nderstanding Switching Costs: Types and Industry Examples

What Are Switching Costs?

Switching costs are the prices paid by a consumer to change brands, suppliers, or products. They are typically kept high, creating a barrier for consumers to switch and allowing companies to keep a loyal customer base and enhance pricing power over their rivals.

Switching costs can be monetary, psychological, effort-based, or time-based. They help companies gain a competitive advantage and more control over pricing—for example, raising prices without losing customers to competition.

Examples of high switching costs are a cellphone carrier charging high cancellation fees to discourage switching to another carrier, and the effort, time, and training costs in learning to use Intuit’s bookkeeping software solutions, which make users reluctant to switch. An example of low switching costs is in apparel, as consumers can go from store to store or online to compare prices and find clothing deals.

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 use strategies to create high switching costs, making it hard for customers to switch to competitors.

For example, many cellphone carriers charge high cancellation fees to discourage switching to another carrier. However, offers by cellphone carriers may compensate consumers for cancellation fees, nullifying such switching costs.

Switching costs help companies gain a competitive edge and more control over pricing. Companies aim to keep switching costs high to retain customers and raise prices without losing them to similar alternatives.

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.

Characteristics of Low Switching Costs

Companies with products or services that are easy to replicate at similar prices usually have low switching costs. Apparel firms face low switching costs because consumers can easily find clothing deals and compare prices by walking between stores. With online retailers and fast shipping, shopping for clothes from home has become easier.

Characteristics of High Switching Costs

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 Business 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 vs. 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 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 has to fill out paperwork to close the account, they may find that the time involved is not worth doing so.

The Bottom Line

Switching costs are the expenses a consumer faces when changing brands, suppliers, or products. These costs can be monetary, psychological, effort-based, or time-based.

Firms often cultivate high switching costs to retain customers, maintain pricing power, and secure a competitive advantage.

Companies with easily replicated products or services at similar prices, such as apparel, usually have low switching costs. Companies with one-of-a-kind products that take quite an effort to master their use and have few substitutes, such as Intuit, have high switching costs.

Assess and consider switching costs before flipping between products or services. While companies use high switching costs to dissuade customers from leaving, consumers should educate themselves on potential offers or incentives from competitors that may offset these costs.