Switching Costs And Why They Matter In Business

Switching costs consist of the costs incurred by customers to change a product or service toward another similar product and service. In some cases, switching costs can be monetary (perhaps, improving a cheaper product), but in many other cases, those are based on the effort and perception that it takes to move from a brand to another.

Why switching costs matter

When launching a new product on the market, it’s critical to look at existing alternatives, as your solution might work, only if it is convenient (either in times of money, effort, or else) for existing customers.

Indeed, for customers to change brand, and use your product there will be an element of friction, defined as switching cost.

Switching costs go beyond price and money

Let’s imagine a simple example.

You use Google as a primary search engine, and Google Chrome as a browser. With Google and Chrome, you get a set of advantages and products (for instance, the Chrome extensions marketplace enables you to download any app to do anything within your browser).

Even if those serivces are free it’s still very hard to switch to any other search engien or browser, as the effort it takes to get used to a new combination of search engien, browser, extensions and so forth is too “expensive” psychologically to take the leap.

Building up moats

Companies that are able to create high switching costs (either through cost leadership, differentiation, or else) will also be able to create a competitive advantage.

A higher friction fro customers to change toward a new product or service might help the company to “lock them in.” Yet, this strategy to be successful it also needs to offer a great customer experience across the several products.

Thnk for instance the case of Microsoft Office that bundles up its products to create a lock-in experience for users to prevent them to switch (together with Office, customers also get other services that go from email to company’s chat like Microsoft Teams).

This closed environment might make it harder for users to switch to a new brand. Yet, the experience can be also frustrating and limiting if those products don’t work extremely well.

Monetary switching costs

A lower price can help as switching costs in those categories where products and services are more commoditized, therefore, the price will have a higher impact and importance on customers’ behaviors.

A lower price will also be more attractive. In those cases, building up switching costs become harder as the

Imagine the case of the gas station selling gasoline. If it is able to offer a lower price compared to the gas station half a mile away, consumers will prefer it, as it might not make much of a difference were to fuel the vehicle, if not the price.

Non-monetary switching costs

Other non-monetary switching costs can be classified in several ways. Some key switching costs require:

  • Effort: it might take the time or mental energy to move from a product to another. Think of the case to change the software that costs less, and yet it’s more complicated to use, therefore requiring more time and effort to learn. The user might still stick with the other more expensive software if that perceived as more comfortable to use.
  • Perception: other switching costs are more related to perception. Let’s take two cases:
    • Branding and status quo: imagine you can buy a pair of shoes from a less known brand, which costs less. Who is passionate about shoes knows that those are fashion statements, not just things to cover your feet. Therefore, the more recognized brand or the brand that is more in line with the perception of the individual will be the preferred one, independently from price (or at least price is less critical).
    • Branding and reliability: imagine the case of a person buying a laptop from a known brand vs. an unknown brand. At the same time, the unknown brand’s laptop might be cheaper, more performant, and overall better. The customer might not switch to it as she/he fears it won’t be reliable.
    • Offering an alternative: think of the case of DuckDuckGo, a search engine prioritizing on privacy. Even if that might not be as good as Google, it will still be the preferred choice for those switching to it due to privacy. And those people will stick around.

Low vs. high switching costs

The inability to create high switching costs (either through pricing, better and simpler product, brand, or all these) might prevent the company to create a long-term competitive advantage.

