It is important not to underestimate the significance of monitoring internal information, as a trend within an organisation’s customers could be indicative of a more general trend in the environment. For example, perhaps a certain demographic group within the customer base is beginning to migrate to different product groups. If the organisation can spot this before the competitors do, it could provide a short term advantage. Suppliers may be aware of factors affecting future supplies, development of new materials, sources of materials, or potential forthcoming legislation concerning the use of materials.
Financial institutions and providers of finance are another source of external information with which the organisation, and in particular the accountant, will interact on a regular basis. Also trade associations, user groups and professional bodies are sources that members of the organisation will be in contact with, often in a personal capacity in the case of professional associations. These often produce reports on the industry or future of the profession that contain useful information. Bodies such as the Federation of Small Businesses in the UK publishes information that is useful for its members, for example, concerning changes in government policy that will affect small businesses. Other countries will have similar bodies dedicated to sectors of the economy. In some countries co-operative societies are common in certain sectors of the economy which provide the opportunity for mutual exchange of information. The annual reports of competitors may contain information on their view of the way the industry will develop in the future. This will be accessed as part of competitor analysis.
Organisations may undertake marketing research for their own specific purposes, but there are a number of organisations that produce market research reports which are made available to subscribers, or available to purchase separately. Think tanks and consulting firms often produce reports for which brief headline information is available for free, with more detailed reports available to purchase. Consumer groups fall into this category. Pressure groups also provide information, but bear in mind that these often have a specific agenda, so there may be a slight bias to the information provided. Always look for other opinions. The same can be said of Blogs by individuals with a specific interest in an industry, but remember these can be opinion only and not necessarily backed up by any research or facts. Expert opinion is also worth seeking out but check the credibility and associations of the individual concerned.
Government statistics are usually available via government agencies and government websites. Also business directories can be useful sources of information, as can academic and professional journals. There are also databases that can be accessed for free, such as EDGAR (Electronic Gathering, Analysis and Retrieval systems). Credit agencies and organisations such as the World Bank provide headline information for free that can be a useful source of emerging trends.
The media can also be a good source of information. Reports, articles, and news items can often contain information relevant to the industry and the organisation, whether it is listening to business reports on the radio, television, or scanning news media and newspapers online, or via a hard copy.
There is also the general access to the internet. This provides a wealth of information, other than access to many of the sources mentioned above, but care needs to be exercised to check the reliability, credibility and validity of the information provided.
The value of information
Information has value in that it can reduce uncertainty. However, the value is subjective and difficult to calculate, as the value increases as the probability of an outcome based on the information becomes more certain, that is, the value increases as uncertainty reduces. The use of the value of information in decision making is based on the fact we will have some information, or knowledge, about an event occurring, or possible outcome being achieved, before the decision is made. We can make an assessment of the probability of the event occurring, or outcome being as we expected. If additional information is provided that can improve the estimate of the probability of the event occurring, or the outcome being as expected, it can improve the payoff achieved from obtaining the information.
This indicates that there is a cost to collecting the additional information and that there would be a maximum price at which the payoff would be beneficial. In terms of the business environment this has limited practical application, as developing strategy is often not just a case of making a single decision. Thinking about the value of information, however, does serve to highlight that there is a cost to collecting information. The cost can be managed more effectively if environmental scanning becomes a regular activity incorporated within the normal job roles of individuals or groups. This needs to be managed via an effective collection and dissemination mechanism through which the information gathered can be communicated to the right people. Information is often disseminated at meetings, within reports, and proposals for future developments. It is beneficial to establish a formal mechanism for dissemination of information, such as regular strategy meetings at which formal reports are considered, rather than relying on the informal network.
The role of the management accountant
There is scope for the information concerning the business environment to be included within the regular management accounting information provided to management, which fits well with the concept of management accounting in support of strategy. The management accountant will need to liaise with functional managers to act as a central coordinator for the dissemination of environmental information, and to report the potential impact on the future strategy. This not only ensures that the management accountant takes a proactive role within the strategic management process, but that senior management are aware of the impact that changes in the business environment could have on the achievement of strategy.
The 'i' sign representing information
An uncertain future
During the past few decades the business environment has become increasingly more complex and dynamic. Changes from the disruption caused by new technologies, deregulation and disintermediation of markets, the threat of new competitive entrants, the opening up of new trade areas and alliances, and the emergence of new business models such as the gig economy, have all added to an increase in the degree of uncertainty about what the future will look like. In turn this puts pressure on senior executives who bear the responsibility for developing and implementing the strategy to deliver the corporate objectives (Oliver & Parrett, 2018).
Forecasting and strategic planning
Organisations create forecasts to estimate how the current strategy will play out. Management accountants play a key role in the use of forecasting, as they are able to provide insight into the potential impact of known changes on the achievement of the organisation’s objectives. These can be expressed in financial terms, and used as the basis for more detailed budgeting of the forthcoming financial year. Furthermore, they form the basis for updating rolling budgets, where the plan for a set period of time, for example the next 12 months, is updated on a monthly or quarterly basis. The use of latest estimated forecasts and rolling budgets allow plans to be updated to take account of known changes.
