Businesses operate within a larger environment that can impact them positively or negatively. This environment can be influenced by internal and external factors, including economic factors.
Today’s blog post will explore the economic factors affecting the business environment.
Economic factors are directly related to money and can significantly impact projects. These factors, called Enterprise Environmental Factors (EEF), include exchange rates, interest rates, inflation rates, tariffs, and more. To minimize deviations, businesses must regularly monitor these factors through trend analysis and budget planning.
Economic Factors Affecting a Business
The PESTEL analysis is useful for examining the external factors that impact a business. PESTEL stands for Political, Economic, Social, Technological, Environmental, and Legal. These factors can significantly impact a business’s survival, but they are beyond its control as they are external.
The second factor in the PESTEL analysis is economic. Economic factors focus on macroeconomic variables that can help assess the state of the market economy and the environmental conditions in which the business operates. These variables are crucial in determining whether a business can be profitable.
Examples of Economic Factors Affecting Business
The following are a few examples of economic factors affecting the business environment:
- Interest rate
- Inflation
- Recession
- Exchange rate
- Taxes
- Market forces
- Crude oil price
Interest rate
High-interest rates on bank loans can significantly impact businesses that need to fund their operations or expand. This can limit growth opportunities and hinder progress, creating challenges for the business.
While high-interest rates may encourage savings, they can also create undue pressure on borrowers who struggle to pay dividends, increasing their financial risk. This can be particularly challenging during periods of slow sales, causing stress for the business.
As a result, interest rates pose a significant financial risk to companies. To mitigate this risk, businesses may set aside a portion of their profits for recapitalization.
Inflation
Inflation can impact the purchasing power of money in two significant ways. First, when the inflation rate is high, the purchasing power of money decreases, making it challenging for customers to engage in business patronage. Additionally, businesses will spend more on inputs like labor, raw materials, machinery, energy, tools, and technology costs, which can affect the prices of goods and services offered.
As inflation rates rise, savings may no longer be an attractive investment option for businesses, and they may look at other avenues like real estate or business expansion. According to the monetary policy set by banks, lenders and financial institutions may also restrict loans during high inflation.
Industries like agriculture, construction, and mining, which require high labor costs, may face challenges in maintaining profitability, even with employees seeking higher income to maintain their standard of living.
Inflation typically impacts large establishments more than small businesses because they have more significant shock resistance and more variables to optimize for adjustment.
Example of Inflation for a four years mega construction project for a dockyard.
Cost of materials in 2003: 2.6 billion USD
Cost of materials in 2006: 2.9 billion USD
Change in material cost: 0.3 billion USD.
The material costs have increased by about 12%. When running the economic model and budgeting, it is important to make allowance for inflation for longer-duration projects. In construction projects spanning over three years, materials and consumables cost increase which, if not considered during the cost estimation stage, the project may have cost overrun.
Recession
A recession is characterized by a downward trend in the economy and investment, which can lead to a decline in productivity within a particular geographic location. Businesses not adequately prepared for a recession may have to cut jobs to stay afloat, while more resilient businesses will look for ways to innovate and create value.
One example of innovation during a recession is the response of some brewery companies during the Covid-19 pandemic. Instead of closing down or cutting jobs, some companies switched their production lines to hand sanitizer production, which helped to address the increased demand for this product.
Exchange Rate
The exchange rate refers to the price paid to convert one country’s currency to another. A change in the exchange rate can lead to increased expenditures for businesses that rely on imports and exports, affecting the prices of goods sold to consumers.
For international business firms, a rise in the exchange rate can also impact the value of goods or services rendered. In some cases, a hike in the exchange rate may result in a dollar scarcity, which can hamper business activities. This is one of the most significant economic factors that can impact businesses within the PESTEL model and may result in currency devaluation.
Taxes
The government has the authority to determine taxation, including income tax, value-added tax, company income tax, and other types of taxes. In certain circumstances, the government may offer tax incentives to businesses, such as in free trade zones, which can be beneficial.
During unfavorable economic conditions, the government may also reduce the tax burden to encourage business activities and boost the economy. Additionally, the government may offer tax exemptions to promote entrepreneurship for the first 3-5 years of a business’s operation.
Market Forces
Market forces are determined by the interplay between supply and demand, and their impact on a business depends on the market it operates in.
In a monopoly market, the business controls the prices of goods or services, which can directly impact its revenue. In contrast, in a monopolistic competition market with free entry and exit, market forces determine the prices of goods or services.
A new business entering a market for the first time may enjoy a temporary monopoly, which can help it grow its customer base and improve its bottom line. However, as new entrants enter the market, the market share becomes divided, and the business may no longer have the same level of control over prices.
Crude Oil Price
This issue primarily pertains to the oil and gas industries. In the upstream sector (i.e., exploration and production), a rise in crude oil prices can result in significant profits for businesses as they earn more per barrel, increasing their revenue.
However, a rise in crude oil prices can be challenging for refineries, as they must spend more to purchase crude oil, which can eat into their profit margins. This is because they may be unable to increase their refined products’ prices due to government regulations influencing petroleum prices. As a result, this can lower their profit margins.
Overall, crude oil prices are a significant external economic factor for the oil and gas industry, as they are beyond the control of individual businesses.
Conclusion
External economic factors can significantly impact a business’s profit and loss, and these factors are outside the control of the business. They are imposed by the economy in which the business operates and may include interest rates, exchange rates, inflation, and other similar factors.
By closely monitoring trends and gaining insights into these factors, businesses can take advantage of opportunities and mitigate threatening economic conditions better. This can help businesses adapt and adjust their operations to navigate economic challenges better and continue to grow and succeed over time.