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Switching Costs

Guide to Understanding Switching Costs

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Switching Costs

Switching Costs in Business Strategy

With high switching costs, customers are inclined to be “locked-in” given the incentive to continue working with their current provider.

Switching costs are the costs that arise from changing from one provider to another. The higher the switching costs, the greater the challenge of successfully convincing customers to proceed with the switch.

Companies with high switching costs are more likely to see high customer retention – i.e. reduced churn rates over time – as the bar for customers to move is set higher.

Switching costs raise the bar for competitors to grab customers, as their value proposition must now outweigh the total costs of moving to a different provider.

Consistent market leadership is a byproduct of high customer retention and establishing a competitive advantage that thwarts margin erosion.

Economics of Switching Costs

Switching costs cause demand to become more inelastic, so customers are less sensitive to changing prices on competing products/services.

Right from the start, new entrants are placed in an unfavorable position where competition is not based solely on price – but rather companies must offer substantially differentiated value propositions to grab market share from incumbents.

Companies eventually turn a profit to continue operating for the long term at the end of the day, so there is a threshold at which cutting prices does not make sense economically.

Therefore, companies should strategize methods to create and capitalize on making the process of churning more inconvenient (and costly), so customers become reluctant to move to a different competitor once acquired.

The end-user type is a major determining factor of how influential switching costs can be.

  • Business-to-Business (B2B): B2B companies can derive more benefits from switching costs due to greater incentives of their customer base to stick with their current providers/suppliers.
  • Business-to-Consumer (B2C): B2C companies typically get fewer benefits because consumers incur relatively less switching costs, especially for individual orders of cheap products.

Types of Switching Costs

Switching costs can be placed into three distinct categories.

  1. Financial Switching Costs: The quantifiable monetary losses where cost-benefit analyses must be performed to determine if the switch is worth the costs.
  2. Procedural Switching Costs: The losses stemming from evaluating potential alternative offerings, set-up costs, and learning/training fees.
  3. Relational Switching Costs: The losses from ending long-term business relationships, as well as giving up loyalty perks and incentives for long-term customers (i.e. “burning the bridge”).

Financial Switching Costs

Examples Definition
Contractual Commitment
  • Moving to a different provider could trigger a provision in an agreed-upon multi-year contract, where conditional fees must be paid as part of the terms.
Fee Penalties
  • Customers can be charged fees for certain actions (e.g. a corporate issuer refinancing bonds and prepayment fees for early redemption, investment banks and client break-up fees).
Operational Disruption
  • Switching providers could slow down productivity and revenue generation throughout the transition (i.e. reduced employee output and quality).

Procedural Switching Costs

Examples Definition
Search Time
  • Customers must spend time searching for an alternative, which can include calling sales reps, receiving live demos, and comparing offerings.
Learning Curve
  • Changing providers could require setting apart dedicated time for onboarding and training on using a certain product/service, which can be time-consuming – plus, “starting over” can be discouraging.
Set-Up Costs
  • Changing service providers can require an initial, upfront expenditure on equipment or set-up costs from product specialists.
Opportunity Cost of Time
  • Customers could regret their decision to leave and end up returning to the original provider (i.e. resulting in lost time and/or money).

Relational Switching Costs

Examples Definition
Loyalty Perks
  • Once a customer has left, any built-up goodwill has been tarnished, causing the customer to miss out on loyalty rewards (e.g. airline points) and incentives for long-term customers.
Specialization
  • For technical products such as companies ordering specialized components from suppliers, customized and streamlined processes are forfeited.
Product Compatibility
  • Switching or mixing providers could reduce capabilities and compatibility, as seen with complementary products (e.g. the Apple Ecosystem).
Data Migration
  • Apps such as G-Suite and the iOS App Store collect user data that is exclusively hosted on proprietary platforms and migrating the data is typically not permitted (or full of issues).

Switching Barriers & Threat of New Entrants

If the switching costs outweigh the benefits offered, the odds of customers churning favor the existing provider.

Switching costs are oftentimes used interchangeably with the term “switching barriers,” as they can deter new entrants from entering the market.

The concept of switching costs is practically akin to building a loyal customer base with recurring purchases and minimal churn.

Unless the new entrant offers a substantially better value proposition with greater technical capabilities, switching costs can function as a barrier to entry.

High switching costs cause customers to be hesitant to move providers, which in turn makes obtaining market share more difficult for new entrants.

By raising the hurdle for customers to change between providers, switching costs can potentially create an economic moat, i.e. a long-term competitive advantage that can protect a company’s profit margins from competition and external threats.

Switching Cost Industry Example – Competition Analysis

One example of an industry benefiting from switching costs is self-storage facilities, where customers usually place their items, such as unused furniture, for long durations.

Suppose a new self-storage facility opened up with the plan of undercutting nearby competitors. The strategy could still fall short in convincing customers to switch.

Why? The price offered by the new entrant must not just be lower than existing market pricing rates but also account for the monetary cost of moving (e.g. the rental equipment, moving trucks).

The pricing must also provide benefits that outweigh the loss of time, so the inconvenience and physical hassle are all worth it.

Hence, self-storage facilities are well-known for exhibiting consistent non-cyclical cash flows and low churn rates, even during market downturns.

High Switching Costs – Apple Ecosystem Example

One publicly-traded company with high switching costs is Apple (NASDAQ: APPL), or to be specific, its line of products which are collectively referred to as the “Apple Ecosystem.”

Apple’s interconnected product offerings are specifically designed to complement one another, i.e. the more Apple products owned → the more benefits customers receive.

iOS users who bought a product such as the iPhone are unlikely to stop at only one Apple gadget.

Each product/service adds yet another layer of benefits – further strengthening the positive effects stemming from switching costs.

If an iPhone user were in the market to purchase earbuds, you could reasonably bet that the majority bought AirPods.

For customers that use an iPhone, MacBook, AirPods, iPad, Apple Watch, and so on, the sync capabilities and features are seamlessly integrated for the smoothest, most optimal user experience, which is precisely what Apple is aiming for.

Apple Ecosystem – Switching Costs Example

Apple Ecosystem (Source: Apple Store)

However, for those that mix Apple and Windows products, the lack of compatibility with certain apps such as iMessage, Apple Calendar app, Notes app, or Mail app can create a frustrating user experience.

Other anecdotes include iCloud’s sub-par sync functionalities for Windows users and how the Safari browser was discontinued on Windows.

The implicit suggestion here is that consumers desiring the absolute best user experience should simply stick to using Apple products.

Considering Apple was the first publicly traded company in the U.S. with a market capitalization of over $1 trillion, leveraging its own ecosystem has clearly paid off – Not to mention the “cult-like” following from Apple’s loyal customer base and its market-leading positions in not one but multiple industries with large total addressable markets (TAMs).

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