Switching Cost

Switching cost refers to the cost incurred by a customer while changing a service, product, or supplier and is not limited to just the financial cost but can also be psychological cost, time cost, etc. Every shift a customer makes comes with a cost, so it should be evaluated properly before making the switch.

Switching to another product, service or service provider involves ample amount of risk. The change of product might not be turn out to be satisfactory, making the risk one of the switching costs for consumers or businesses besides the monetary losses involved, if any.

A switching cost refers to both financial and non-financial costs that consumers incur when they opt to switch to other products and suppliers due to certain reasons. While the cost of the products they are switching to may be higher than the cost of the items they preferred earlier, they might not find them satisfactory at the same time. This not only impact consumer choices negatively in financial terms but also in terms of the utility.

The case is no different when a customer switches to another supplier. When a customer plans to use different products or services from a different supplier, the main thing the customer worries about is the switching cost. When a customer uses a product of a particular supplier, that product comes with a set-up that the customer is installing.

When a customer plans to switch, it will have to use a different set-up from the new supplier, which will involve the training process and hence loss in productivity for the initial months. So, if the collective cost for switching is huge, then the customer gets a bit skeptical about making a move.

The sense of doubt that switching costs raise in customers, sometimes, become a barrier for them to switch to other products. As switching barrier, these costs reduce the switching rate in the market, thereby confirming retention for one brand or product and no new leads for the other.

The following are some types:

#1 - Financial Cost

When a switch is made, the customer needs to reinstall the setup of the new supplier. This requires money and also space. If the old facility is not big enough for the new installment, the customer will have to manage a bigger place for the set-up.

#2 - The Cost of Time

When a customer switches to a new product, the new product must be trained first. This requires time. Old employees may not have sufficient skills to run the product. So new skilled employees will have to be hired. All these are time-consuming.

#3 - The Cost of Risk

The old machinery was already running and was producing finished products. The new machinery is not yet operational. Whether the new machinery will serve the purpose is still unknown. So there is a risk.

Let us consider the following instances to understand what is switching cost and how it is calculated:

Example 1

Company ABC is planning to change its car vendor. The company needs 90 operational cars for its employees to commute. There are several switching costs involved in the transaction. The current vendor charges $20,000/month, and a new vendor has quoted $18,000/month. So the company is planning to change its vendor.

The current vendor provides well-maintained cars, so it is comfortable for the employees. Now the company is not sure about the cars that the new vendor will provide. So psychological cost is involved.

A lot of time will be spent on properly making the new vendor aware of the routes. This may take a few days. So the time cost.

All drivers' entry needs to be done along with background checks. So the operational cost is involved.

Adding all the above costs will lead to a huge switching cost, and in the end, it depends on the company whether they are ready to incur the cost.

Example 2

In September 2023, Costco revealed how some customers are preferring to buy pork and chicken over beef products. CEO Richard Galanti claimed that the same trend was observed in the past when the United States slipped into recession. In the process, the consumers shift to purchasing less expensive products and store non-perishable items to save some amount for their bad days.

The example above shows how the switching of the products can make a business bear significant switching cost as well.

Companies try to keep switching costs high to maintain competitiveness in the market. If this cost of a product cost is high, it gets difficult for customers to switch easily, thus keeping demand at the proper level. So few strategies that companies apply are:

• The lengthy process to switch. If the service cancellation process involves lots of paperwork, it will discourage the customer from applying for the switch.
• Charge a higher cancellation fee. If a large cancellation fee is charged, the customers must do a thorough cost-benefit analysis before making the switch.
• Make unique installation equipment that will not support other products. So if a company produces machinery and the installed set-up is different than market standards, then the customer will have to buy a new set of installation equipment if they plan to switch. This increases the switching cost.

Determining switching costs or the switch costs themselves have several benefits to offer to businesses and customers both simultaneously. Listed below are the merits of computing these costs to have a quick look:

• It helps companies to stay competitive in the market. As the customer can’t switch the product easily with high switching costs, the demand for their product is safe.

• Investors can easily assess the product stickiness in a target market. As a result, investor know if a business would do better and if they should invest in it for returns.
• When the cost of switching is higher, it indicates customer retention opportunities.
• The stability that a product has in terms of demand, as indicated by these costs of switching, exhibit sustainability and profitability of investment at the same time.

Besides the benefits, there are disadvantages of these costs, which have been listed below:

• Switching costs act as switching barriers, restricting customers from changing their product preference. As a result, no new entrants get an opportunity to approach those customers who are loyal to other brands or products.
• If the switching cost is low, customers are more likely to switch to other brands or products. As a result, the loyalty factor is at risk and market sustainability is in danger.

This has been a guide to Switching Costs and its definition. Here, we explain the concept with examples, strategies, types, benefits, and limitations. You may learn more about financing from the following articles –

• Benefit Cost Ratio
• Backflush Costing
• Cost Classification
• Cost Allocation