Switching costs are the real and perceived costs a customer incurs when changing from one supplier to another. They are the “go to” competitive advantage for digital businesses.

In the digital world, network effects are the coveted moat everyone (especially venture capitalists) dreams about. But they are actually very rare. And only available to the market leader.

In contrast, switching costs are a far more readily achievable form of customer capture. And they are non-exclusive. Many businesses in the same industry can capture the loyalty and pricing power that switching costs can provide.

However, switching costs are often misunderstood, leading to flawed strategies and missed opportunities. This article details five common misconceptions about switching costs.

But first, one key point to keep in mind.

Switching costs are all about repeat purchases.

If there are no repeat purchases, then switching costs do not exist.

I draw a “bright red line” between the initial purchase and subsequent purchases when thinking about switching costs. The pricing you do on the first purchase can be dramatically different. So is the marketing spend. And you really want to think about the lifetime value of a customer when thinking about the initial purchase.

After you get the customer locked up (to some degree), you then think about subsequent purchases. Which can have different pricing. And different marketing.

But if you don’t have repeat purchases, you don’t have switching costs. And low frequency purchases make switching costs much more difficult as well.

Ok. Back to the misconceptions.

Misconception 1: B2C Subscription Models Are About Switching Costs

B2C businesses love subscription business models. We see them everywhere. Netflix and so on. And they are talked about all in the time in business strategy. Recurring revenue plus switching costs!

But this is usually not true in B2C.

While consumer-facing switching costs certainly exist – think of the effort involved in transferring years of photos from one cloud storage to another or of rebuilding a curated music library on a new streaming platform – switching costs are mostly business-to-business (B2B). In the B2B world, switching costs can be deeply embedded in operational and technical integrations.

Consider Enterprise Resource Planning (ERP) systems. Implementing a new ERP system is a major decision involving significant upfront financial investment, extensive integration with existing IT infrastructure, customized functions and applications, and substantial staff training.

The cost of switching to a competitor’s ERP system involves not only the direct financial outlay for the new software but also the indirect costs of data migration, business disruption, and retraining employees on a new system. Plus, there is the risk of errors or loss of productivity during the transition.

Big switching costs like this are mostly on the B2B side.

Additionally, marketplaces and audience builder platforms often cultivate switching costs on the producer sides. Merchants and content creators invest considerable time, activity, and capital as participants in these platforms. And they usually become dependent on the platform for their customers, operations, and data.

For instance, a content creator who has spent years building an audience on a platform like YouTube is less likely to switch to a new, smaller platform due to the lost reach and the effort required to rebuild their following. Although they can multi-home pretty easily. Similarly, merchants integrated into a platform like Alibaba through their digital tools and operational systems face high procedural switching costs.

Even within the service industry, switching costs can be significant for merchants and suppliers. Consider the relationship between a small company and its accountant. While the direct financial cost of switching might be manageable, the time and effort required to onboard a new accountant who is unfamiliar with the business’s history and financial intricacies, coupled with the potential risk of errors, creates a significant switching cost. This is why service businesses often love switching costs.

Therefore, it is crucial to recognize that switching costs are not limited to end consumers but are a pervasive phenomenon across various user groups. And are particularly potent in B2B relationships and on multi-sided digital platforms.

Misconception 2: Switching Costs Are Primarily Financial

Direct financial costs are a tangible and easily calculable form of switching cost. You can actually calculate the cost to a customer to switch. Buying the new system, installing it, etc. And therefore, you can estimate how much you can increase prices without losing that customer.

Such direct financial costs are usually from contractual commitments, durable purchases, and specialized supplier costs. This is a good way to look at switching costs. You can get a nice clean number.

However, this overlooks the significant role of non-financial factors in customer lock-in. Such as:

• Procedural switching costs. These indirect costs are from the effort and disruption involved in learning a new product or service. And from retraining staff, adapting existing workflows, and handling the complexities of operational and digital integration. The more integrated a product or service becomes into a company’s operations, the higher the procedural switching costs. For example, a company heavily reliant on customized software faces big procedural hurdles in switching to a new, potentially less tailored solution.
• Time costs and hassle factors. The inconvenience of migrating data, setting up new accounts, and learning new interfaces can deter customers from switching. Even if the potential financial savings are significant. Data migration is a big category of switching costs. A less digital example is the annoyance of changing storage facilities. Personal storage facilities love to attract new customers with 3-month promotional rates. And then raise rates late. Because customers don’t like moving all their stuff to a different facility. The physical effort of moving stored items is a substantial hassle-based switching cost.
• Uncertainty and real or perceived risks. This is important. Customers may be hesitant to switch to an unfamiliar supplier due to concerns about the quality of the product or service, the reliability of the new provider, and the potential for unforeseen problems. Uncertainty and risk, even if it is more perceived than real, can be a powerful switching cost. In critical B2B purchases, such as medical devices or automotive parts, the perceived risk of using a cheaper, untested alternative and the potential impact of failure (recalls, reputational damage, even loss of life) can create extremely high switching costs, often outweighing potential cost savings. As Warren Buffett famously said, “nobody argues price with their heart surgeon”. This highlights the power of uncertainty and risk (real and perceived) as a switching cost.
• Relational switching costs. This is about losing personal connections, established relationships, and personal bonds with current suppliers. These can also play a role, particularly in long-term supplier relationships.

