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-based, and time-based switching costs.
- Switching costs are the costs a consumer pays as a result of switching brands or products.
- Switching costs can be monetary, psychological, effort-based, and time-based.
- Switching costs can be classified as high switching costs or low switching costs.
- Companies seek to employ high switching costs to prevent customers from moving to another brand.
- Companies with difficult-to-perfect products and low competition will use high switching costs to maximize profits.
- Some companies who are unable to charge higher dollar amounts for switching will ensure long wait times and product delays, keeping their consumer base via a strictly time-based switching cost.
How Switching Costs Work
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, or a failure to obtain similar replacements of products or services.
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 cell phone carriers to compensate consumers for cancellation fees nullified such switching costs.
Switching costs are the building blocks of competitive advantage and the 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.
Types of Switching Costs
Switching costs can be broken down into two categories: low- and high-cost switching. The price difference depends mostly on the ease of transfer, as well as the availability of similar products of the competitor.
Low Switching Cost
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 easily and can quickly compare prices by walking from one store to another. The rise of Internet retailers and fast shipping has made it even easier for consumers to shop for apparel at their homes across multiple online platforms.
High Switching Cost
Companies that create unique products that have few substitutes and require significant effort to perfect their use enjoy significant switching costs. Consider Intuit Inc. (INTU), 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.
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.
Common Switching Costs
There are a variety of specific switching costs that companies can use to deter their customers from jumping ship and going to a competitor. Common ones include the following:
Convenience: A company may have many locations of its stores or products, making it easy for customers to buy its goods. If a competitor has cheaper products but is further away and difficult to get to, customers may choose to stay with the higher cost product because of its convenience.
Emotional: Many companies continue doing business with their current suppliers, for example, just because the emotional cost of finding a new supplier, building a new relationship, and getting to know new individuals might be high.
It is similar to why a person may choose to stay in one job versus leaving for another that might pay a slightly higher salary. The individual knows their boss and their colleagues, and therefore the emotional cost of switching might be too high.
Exit Fees: Many companies charge exit fees for leaving. These fees are usually not necessary but a company tacks them on at the end just so a customer won't leave. A company can classify these fees as they so choose, including administrative fees for closing an account.
Time-Based: If it takes a long time to switch from one brand to another, customers often forego doing so. For example, if an individual has to wait a long time on the phone to speak to someone to close an account and on top of that they have to fill out paperwork to close the account, they may find that the time involved is not worth doing so.