Why Switching Costs Are Good For Business

Through the economic moat series, we've so far covered strong brands, then the network effect, followed by government regulatory barriers, and most recently economies of scale.

We're now down to just 2 moat factors left.

In today's article, we will go over one of the more prevalent moats in the emerging digital economy: HIGH SWITCHING COSTS.

Easy To Get In, Not So Easy To Get Out

High switching costs - also less flatteringly called customer lock-in - has been a "holy grail" of business for quite some time.

To have high switching costs, the product or service has to be foundational to a consumer's way of life, or critical to business process for a company. It has to fulfill a basic requirement that would need to be replaced in some shape or form by a competing product or service.

The criticality of this need creates risk to changing suppliers. Changing accounting software for a business would require evaluating a new package, then porting all existing data into the new software, then spending time auditing the transitioned data, developing new processes and training employees on the new system, and finally going "live" with it. That's a lot of time, effort, and risk, to say nothing of the possibility of future bugs or lack of support from the new vendor. Companies are going to be very deliberate about changing suppliers. It will have to take substantial advantages to consider a change.

High switching costs are really accentuated by a recurring revenue business model. It's great to sell a product that is essential to a business or consumer... but if you only sell it once, or infrequently, it creates clear decision points where the customer can consider and prepare for switching. With recurring revenue, the product or service becomes just a "way of life", with customers simply paying up and rarely considering whether to switch or not.

Where To Find High Switching Costs

Almost invariably, you find high switching costs in service-based companies - particularly business services.

Business customers are better lock-in candidates than consumers for several reasons. For one, they are larger, with numerous decision makers, all of whom are trying not to look bad or get fired for making a bad, high-profile decision. Secondly, they require more critical services to operate. All businesses need systems for paying employees, managing inventory, tracking costs and sales, marketing, and a whole lot more. Modifying any of these creates risk to ongoing business.

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Disclaimer: The content is provided by Alexander Online Properties LLC (AOP LLC) for informational purposes only. The material should not be considered as investment advice or used as the basis ...

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Cynthia Decker 7 months ago Member's comment

Cell phone companies were the kings of this strategy. Always hated that.