Switching costs are costs that are incurred when converting from one product or service to another. They can act as a barrier to entry very nicely because if it is expensive for a user to move from one product to another, odds are that they probably won’t, and therefore new companies would be deterred from entering into that space. Switching costs are one of my favourite economic moats to look for because they are usually interesting to learn about, but they are also quite frequently immeasurable or intangible.
If a product is developed so that users don’t switch away from it and go to the competitor because of costs, it is said to be “sticky”. An example of stickiness in a product is with computer software. Typically each industry has some sort of computer software associated with it. Within each industry there is usually one major software player that most companies use. This software is sticky because changing to a new vendor incurs such huge costs in training, migration, and even user satisfaction that a firm wouldn’t do it. For example, most word processing and spreadsheet work is done by the Microsoft Office suite. Employees are typically very fluent in this suite of software and replacing it would require retraining them as well as converting all of their old documents to new formats, and migrating databases. Therefore, if you’re an office user, you’ll probably stay an office user.
Retail banking also has switching costs as a moat. In Canada the majority of the population banks with one of the big 5 banks: TD Canada Trust, BMO, Scotiabank, CIBC, or RBC. Although there are other competitors, these 5 dominate the market and people won’t change banks because of the costs that are incurred. These costs include the time to drive around and sign paperwork, the hassle of changing direct deposit instructions, the risk of losing mortgage payments and even the simple commute variation.
Having switching costs as a moat is a fantastic advantage to any company. This is not only because it helps in the retention of clients and building a competitive advantage, but it also gives room for the company to extract additional profits. A firm can adjust their costs that they impose by very small and immaterial amounts; amounts that a client would ignore because it isn’t worth the switch. The more frequently a company does this, the more they are able to build their revenue base and chances are that a client would ignore it: The costs of switching are too high. But note that this can’t continue indefinitely. At some point switching costs can be a moat that is eroded away.
The above being said, there are many industries that have switching costs. Financial services, such as custodial services, provided to asset managers carrying with it a huge operational risk and paperwork headache for switching. Health care products also carrying large switching costs; technicians need to be retrained on the use of machinery, such as MRI apparatus. Even human safety acts as a switching cost; how likely is it that an airline company would gamble with the safety of an airplane simply to shop around for new components such as jet propellers.
It’s interesting how we’d driving an extra 10 minutes to save a couple cents on gas but the inconvenience of switching to a product that could provide net positive future benefits outweighs on an immediate basis , isn’t it? Maybe we should start thinking more long term as a population, or find the value in the cost as an investor.