Introduction

This article is a part of our business moats series intended to give readers a deeper grasp of various competitive advantages and highlight different analytical aspects of each moat. The first article was an introduction to economic moats that shared an outline of different kinds of Moats while the second article was based on network effects. In this third article, switching costs are going to be discussed as a potential source of long-term competitive advantage.

This article examines moats in which client retention is driven by barriers that prevent customers from moving from their current provider to a competitor. These moats are referred to as switching-cost moats. In this article, we’ll discuss various aspects of switching costs, its related ancillary factors, and how it can be useful for businesses.

The switching-cost moat: Definition

As the name implies, switching-cost moats are present when the customer incurs large fees when changing service providers. Switching costs are the monetary expenses experienced by a consumer when switching brands, goods, services, or suppliers. However, it is essential to recognise that these prices also include non-monetary expenses. There are also psychological, time-based, and effort-based expenses.

Consider a client who now spends 100 bucks per month on a postpaid mobile bill. The client discovers that another service provider offers an identical package for 85.00 bucks per month.

In the above scenario, the individual will save 15.00 bucks by switching mobile plans. However, there are a variety of expenses to consider, including:

• Time: Whether a considerable amount of time is required to switch phone plans (i.e., driving to the store or waiting for an available store representative)
• Experience: Whether the new phone plan would be superior to the current one (i.e., whether the new phone plan offers better city-wide signal coverage)
• Effort: Whether a person needs to take a substantial effort to change phone plans (i.e., whether a lot of paperwork must be completed)

Moats based on switching costs come clearly under the category of competitive advantages resulting from captive customers. The expenditures associated with switching providers are known as switching costs. The more switching expenses there are, the harder it will be to persuade clients to make the transition. Given that their value proposition now needs to offset the whole expenses of switching providers, switching charges raise the bar for competitors trying to win over clients.

How Does Switching Cost Work?

A switching cost may manifest as a significant amount of time and effort needed to shift to a new supplier, a risk that regular business operations will be disrupted during the transition, high cancellation charges, or the inability to find similar replacement goods or services.

Successful organisations typically employ strategies that place high switching costs on customers to deter them from switching to a competitor’s product, brand, or services.

For instance, high switching costs are profitable for both banks and DTH service providers. Pay a price for the dish and the set-top box when purchasing a dish from a DTH provider. If the same consumer decides to switch service providers, the customer needs to pay the installation costs again. This makes switching less appealing.

Due to how challenging it has become to switch banks, few customers would do so unless they had a compelling reason to. The client has to close his bank account, he needs to close related Internet banking solutions (mobile banking or net banking), cheque books, SIP mandate, etc. He will need to restart the KYC process, go through several paperwork, and follow all the previous instructions again in order to open a new bank account. As a result, switching has a high price in terms of the efforts involved.

Companies use a variety of tactics to raise the expenses associated with switching for customers. For instance:

• Charging a hefty cancellation fee when cancelling services
• Creating a drawn-out or challenging cancellation process

Switching-cost and sustainable competitive advantages

The switching costs that produce really dominating moats are not one-off expenses. Instead, it becomes a long, drawn-out process where the customer has to endure inconvenience for a lengthy period of time after transferring from its current provider. For instance, a business that plans to switch to a new cloud provider needs to spend a lot of time and cost to shift the entire data, check its sanity, retrain its workforce, address any new situations in the new provider, etc. For switching costs to create a long-term competitive advantage, two crucial factors must exist: customer captivity and pricing power. A detailed overview of both is shared here:

1. Customer Captivity: Customer captivity drives switching cost-driven moats. Customers are less likely to switch their service provider when switching costs are present, resulting in customer captivity. Several factors can contribute to one becoming captive, such as higher learning costs for the new product, business disruption, or significant inconvenience.
2. Pricing power: Pricing power is another crucial factor for the existence of switching cost-based competitive advantages. If the presence of switching costs does not confer price power on the firm, its competitive advantage will be minimal to nonexistent. The business’s capacity to charge a greater price enables it to produce above-average capital returns. The existence of pricing power enables the firm to pass on any cost inflation to its consumers in the form of a price hike, allowing it to sustain its extraordinary profitability across business cycles. Pricing power does not relate to an organisation’s limitless or unrestricted authority to raise prices at will. In fact, the price power of a switching cost moat is constrained by the magnitude of the customer’s switching costs, minus the switching advantages.

Types of Switching-cost

There are two kinds of switching costs: low-cost and high-cost switching. The price difference is mostly determined by the ease of transfer and the availability of comparable items from the competition. 

Companies with low switching costs generally provide products or services that are simple for rivals to reproduce at comparable pricing. Consumers may readily locate clothing offers and swiftly compare prices by strolling from store to store, resulting in relatively low switching costs for apparel companies. 

Companies whose goods are distinctive, have few alternatives and take substantial effort to master their usage have high switching costs. High switching costs are the goal of businesses when trying to “lock in” clients. The more clients a business has locked in, the more likely it is that it can pass on increased costs to them without running the danger of losing them to a rival.

Switching-cost and ancillary factors

Till now the fundamental components of switching costs are discussed. When organisations or startups try to create a switching cost moat, the business analyst should pay attention to extra aspects known as ancillary factors. With the help of ancillary factors, owners or entrepreneurs can figure out how they can tie customers with their platform for a longer time period. Some important ancillary factors are discussed below:

1. Retention rate: Customer captive is the most crucial aspect of such moats, as previously noted. Consequently, the analyst must pay close attention to the retention rate of such companies. It’s necessary to identify the reasons behind the numbers. For instance, if a company’s customer retention percentage is 90%, it does not necessarily suggest that 10% of its customers have transferred to competitors’ products/services. Identifying the why is essential to understanding this metric. 
2. Incremental market share: Consideration must be given to the business’s market share in relation to the additional volume of the industry. After constructing a moat, a corporation cannot afford to rest on its laurels. To ensure that the competitive advantage that the firm presently has will continue into the future, the business must consistently innovate and remain ahead of the competition.
3. Reduced switching hurdles: The analyst should identify different ways of improving the businesses’ existing offering in such a way that any non-user should find it easy to switch to the businesses’ solutions.
4. Longer life cycles: It is possible for a business to gain an edge over its competitors due to very long product life cycles and the inability to exit from the initial investment. It will create a substantial competitive edge if the supplier can generate significant aftermarket revenues.

Conclusion

When a business is able to embed itself in the client’s business operations in such a manner that it seems like a disincentive for the customer to switch, and when the firm is able to continuously increase the value realised by its customers, it develops substantial competitive advantages. Companies that make it tough for customers to switch to a competitor are in a position to increase prices year after year to deliver hefty profits. To get such an advantage, businesses should focus on ancillary elements that bolsters the value proposition of the firm and enables it to become a genuine moat, one that works to preserve and develop wealth for its stakeholders. Startups should consider the creation of a switching-cost moat to increase the profit share year by year by providing all important features related to the business.