Key Highlights

  • Understanding Switching Costs:
    • Switching costs refer to the barriers that customers face when they consider changing from one brand or product to another.
    • These costs can be monetary or non-monetary and involve factors beyond just the price.
  • Importance of Switching Costs:
    • When introducing a new product, it’s crucial to consider existing alternatives and how convenient it is for customers to switch.
    • Switching costs create friction and make it less likely for customers to switch to a new brand.
  • Non-Monetary Switching Costs:
    • Non-monetary switching costs include effort and perception-based factors.
    • Effort: Customers might hesitate to switch to a product that requires more time and energy to learn and adapt to.
    • Perception: Branding, status quo, and reliability influence customers’ decisions.
    • Branding and Status Quo: Recognizable and well-regarded brands can have an advantage even if their products cost more.
    • Branding and Reliability: Customers might stick to a known brand due to concerns about the reliability of alternatives.
  • Creating High Switching Costs:
    • Companies that successfully create high switching costs can build competitive advantages.
    • High switching costs can be achieved through cost leadership, differentiation, or other means.
    • An example is Microsoft Office, which offers a suite of interconnected products, creating a lock-in experience for users.
  • Low vs. High Switching Costs:
    • The inability to establish high switching costs might hinder a company’s ability to maintain a long-term competitive advantage.
    • In certain cases where products are commoditized, a lower price can influence customer behavior.
  • Examples of Switching Costs:
    • Example of Effort: Changing to software that is cheaper but more complex to use might deter customers from switching.
    • Example of Perception: Customers might choose a more recognized brand or a brand that aligns with their perception, regardless of price.
    • Example of Reliability: Even if a lesser-known brand offers better features, customers might stick to a familiar brand due to reliability concerns.
    • Example of Offering an Alternative: DuckDuckGo, a search engine prioritizing privacy, can attract users who value privacy even if it’s not as feature-rich as competitors.
  • Creating Competitive Advantage:
    • Building high switching costs is a way to create a competitive advantage.
    • However, the experience across products must be excellent for this strategy to be successful.

FourWeekMBA Toolbox

FourWeekMBA Squared Triangle Business Model

This framework has been thought for any type of business model, be it digital or not. It’s a framework to start mind mapping the key components of your business or how it might look as it grows. Here, as usual, what matters is not the framework itself (let’s prevent to fall trap of the Maslow’s Hammer), what matters is to have a framework that enables you to hold the key components of your business in your mind, and execute fast to prevent running the business on too many untested assumptions, especially about what customers really want. Any framework that helps us test fast, it’s welcomed in our business strategy.

An effective business model has to focus on two dimensions: the people dimension and the financial dimension. The people dimension will allow you to build a product or service that is 10X better than existing ones and a solid brand. The financial dimension will help you develop proper distribution channels by identifying the people that are willing to pay for your product or service and make it financially sustainable in the long run.

FourWeekMBA VTDF Framework For Tech Business Models

This framework is well suited for all these cases where technology plays a key role in enhancing the value proposition for the users and customers. In short, when the company you’re building, analyzing, or looking at is a tech or platform business model, the template below is perfect for the job.

A tech business model is made of four main components: value model (value propositions, mission, vision), technological model (R&D management), distribution model (sales and marketing organizational structure), and financial model (revenue modeling, cost structure, profitability and cash generation/management). Those elements coming together can serve as the basis to build a solid tech business model.
Business Model Template - FourWeekMBA

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FourWeekMBA VBDE Framework For Blockchain Business Models

This framework is well suited to analyze and understand blockchain-based business models. Here, the underlying blockchain protocol, and the token economics behind it play a key role in aligning incentives and also in creating disincentives for the community of developers, individual contributors, entrepreneurs, and investors that enable the whole business model. The blockchain-based model is similar to a platform-based business model, but with an important twist, decentralization should be the key element enabling both decision-making and how incentives are distributed across the network.

A Blockchain Business Model according to the FourWeekMBA framework is made of four main components: Value Model (Core Philosophy, Core Values and Value Propositions for the key stakeholders), Blockchain Model (Protocol Rules, Network Shape and Applications Layer/Ecosystem), Distribution Model (the key channels amplifying the protocol and its communities), and the Economic Model (the dynamics/incentives through which protocol players make money). Those elements coming together can serve as the basis to build and analyze a solid Blockchain Business Model.
VBDE Blockchain Business Model Template

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Connected Business Concepts

AARRR Funnel

Venture capitalist, Dave McClure, coined the acronym AARRR which is a simplified model that enables us to understand what metrics and channels to look at, at each stage for the users’ path toward becoming customers and referrers of a brand.