Misconception 3: Consumers Will Tolerate Hard Switching Costs

While switching costs are a degree of customer captivity, it is a wrong to believe that consumers will passively accept high hurdles to switching without complaint or consequence. If consumers perceive that a business is unfairly exploiting their lock-in by excessively raising prices or reducing service quality, they may actively seek alternatives, even if it requires effort.

This is the problem with many switching costs. They are contrary to the best interests of consumers.

Consumers increasingly desire endless options and the freedom to shop around. They want convenience. Increased convenience is a common approach to lots of digital goods. But switching costs are, by definition, inconvenient.

That conflict is a problem. Switching costs are a pain point for consumers. And they can be a point of attack for rivals and new entrants.

So, consumer-facing switching costs need to be implemented subtly and with a focus on providing value that justifies the inertia. You don’t want to make it hard to cancel. You want to provide valuable services like loyalty programs, accumulated benefits, and a sense of community. These are a softer, more palatable forms of switching costs for consumers.

For instance, airlines and coffee houses offer miles and points, incentivizing repeat business without creating insurmountable barriers to leaving. And the holy grail for retention for consumers is the creation of a community, where the switching cost involves losing an identity, a group, and a sense of belonging.

Netflix is a prime example of a digital company that, despite operating on a subscription model, has chosen not to go for switching costs. It super-easy to pause or cancel the subscription at any time without cost. While Netflix could easily implement stricter cancellation policies, they are positioned as a highly convenient service. They are betting that the future of B2C is convenience.

In contrast, future of B2B looks like it involves strong switching costs. The increasing operational and technical integration inherent in many B2B relationships is creating stickier and stickier customer relationships.

Therefore, while businesses can and do build switching costs for consumers, there is a limit to how much inconvenience or perceived exploitation consumers will tolerate. Excessively high or unfair switching costs can lead to customer dissatisfaction and a determined search for alternatives, ultimately undermining the intended benefits of lock-in.

Misconception 4: Any Business Can and Should Build Switching Costs

While switching costs are “non-exclusive” competitive advantages, meaning multiple companies can have them, it is a misconception to believe that all companies can implement strong and effective switching costs. It’s all over the map in practice. The ability to build substantial switching costs depends heavily on the nature of the product or service, the business model, and the specific user group being targeted.

For commodity-like services where differentiation is low and user needs are primarily focused on price and convenience, building strong switching costs can be difficult on the consumer side. An example is ride-sharing platforms like Didi and Uber, where riders are price-sensitive and prioritize short wait times. In such cases, building strong switching costs with riders is difficult due to the ease of “multi-homing” – using multiple apps simultaneously to find the best available option. However, Didi has successfully built switching costs on the driver side. They have an entire suite of services they offer (such as financing, insurance, and government services) that create stickiness for their top drivers.

In contrast, businesses offering complex software solutions, highly integrated B2B services, or platforms that require significant user investment in terms of data, content, or relationships. These businesses have a greater ability to build strong switching costs.

Basically, it’s a big messy picture. You can find effective switching costs in lots of strange places. And you can see that they don’t work at in many others. You have to take it apart business by business.

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Ok. That’s it for today.

Cheers, jeff

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• 3 Factors Will Determine the Future of Verisign Inc. (Tech Strategy – Podcast 191)

From the Concept Library, concepts for this article are:

• Switching Costs

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Photo by niu niu on Unsplash

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I write, speak and consult about how to win (and not lose) in digital strategy and transformation.

I am the founder of TechMoat Consulting, a boutique consulting firm that helps retailers, brands, and technology companies exploit digital change to grow faster, innovate better and build digital moats. Get in touch here.

My book series Moats and Marathons is one-of-a-kind framework for building and measuring competitive advantages in digital businesses.

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