PEST Analysis

A scan of the external macro-environment in which the firm operates can be expressed in terms of the following factors:

Political Economic Social Technological

The acronym PEST (or sometimes rearranged as "STEP") is used to describe a framework for the analysis of these macro environmental factors. A PEST analysis fits into an overall environmental scan as shown in the following diagram:

Environmental Scan / External Analysis / Macro environment | P.E.S.T. \ Microenvironment \ Internal Analysis

Political Factors Political factors include government regulations and legal issues and define both formal and informal rules under which the firm must operate. Some examples include:

tax policy employment laws environmental regulations trade restrictions and tariffs political stability

Economic Factors Economic factors affect the purchasing power of potential customers and the firm's cost of capital. The following are examples of factors in the macroeconomy:

economic growth interest rates exchange rates inflation rate

Social Factors Social factors include the demographic and cultural aspects of the external macro environment. These factors affect customer needs and the size of potential markets. Some social factors include:

health consciousness population growth rate age distribution career attitudes emphasis on safety

Technological Factors Technological factors can lower barriers to entry, reduce minimum efficient production levels, and influence outsourcing decisions. Some technological factors include:

R&D activity automation technology incentives rate of technological change

External Opportunities and Threats The PEST factors combined with external micro environmental factors can be classified as opportunities and threats in a SWOT analysis.

Supply Chain Management

A supply chain is a network that includes vendors of raw materials, plants that transform those materials into useful products, and distribution centers to get those products to customers. Without any specific effort to coordinate the overall supply chain system, each organization in the network has its own agenda and operates independently from the others. However, such an unmanaged network results in inefficiencies. For example, a plant may have the goal of maximizing throughput in order to lower unit costs. If the end demand seen by the distribution system does not consume this throughput, there will be an accumulation of inventory. Clearly, there is much to be gained by managing the supply chain network to improve its performance and efficiency.

Decision Variables in Supply Chain Management

In managing the supply chain, the following are decision variables:

Location - of facilities and sourcing points Production - what to produce in which facilities Inventory - how much to order, when to order, safety stocks Transportation - mode of transport, shipment size, routing, and scheduling

The Bullwhip Effect A problem frequently observed in unmanaged supply chains is the bullwhip effect. This effect is an oscillation in the supply chain caused by demand variability. This problem must be addressed in order to avoid the poorer service and higher costs that stem from it.

Inventory Management Variation in demand increases the challenge of maintaining inventory to avoid stockouts. There exist techniques for inventory management that optimize the performance for a given set of parameters.

Vendor Managed Inventory

An effective way to improve supply chain performance is for the vendor to determine the quantities that should be ordered by its downstream customers, rather than the other way around. This approach is known as Vendor Managed Inventory, abbreviated VMI. While its implementation faces practical challenges, it can be an effective method for reducing inventory and stock-outs.

Accurate Response In the classical news vendor problem, one must decide the best order quantity that maximizes profits given that some money is lost if all of the units do not sell and given the fact that potential profits are lost if the units sell out. In some situations, a second order can be placed once the sales period begins. Such an opportunity helps one to better match supply and demand, since the first order can be a quantity equal to the expected demand minus a selected number of standard deviations ( 2, for example) below that mean. Of course, any minimum order quantities must be taken into account. In many industries, the variance in demand is proportional to the variance in the forecasts for that demand. This relationship even exists in stock price forecasting. When this relationship holds, it can be used to estimate the mean demand and its variance, and these values can be used in optimization models. For seasonal goods such as winter sportswear, which has a short selling season and long lead times, a firm can do several things to better match supply and demand:

Additional events can be held before large trade fairs in order to secure orders further in advance. Supplier capacity can be reserved without specifying the exact product mix. This postponement of the final mix has benefits similar to those of postponing product customization until the distribution center. Common parts can be used in designs in order to pool some of the variation between individual demands.

Supply Chain Structure

The performance of a supply chain is measured in terms of profit, average product fill rate, response time, and capacity utilization. Profit projections may improve if another parameter is relaxed, but one must consider the impact of all aspects of the relaxed parameter on profits. For example, if customers are lost because response time is too slow, then the profit projections may be artificially high. Average fill rate can be improved by carrying more inventory in order to reduce stock-

outs. The optimal balance must be achieved between inventory cost and lost profits due to stock-outs. Response time often can be improved at the expense of higher overall costs. As with fill rate, the optimal trade-off should be found. If response time is sacrificed in order to achieve higher profits, sales forecasts may have to be modified if the elasticity of demand with respect to service is significant at the chosen service levels. Capacity utilization should be high enough to reduce overhead sufficiently, but not so high that there is no room to grow or to handle fluctuations in demand. Problems often are encountered when capacity utilization exceeds 85%. Lower capacity utilization in effect buys an option for increased output in the future. Higher capacity utilization decreases downside risk since costs are reduced, but also limits the upside gain if future demand should outstrip supply.

