By Gennaro Cuofano
Switching costs consist of the costs incurred by customers to change a product or service toward another similar product and service. In some cases, switching costs can be monetary (perhaps, improving a cheaper product), but in many other cases, those are based on the effort and perception that it takes to move from a brand to another.
Why switching costs matter
When launching a new product on the market, it’s critical to look at existing alternatives, as your solution might work, only if it is convenient (either in times of money, effort, or else) for existing customers.
Indeed, for customers to change brand, and use your product there will be an element of friction, defined as switching cost.
Switching costs go beyond price and money
Let’s imagine a simple example.
You use Google as a primary search engine, and Google Chrome as a browser. With Google and Chrome, you get a set of advantages and products (for instance, the Chrome extensions marketplace enables you to download any app to do anything within your browser).
Even if those serivces are free it’s still very hard to switch to any other search engien or browser, as the effort it takes to get used to a new combination of search engien, browser, extensions and so forth is too “expensive” psychologically to take the leap.
Building up moats
Companies that are able to create high switching costs (either through cost leadership, differentiation, or else) will also be able to create a competitive advantage.
A higher friction fro customers to change toward a new product or service might help the company to “lock them in.” Yet, this strategy to be successful it also needs to offer a great customer experience across the several products.
Thnk for instance the case of Microsoft Office that bundles up its products to create a lock-in experience for users to prevent them to switch (together with Office, customers also get other services that go from email to company’s chat like Microsoft Teams).
This closed environment might make it harder for users to switch to a new brand. Yet, the experience can be also frustrating and limiting if those products don’t work extremely well.
Monetary switching costs
A lower price can help as switching costs in those categories where products and services are more commoditized, therefore, the price will have a higher impact and importance on customers’ behaviors.
A lower price will also be more attractive. In those cases, building up switching costs become harder as the
Imagine the case of the gas station selling gasoline. If it is able to offer a lower price compared to the gas station half a mile away, consumers will prefer it, as it might not make much of a difference were to fuel the vehicle, if not the price.
Non-monetary switching costs
Other non-monetary switching costs can be classified in several ways. Some key switching costs require:
- Effort: it might take the time or mental energy to move from a product to another. Think of the case to change the software that costs less, and yet it’s more complicated to use, therefore requiring more time and effort to learn. The user might still stick with the other more expensive software if that perceived as more comfortable to use.
- Perception: other switching costs are more related to perception. Let’s take two cases:
- Branding and status quo: imagine you can buy a pair of shoes from a less known brand, which costs less. Who is passionate about shoes knows that those are fashion statements, not just things to cover your feet. Therefore, the more recognized brand or the brand that is more in line with the perception of the individual will be the preferred one, independently from price (or at least price is less critical).
- Branding and reliability: imagine the case of a person buying a laptop from a known brand vs. an unknown brand. At the same time, the unknown brand’s laptop might be cheaper, more performant, and overall better. The customer might not switch to it as she/he fears it won’t be reliable.
- Offering an alternative: think of the case of DuckDuckGo, a search engine prioritizing on privacy. Even if that might not be as good as Google, it will still be the preferred choice for those switching to it due to privacy. And those people will stick around.
Low vs. high switching costs
The inability to create high switching costs (either through pricing, better and simpler product, brand, or all these) might prevent the company to create a long-term competitive advantage.
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Switching costs are the costs associated with changing from one value provider to another and can be costs relating to learning, finding alternatives, compatibility costs, uncertainty costs, psychological costs, transaction costs, or contractual costs. It is a
control mechanism that exists in most markets and can be real or perceived costs such as frequent flyer programs, in which passengers don't want to lose credits earned in one program by switching to another.
Switching costs give the value provider market and pricing power, thus current adoption or market shares become important determinants of future success. Social networks such as Facebook and Twitter base their business models on future revenues generated from a large base of user and developers that won't switch to another social network due to real or perceived switching costs.
Understanding switching costs is a key component to create sustainable business models for both incumbent firms and start-ups trying to break into an existing market or build a new one. I will follow-up this post with identified strategies on how to use switching costs as a value provider and how to manage own switching costs in relation to external partners and suppliers.
Not limited to customers
The traditional way of looking at switching costs is between the value provider and paying customer but I believe the concept is valuable also in relation to other stakeholders. When companies develop strategies in relation to suppliers, government/regions, own employees, developer communities, companies providing complementary products and service etc. switching costs are an important factor to include. The economic downturn makes this kind of reasoning evident for many suppliers and governments.
Switching costs and network effects
In most cases switching costs go hand in hand with network externalities or network effects. If adoption by different value recipients is complementary so that each value recipient's adoption payoff, the incentive to adopt increases as more others adopt. Thus, the more users of a communication service such as Skype, the more valuable the service is to each user and the higher the switching cost to switch to another communication service bringing all users or friends.
Switching costs and standards
Almost everything is affected by standards, in relation to different forms of compatibility, interoperability, safety or quality. Standards can be both a solution to avoid high switching costs and a source of the same. Standards are most often developed to reduce switching costs in having several products or systems based on the same principles, technologies or formats.
When a company manage to get a dominant position for its technology, products or services, by tradition, enforcement, or market dominance, it is said to have a de facto standard. A classical example is Microsoft Office that is believed to have a perceived switching cost of over $1000 thus buyers are paying hundreds of dollars for Microsoft Office even when free alternatives exists. In the case of Microsoft Office almost all different forms of switching costs occur. What would be the alternative? Would this be compatible with everyone else that are using Microsoft Office? Can I transfer my templates? Would I learn fast enough to work in the same pace? Would I miss any functions or features? etc.
Switching costs and competitive pricing
Switching costs shift competition away from a single value recipient's needs in a single period to needs over time, thus the outlook of higher profits later provides a strong incentive to buy adoption today. Each value provider faces a trade-off between investing in adoption by charging a low price or give away something for free to attract new value recipients or on the other hand charging a higher price reflecting the value of what is being offered. When network effects exist the share of adopters makes a valuable asset, reflected in strategies such as penetration pricing. Examples of aggressive competition for market share before the customers have developed switching costs are banks providing free banking services to students, online poker sites offering cash bonuses when opening accounts or free access to proprietary databases with training material to schools to make students used to tools and available data.
Smaller actors often have a stronger incentive for price competition than larger ones as they can enlarge their customer base without hurting their revenues from their current customer base that is small. Larger actors on the other hand, have little incentives to cut prices because this hurts more with their current (larger) customer base.
Switching costs varies over time depending on the business model
The switching costs vary over time and depending on the business model it can either increase or decrease over time. If you sell a computer storage device the value of the device depreciates over time and the customer might chose another brand when it is time to replace it. If you sell online storage, the service will become increasingly valuable to the customer over time as it gets dependent on the increased amount of stored data and relating services such as back-up, mobile access or file sharing possibilities. With the increasingly popular concept of cloud software and platforms, that in some cases uses nonstandard APIs and proprietary technologies, some companies will probably find themselves facing high switching costs in the near future.
Switching costs and lock-in
When the value recipient is dependent on a single value provider or cannot move to another value provider without substantial costs or inconvenience, the value recipient is said to be locked in to the value provider. Lock-in is seldom absolute but when lock-ins is created by dominant companies and there are too high barriers to market entry, it may result in antitrust action.
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