Why is it important for a firm to study and understand the external environment?

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A business's external environment is very important to its success. Companies can adjust their plans according to changes in the external environment. For example, lower interest rates may lead a business to take on more debt in order to expand operations. Falling real estate values may also lead a company to build more stores.

The public mood is also important to a company's success. Given the new emphasis on environmentally sound practices, many companies now tout their sustainability efforts and attempts to become more eco-friendly. This is an attempt to bring in socially conscious consumers and to make people feel better about buying the products in the store. Many companies now claim to be switching to green sources of energy and reducing their plastic bag use for this reason.

The weather can also play a role in a business's success. Many grocery stores in the South order extra milk and bread whenever snow is in the forecast because they know that customers will rush to the store to stock up on this staple. Stores in hurricane-prone areas will try to sell bottled water and other foods that will not spoil in the event of a power outage.

International companies also pay attention to events happening overseas. Turmoil in one part of the world may affect supplies coming from that region. Severe weather in one area may lead to a grocery store seeking a different region for a supply of fresh produce. Companies also pay attention to trade wars and potential economic sanctions.

Economic news is often a collection of domestic and international news that affects businesses. The larger the business, the more factors that go into its success or failure.

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Understanding the external environment in which a business is operating is not a luxury; it is a necessity. A business cannot function without knowledge of what are called micro and macro factors that affect the ownership’s ability to produce, distribute and market its goods or services. Micro factors are those with which the business owner interacts daily, including suppliers and distribution networks as well as sources of cash that may be needed to finance plant recapitalization or long-range research and development efforts. A glitch in any of these components of the external environment can adversely impact productivity and profitability.

The macro environment in which a business operates—in fact, in which all businesses operate—include interest rates set by the Federal Reserve System, perturbations in stock markets that reflexively react to all kinds of stimuli (e.g., rumors of an event in another region of the world or of possible adjustments by the Federal Reserve to the lending rates used by banks), major developments in key regions such as the impact on oil prices of instability in oil-producing areas, natural disasters, etc. Most businesses are affected one way or another by such factors, and it is incumbent upon business owners to be aware of such possibilities. The sudden death of the ruler of a major oil-producing country, for instance, can cause fluctuations in markets and increases in oil prices that will, in turn, increase the cost to businesses of producing and/or shipping goods.

In short, the external environment in which businesses operate is complex and susceptible to many variables. Business owners ignore the external environment, both micro and macro, to their peril.

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The external environment defines the opportunities and risks affecting a business. No business exists in a vacuum. 

To take a somewhat intuitively obvious example, two elements of the external environment are seasons and weather. A clothing retailer should stock many warm coats, gloves, hats, and parkas in Minnesota but should focus more space on swimsuits and shorts in Florida. Retailers must respond to seasons (selling snowblowers in winter and air conditioners in summer), holidays, and local preferences as well (i.e. selling more conservative clothing in small Midwestern towns than in San Francisco or New York, which demand more extreme fashions). 

Next, economic trends are part of the external environment. During economic downturns, people buy less expensive products, tend to repair older items instead of buying new ones, remodel instead of buying more expensive houses, and generally try to save money. Thus in such periods, retail and service firms should focus on opportunities in repair, selling generic inexpensive goods and other items that help people save money, such as cars that get better gas mileage or energy-efficiency upgrades for homes. 

Interest rates are an important external factor in business decisions. If interest rates are low, it makes sense to borrow money and invest in expanding or innovating, but if interest rates are high, you may get a better return simply by sitting on a pile of cash that returns interest. 

Another important element of the external environment is politics. For example, if one is thinking about where to locate a European branch, Brexit may make London less appealing than Paris, while political instability can affect many of one's decisions about investing in South America, Africa, or the Middle East. Similarly, for outsourcing manufacturing, one must assess political risks and economic issues such as exchange rates and wage trends. 

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It is important for a firm to study and understand the external environment because that environment can determine what strategies the company will need to pursue in the future.  Let us look at the example of an oil/gas company in the United States right now.  It must understand:

  • The political environment, in which a Romney victory might lead to fewer restrictions on drilling.  An Obama victory might be seen as a political risk because of the possibility of tightened regulations.
  • The social environment.  The firm has to understand how (or if) consumers' attitudes towards oil and energy consumption are changing.
  • The technological envrionment.  Firms have to be up on the latest in "fracking" technology so they do not get left behind.

These are examples of aspects of the external environment that could affect a business's prospects.  If a firm does not study and understand these things, it could get caught by surprise, leading to a loss of profit.

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