Make-To-Order

To reduce inventory and increase flexibility, some firms have turned to make-to-order production systems. Some companies can reap great benefit from such a system. Make-to-stock is better for other companies, such as those whose customers are not willing to wait for the product.

Inventory Management

To minimize supply and demand imbalances in the supply chain, firms utilize various methods of inventory management. The problem is complicated by the fact that demand is uncertain, and this uncertainty can cause stockouts in which inventory is depleted and orders cannot be filled. Here, we discuss a model in which the inventory level is reviewed periodically, and orders are placed at regular intervals to order up to a certain base stock. This policy is known as a Policy of Periodic Review, Order-Up-To Base Stock. Under this policy, one orders a variable quantity Q every fixed period of time p in order to maintain an inventory position ( Qty on hand + Qty on order ) at a predefined base stock level S, also known as the "order-up-to level." The base stock level S is determined by calculating the quantity needed between the time the order is placed and the time that the next period's order is received, and adding a quantity of safety stock to allow for variation in the demand. The time between the placing of the order and the receiving of the next period's order is the sum of the review period p and the replenishment lead time l (lower-case L). The demand per unit of time, , is multiplied by the time between order placement and the next period's order arrival ( p + l ) to determine the expected quantity to be sold. The safety stock depends upon the variability in the demand and the desired order fill rate. To calculate the safety stock, first calculate the standard loss function, designated as L(z). This function is dependent on the values of the desired fill rate f, the demand and its standard deviation , the time between orders p, and the replenishment lead time l : L(z) = ( 1 - f ) p / ( p + l )1/2

Once L(z) is known, z can be found in a look-up table and the safety stock can be calculated by: Safety Stock = z ( p + l )1/2

If the review period p is reduced, the safety stock does not necessarily reduce because p is in both the numerator and denominator of the standard loss function which determines the value of z. The average level of on-hand inventory is the sum of the cycle stock ( equal to p/2 ) and the safety stock. The on-hand inventory does not include those units in the delivery pipeline. This model can be complicated by the following real-world issues: variable lead times, non-stationary demand, multiple inventory sites, multiple customer classes, and multiitem order fill rate.

When several components are needed to build a system, each component having the same fill rate, the overall system order fill rate (multi-item fill rate) will be lower than the component fill rate since an order cannot be completed even if only a single component is missing. The multi-item fill rate is the product of the individual item fill rates. For n items having the same component fill rate: order fill rate = (component fill rate)n

When there are long shipping times, the idea of postponing the last stages of final assembly until the product reaches the distribution center (DC) may become attractive. At the DC, the units can be localized and customized according to the demand patterns seen at that time. The result is that the total safety stock required at the DC is reduced by a factor of n1/2, where n is the number of different SKU's for which the customization is being postponed. To maximize the benefits of postponement, the product should be designed to be distribution center localizable. The variable features of the product can be isolated into one or two modules that are to be installed in the distribution center.

Quality and Productivity

Introduction All businesses have process flows in which a product is designed or manufactured or in which a service is rendered. An on-going goal is to achieve the maximum possible

throughput at the lowest possible cost while meeting all the requirements of the product or service.

Inventory Benefits A certain minimum amount of in-process inventory is always necessary. This level is defined by Little's Law: I=RxT where I = inventory, R = flow rate, and T = flow time, all of which are average values. The actual amount of inventory in the process will be greater than the theoretical amount because some inventory always will be in-transit between different locations. Furthermore, the actual levels usually are planned to be even higher. There are four possible reasons that firms intentionally plan excess inventory levels: 1. Economies of scale

Quantity discounts offered by suppliers. Fixed ordering costs and fixed setup costs are lower if spread across more units.

2. Production and capacity smoothing

Rather than vary processing rate to match varying demand, it may be more economical to process at a constant rate and use inventory as a buffer.

3. Protection against supply disruptions and demand surges

Supply disruptions may result in process starvation, downtime, and throughput reduction. Demand surges can result in delayed deliveries, lost sales, and customer dissatisfaction.