North Star Metric

A north star metric (NSM) is any metric a company focuses on to achieve growth. A north star metric is usually a key component of an effective growth hacking strategy, as it simplifies the whole strategy, making it simpler to execute at high speed. Usually, when picking up a North Start Metric, it’s critical to avoid vanity metrics (those who do not really impact the business) and instead find a metric that really matters for the business growth.

Profit Margin

The profit margin is a profitability financial ratio, given by the net income divided by the net sales, and multiplied by a hundred. That is expressed as a percentage. That is a key profitability measure as combined with other financial metrics, it helps assess the overall viability of a business model.

Balance Sheet

The purpose of the balance sheet is to report how the resources to run the operations of the business were acquired. The Balance Sheet helps to assess the financial risk of a business and the simplest way to describe it is given by the accounting equation (assets = liability + equity).

Business Analysis

Business analysis is a research discipline that helps drive change within an organization by identifying the key elements and processes that drive value. Business analysis can also be used in Identifying new business opportunities or how to take advantage of existing business opportunities to grow your business in the marketplace.

Cash Flows

The cash flow statement is the third main financial statement, together with the income statement and the balance sheet. It helps to assess the liquidity of an organization by showing the cash balances coming from operations, investing, and financing. The cash flow statement can be prepared with two separate methods: direct and indirect.

Comparable Analysis

A comparable company analysis is a process that enables the identification of similar organizations to be used as a comparison to understand the business and financial performance of the target company. To find comparables you can look at two key profiles: the business and financial profile. From the comparable company analysis, it is possible to understand the competitive landscape of the target organization.

Cost Structure

The cost structure is one of the building blocks of a business model. It represents how companies spend most of their resources to keep generating demand for their products and services. The cost structure together with revenue streams, help assess the operational scalability of an organization.

Financial Moat

Economic or market moats represent long-term business defensibility. Or how long a business can retain its competitive advantage in the marketplace over the years. Warren Buffet who popularized the term “moat” referred to it as a share of mind, opposite to market share, as such it is the characteristic that all valuable brands have.

Financial Statements

Financial statements help companies assess several aspects of the business, from profitability (income statement) to how assets are sourced (balance sheet), and cash inflows and outflows (cash flow statement). Financial statements are also mandatory for companies for tax purposes. They are also used by managers to assess the performance of the business.

Marketplace Business Models

A marketplace is a platform where buyers and sellers interact and transact. The platform acts as a marketplace that will generate revenues in fees from one or all the parties involved in the transaction. Usually, marketplaces can be classified in several ways, like those selling services vs. products or those connecting buyers and sellers at B2B, B2C, or C2C level. And those marketplaces connecting two core players, or more.

Network Effects

network effect is a phenomenon in which as more people or users join a platform, the more the value of the service offered by the platform improves for those joining afterward.

Platform Business Models

A platform business model generates value by enabling interactions between people, groups, and users by leveraging network effects. Platform business models usually comprise two sides: supply and demand. Kicking off the interactions between those two sides is one of the crucial elements for a platform business model success.

Negative Network Effects

In a negative network effect as the network grows in usage or scale, the value of the platform might shrink. In platform business models network effects help the platform become more valuable for the next user joining. In negative network effects (congestion or pollution) reduce the value of the platform for the next user joining. 

Virtuous Cycles

The virtuous cycle is a positive loop or a set of positive loops that trigger a non-linear growth. Indeed, in the context of digital platforms, virtuous cycles – also defined as flywheel models – help companies capture more market shares by accelerating growth. The classic example is Amazon’s lower prices driving more consumers, driving more sellers, thus improving variety and convenience, thus accelerating growth.

Amazon Flywheel

The Amazon Flywheel or Amazon Virtuous Cycle is a strategy that leverages on customer experience to drive traffic to the platform and third-party sellers. That improves the selections of goods, and Amazon further improves its cost structure so it can decrease prices which spins the flywheel.

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