Switching costs: The impact of locking in customers

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Switching costs are the ‘costs’ incurred by customers in moving between suppliers. Such costs can including both monetary factors involved in changing suppliers, such as termination fees, as well as other difficulties in changing suppliers, such as the disruption associated with changing suppliers.

Switching costs essentially lock customers into a particular supplier, increasing the difficulty to change suppliers. This article explores the impact of switching costs and the various barriers to changing suppliers.

The impact of switching costs

Retains a user base

Possibly the most direct impact of switching costs is that it locks in a firm’s customer base. If there are specific reasons why customers are tied in to a particular provider, then the churn of a firm’s customer base is likely to be low.

Allows elevated prices to be charged

Making it difficult for customers to switch to a competing firm can also allow higher prices to be charged. If it is easy to switch, customers can easily move to the firm that offers the lowest price – if a cell phone plan is a few dollars a month cheaper at a competitor, you can easily move. If on the other hand there are high costs associated with moving – termination fees, or simply the difficulty in porting your number over, you are in some ways locked into your existing plan. This can allow companies to charge higher prices – gradually increasing the prices in the knowledge that you are a captive audience, unlikely to move to a different company despite higher prices, due to the difficulty associated with moving firm.

Acts as a barrier to entry

A slightly more subtle effect of high switching costs is the difficulty it can pose new firms in entering the market. High switching costs can also act as a barrier to entry, making it difficult for new firms to be able to attract customers from existing firms. As such, not only do high switching costs allow firms to directly charge higher prices, but their margins can be further protected by impeding the ability for new companies to enter the market.  

Monetary switching costs

Termination payments and long-term contracts

It is not uncommon for contracts to have a minimum commitment – requiring a termination fee to be paid before the contract can be ended. If you have a cell phone contract, for example, you may be tied into a two-year term, with a termination fee required should you want to change who your service is provided by.

Such termination fees are one of the most direct examples of switching costs – these termination fees make it more costly to change suppliers (in turn discouraging customers from changing their suppliers). 

Capital outlays to change supplier

Another financial tie-in is costs that must be re-incurred if you were to move suppliers. For example, if you have purchased a PS5, to move over to the Xbox Series X (for example, if a game you wanted was cheaper) you will need to pay another $500 for the competing console. As a consumer you are essentially locked in with the console that you currently have – moving to the alternative platform would require you to make a large purchase.

Other forms of switching costs

Beyond directly financial reasons for getting locked-in are the non-financial ‘costs’ that make it difficult to move to a different supplier.

Learning requirement

A key indirect cost why customers don’t move between competing products is the learning that is required to re-train to use a different product.  If we take Microsoft Windows as an example – while it would be possible for firms to move to a competing operating system such as Mac or Linux, doing so would require substantial effort to retrain employees on a different system.

Some specific examples of learning costs include:

  • Time to retrain: The time that it takes to retrain a workforce can be a significant factor when considering transitioning a large number of workers from one platform to another.
  • Downtime and disruption: The learning difficulty is likely to extend beyond the direct time involved in training employees to switch from one system to another. Productivity may be lower on a new system, and mistakes may be greater.
  • Annoyance: Finally, having to re-learn to use a different system be uncomfortable. It is annoying not knowing how to do something that you used to be able to perform. As such, while most individuals could move between say an iPhone and Android, the frustration that having to learn how to use a new system entails means that some users will opt against considering the alternative.

Loyalty

Loyalty can act as a kind of switching cost – if customers have a strong loyalty to a particular brand or firm, they may be reluctant to move to a different supplier. 

Customer loyalty can come from many sources – past experiences, the brand, or relationships established with employees at the supplying firm. The more psychological reasons that individuals have to a particular firm, the less likely they are to switch. 

Time required to establish a new supplier relationship

Supplier relationships can take a long time to establish – it can be time-consuming to establish what a company’s requirements are, develop the contract, and get a new product supplied. The more customized the product is, the likely more time-consuming and difficult it is to move to a different supplier. 

Integrations with your supply chain

Sometimes switching costs can arise because a particular company has been integrated into a company’s operations. Ordering systems may be integrated, with materials automatically ordered from suppliers. The greater the integrations between companies, the more difficult it is to move to a different supplier. 

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Examples of switching costs

This article explores some of the most common forms of switching costs – from termination fees to effort to relearn a new system.