4. Profiting from price changes

Speculative inventories can be used to protect and profit from sudden price changes. Inflows and outflows can be managed in order to optimize the financial value of the inventory.

Inventory Costs (Disadvantages of a large inventory)

Increased response time to changes in market demand. Increased time to change to new products. Delay in detection of quality problems Decouples stages of the process flow, discouraging teamwork Holding costs (physical holding cost and cost of capital) Physical holding costs include operating costs and losses due to spoilage, obsolescence, pilferage, etc. Expressed as a fraction h of the variable cost C of one flow unit of inventory. So the physical holding cost for one unit of inventory for one time period is equal to h x C. Cost of capital is the opportunity cost of foregone returns on the amount invested in inventory that could have been invested in other projects. Cost of capital per flow unit is expressed as r x C where r is the cost of capital and C is the variable cost of one flow unit. Total holding cost is: H = (h + r) x C.

When counting average inventory in a process, the steps prior to the process bottleneck will be full, and those afterwards will be occupied by a ratio of the throughput rate of those steps to that of the bottleneck.

Competitive Advantage
When a firm sustains profits that exceed the average for its industry, the firm is said to possess a competitive advantage over its rivals. The goal of much of business strategy is to achieve a sustainable competitive advantage. Michael Porter identified two basic types of competitive advantage:

cost advantage differentiation advantage

A competitive advantage exists when the firm is able to deliver the same benefits as competitors but at a lower cost (cost advantage), or deliver benefits that exceed those of competing products (differentiation advantage). Thus, a competitive advantage enables the firm to create superior value for its customers and superior profits for itself. Cost and differentiation advantages are known as positional advantages since they describe the firm's position in the industry as a leader in either cost or differentiation. A resource-based view emphasizes that a firm utilizes its resources and capabilities to create a competitive advantage that ultimately results in superior value creation. The following diagram combines the resource-based and positioning views to illustrate the concept of competitive advantage:

A Model of Competitive Advantage

Resources

Distinctive Competencies

Cost Advantage or Differentiation Advantage

Value Creation

Capabilities

Resources and Capabilities According to the resource-based view, in order to develop a competitive advantage the firm must have resources and capabilities that are superior to those of its competitors. Without this superiority, the competitors simply could replicate what the firm was doing and any advantage quickly would disappear. Resources are the firm-specific assets useful for creating a cost or differentiation advantage and that few competitors can acquire easily. The following are some examples of such resources:

Patents and trademarks Proprietary know-how Installed customer base Reputation of the firm Brand equity

Capabilities refer to the firm's ability to utilize its resources effectively. An example of a capability is the ability to bring a product to market faster than competitors. Such capabilities are embedded in the routines of the organization and are not easily documented as procedures and thus are difficult for competitors to replicate. The firm's resources and capabilities together form its distinctive competencies. These competencies enable innovation, efficiency, quality, and customer responsiveness, all of which can be leveraged to create a cost advantage or a differentiation advantage.

Cost Advantage and Differentiation Advantage Competitive advantage is created by using resources and capabilities to achieve either a lower cost structure or a differentiated product. A firm positions itself in its industry through its choice of low cost or differentiation. This decision is a central component of the firm's competitive strategy. Another important decision is how broad or narrow a market segment to target. Porter formed a matrix using cost advantage, differentiation advantage, and a broad or narrow focus to identify a set of generic strategies that the firm can pursue to create and sustain a competitive advantage.

Value Creation

The firm creates value by performing a series of activities that Porter identified as the value chain. In addition to the firm's own value-creating activities, the firm operates in a value system of vertical activities including those of upstream suppliers and downstream channel members. To achieve a competitive advantage, the firm must perform one or more value creating activities in a way that creates more overall value than do competitors. Superior value is created through lower costs or superior benefits to the consumer (differentiation).

Recommended Reading
Porter, Michael E., Competitive Advantage: Creating and Sustaining Superior Performance In Competitive Advantage, Michael Porter analyzes the basis of competitive advantage and presents the value chain as a framework for diagnosing and enhancing it. This landmark work covers: The 10 major drivers of the firm's cost position Differentiation with the buyer's value chain in mind Buyer perception of value and signals of value How to defend against substitute products The role of technology in competitive advantage Competitive scope and its impact on competitive advantage Implications for offensive and defensive competitive strategy

Competitive Advantage makes these concepts concrete and actionable. It rightfully has earned its place in the business strategist's core collection of strategy books.