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What are 'Switching Costs'

Switching costs are the costs that a consumer incurs as a result of changing brands, suppliers or products. Although most prevalent switching costs are monetary in nature, there are also psychological, effort- and time-based switching costs. A switching cost can manifest itself in the form of significant time and effort necessary to change suppliers, the risk of disrupting normal operations of a business during a transition period, high cancellation fees, and a failure to obtain similar replacement of products or services.

BREAKING DOWN 'Switching Costs'

Successful companies typically try to employ strategies that incur high switching costs on the part of consumers to dissuade them from switching to a competitor's product, brand or services. For example, many cellular phone carriers charge very high cancellation fees for canceling contracts in hopes that the costs involved with switching to another carrier will be high enough to prevent their customers from doing so. However, recent offers by numerous cellphone carriers to compensate consumers for cancellation fees nullified such switching costs.

Switching costs are the building blocks of competitive advantage and pricing power of companies. Firms strive to make switching costs as high as possible for their customers, which lets them lock customers in their products and raise prices every year without worrying that their customers will find better alternatives with similar characteristics or at similar price points.

Example of Low Switching Costs

Companies that offer products or services that are very easy to replicate at comparable prices by competitors typically have low switching costs. Apparel firms have very limited switching costs among consumers, who can find clothing deals and easily compare prices by walking from one store to another. The rise of Internet retailers and fast shipping made it even more easier for consumers to shop for apparel at their homes across multiple online platforms.

Example of High Switching Costs

Companies that create unique products that have few substitutes and require significant effort to master their use enjoy significant switching costs. Consider Intuit Inc., which offers its customers various bookkeeping software solutions. Because learning to use Intuit's applications takes significant time, effort and training costs, few users are willing to switch away from Intuit. Also, many of Intuit's applications are interconnected, which provides additional functionalities and benefits to users, and few companies match the scale and usefulness of Intuit's products. Small businesses, which are the primary buyers of Intuit's bookkeeping products, can incur disruption in their operations and risk incurring financial error if they decide to move away from Intuit's software. These factors create high switching costs and stickiness of Intuit's products, allowing the company to charge premium prices on its products.

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