Forecasts typically make use of quantitative models based on past behaviour using techniques such as time series analysis to help identify seasonal and cyclical trends, and regression analysis and econometric models to identify possible correlations and relationships between variables. However, it is not just the relationship between variables that is interesting, but identifying the driving forces for change, and responding to these in a timely manner. For example, leading indicators, such as a change in demographics created by an increase in the number of children, will impact on the market for children’s clothes, toys, and more broadly the number of schools, and so on. The time span between changes impacting on certain markets can add to the complexity. The impact of the changing demographics is relatively easy to estimate but the impact of disruptive technologies is more difficult. These can impact on certain industries, for example, the impact during the last decade of the internet on retailing and banking, and digital technology on telecommunications from the introduction of the mobile phone. The development of the smart phone has impacted on our social interactions, leisure activities, and how we interact with organisations, for example, ordering a taxi on demand, or a take-away meal via a mobile app. However, forecasting, while useful, does not necessarily prepare organisations to deal with the increasing level of uncertainty caused by the high level of complexity and dynamism in the business environment.
Writers such as Hamel (1996) and Prahalad (Hamel & Prahalad, 1989, 1994) emphasise the importance of looking to the future, and the dangers of becoming trapped in the ritual of strategic planning as a routine annual activity. Organisations need to be prepared to embrace change and avoid the status quo. Taking a broader look at the environment, and creating multiple scenarios of what the future may look like, can aid the understanding of the business environment by providing the opportunity for strategic conversations, in which possible views of the future are debated (Grant, 2003; Bowman et al., 2007). Undertaking scenario analysis enables an organisation to stay relevant to the times and to anticipate changes.
A scenario is not a forecast, but a narrative of a possible future outcome. They are not a prediction of the future, but rather developed to enhance organisational learning about possible actions that can be taken in response to potential events and shocks to the business environment (Wright et al., 2013). They are expressed in qualitative, rather than quantitative terms. The timespan used can vary from 5, 10 to 20 years from now, but the further away the horizon, the more speculative the outcome becomes. The key benefit is that the development of scenarios allow organisations to gain an understanding of how they might respond, and to test possible strategies against changes in the business environment. This process enables organisations to be better prepared for changes should they materialise in the future. In addition possible triggers and environmental indicators can be identified and tracked, as part of an early warning system that the changes imagined in a scenario might actually happen (Wilburn & Wilburn, 2011). The more prepared an organisation is the better they are able to sense, seize and handle external changes quickly (Teece, 2007). Flexibility, responsiveness, and a willingness to change are undoubtedly key attributes for success in today’s business environment.
Using scenarios can have a positive impact on performance as managers are better prepared to deal with changes in the environment, and challenge the status quo (Visser & Chermack, 2009; Bouhalleb & Smida, 2018). Scenario planning does not only help to identify indicators to monitor, but also identify areas where the organisation can attempt to influence the future environment. It should not just be a case of accepting and responding to changes as they develop. Organisations can proactively engage with the environment in an attempt to change the way the industry looks in the future. For example, by lobbying governments, or developing and applying disruptive technologies and disintermediation strategies. This requires organisations to ask the question, what do we want the industry to look like in 5 or 10 years’ time, and what can we do to make sure it does?
Objectives of scenario planning
Wright, Bradfield and Cairns (2013) suggest that there are three objectives to scenario planning: enhancing understanding; challenging conventional thinking; and improving decision making, although they felt there was little evidence to suggest that the third objective was achieved. In truth, all the objectives have a degree of subjectivity and there is little empirical research that categorically proves the benefits in quantitative terms, but the intangible benefits emerge through contributing to the process of organisational learning and an enhanced sensemaking ability from undertaking the scenario planning activity. This can be illustrated by looking in more detail at the three objectives proposed.
Benefits of scenario planning
There are several reported benefits claimed for scenario planning – the following are adapted from Wright, Bradfield and Cairns (2013).
There are, however, some aspects to be aware of when using scenario planning.
The process of developing scenarios
There is no one set method of developing scenarios but the following phases represent a logical sequence of activities that can be compressed, extended, re-ordered, or amended, as suits the organisational needs.
Schools of scenario planning
Huss and Honton (1987) suggest that there are three basic schools of thought in scenario planning. These are intuitive logic, trend-impact analysis, and cross-impact analysis.
The scenario planning activity can take several forms but essentially they are intended to generate discussion about the future and the organisational response. There are several ways in which scenarios can be used in practice which include:
Scenario planning was popularised during the 1970’s, primarily by Royal Dutch Shell, but the practice waned a little during the 1980s. It has, however, enjoyed a resurgence in recent times with many organisations and senior executives promoting its use and benefits. The major benefit is that it encourages organisations to think about the future and the organisation’s ability to deal with uncertainties. Thinking about how the business environment might change, or could be changed, and the strategic responses, or initiatives, that can be made, ensures that organisations are better prepared to face the uncertainties of the future.
Generating ideas about the future - lightbulb moments
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