Switching costs are costs that an organization or consumer incurs to change from one product or service to another. The ability of a company to retain its customers despite increasing prices determines whether they have high or low switching costs. Companies might be forced to raise prices, for different reasons.
If for example the cost of making a product, or delivering a service increases, they will have to raise prices in order to maintain their margins. Ultimately the consumers will have to pay for the price increase, but switching costs may be influenced by more than just price. In fact, switching costs can be based on effort or time. They might even be psychological, and they define whether a company has a competitive advantage and pricing power.
Pricing power and competitive advantages
A company that has pricing power is able to raise the prices of its products and services without losing its customer’s loyalty. This happens when the products and services distinguish themselves in contrast to the competitors. When this happens the company has pricing power, and it is able to increase the price of its products or services to a certain threshold without losing any customers, or revenues. This ability to raise prices without directly influencing sales is a feature of companies that have competitive advantages.
One of the goals of every company is to have a product or service that is highly distinct from the competitors that the switching costs are high. This allows the company to retain its customers, and there are several approaches that companies put in place in order to be able to have high switching costs.
High or low switching costs
Switching costs can be categorized as low or high. Depending on the advantages of using a certain product or service compared with the competition.
Low switching costs
Companies that have low switching costs often have products or services that do not differentiate themselves. For that reason, they are easily emulated by competitors, and there is no reason why the consumer would choose one over the other.
High switching costs
Having high switching costs is a feature of high-quality businesses. Their products and services are so unique that even if consumers want to replace them with a viable alternative, they will find it difficult to switch to a competitor. This allows companies to keep their customers even if prices for their products and services are higher. Giving them pricing power over the consumer. Overall it makes the company less prone to disruption and allows it to maintain its market share.
Types of switching costs
Some switching costs are obvious, such as a customer who is used to a specific product or service and has invested time, money, and effort into it. Businesses have to be prepared to deal with the fallout of any negative customer feedback. Other switching costs are less obvious but just as damaging.
Some brands are so well regarded by consumers and businesses that they have large pricing power over them. This in itself prevents the consumer from switching to another product or service due to the value added by the brand.
Installation and equipment costs
Some consumers and corporations are deterred from switching to a competitor because of installation expenses. The installation price could make it nearly impossible to change. This allows the company with the high switching costs to have recurring revenues.
The same thing happens with certain products and services that require special equipment to use. Consumers may stick with their current choice, due to the cost of the new equipment.
Certain products or services require the consumer to learn more in order to use them properly. This requires not only time to get acquainted with the new product or service, but it also requires effort. Consumers might perceive the high switching costs based on how much time and effort they need to invest before they change to a competitor.
Exit fees and contracts
Some services are based on a contractual obligation between the consumer and the business. Broadly speaking this makes the switching costs high, because there are expenses associated with breaking the contract. On the other hand, some companies charge exit fees that limit the ability of the consumer to choose another service provider.
Some consumers are affected by the location of certain businesses, and this affects their consumer behavior. Even if a competitor has a better price or product, consumers might be deterred from choosing it based on how easy it is to access that particular product or service.
Some businesses and consumers stick with the same companies due to their emotional attachment towards the product, or service. Sometimes it might even be influenced by the emotional relationship you build with the company itself or their staff members. After using a certain product or service for years, there might be extensive relationships established. This makes it difficult to switch to a competitor.
If switching costs are high enough, it makes the business less vulnerable to competition because they won't attract as many customers. If they are low enough, it makes the company vulnerable to competition because consumers can easily choose the competitor.
The switching costs that a business faces will depend on what product or service they offer. A product or service that has competitive advantages will be able to retain customers, even despite price increases. Overall, it can be a double-edged sword to companies and consumers alike. However, they need to be considered when making any choice.
Image source: Lione