Sunday, July 24, 2011

Business Model Analysis, Part 3: Switching Costs

This post is part of a series on business model analysis for entrepreneurs. The first post in the series presents a comprehensive list of issues (available as a downloadable PDF) entrepreneurs should consider when designing a business model. Others delve into specific issues; this one provides an overview of switching costs.

Switching costs are incremental expenditures, inconveniences, and risks incurred when a customer changes from one supplier to another. For example, when consumers switch from a Windows PC to a Macintosh computer, they must buy and install Mac-compatible application software and invest time in mastering a new interface.

Switching costs fall into three broad categories:

  • Redundant Relationship-Specific Investments. Because their old and new vendors may have different requirements, customers who change suppliers sometimes must invest in new software/hardware or repeat certain activities they have already completed. For example, to switch online stockbrokers, users incur the hassle of transferring funds and securities. For that reason among others, customer retention rates for online stockbrokers have been high.
  • Disruption Risks. When businesses outsource “mission critical” activities, changing vendors may involve considerable risk. For example, some companies reduce their need for IT staff and infrastructure by relying on cloud computing services. Switching from one cloud service to another exposes a company to significant risk if customer records are lost or corrupted during the transfer.
  • Contractual Penalties. Companies can impose penalties on customers if they end a contractual relationship prematurely. For example, mobile phone carriers often charge an early termination fee to customers who have signed multi-year contracts. In some cases, these contractual penalties significantly exceed the true costs incurred by a firm due to customer attrition.
When its current customers confront high switching costs, a firm is well positioned to capture a portion of the value it creates. Specifically, by raising its price just below the point where current customers are indifferent between staying with a firm’s product and switching to a rival’s, a firm should be able to earn above-normal profits equal to the sum of the switching costs confronting its customers (“above normal” implies profits in excess of a competitive return on capital; see the technical appendix below for analysis of the impact of switching costs on pricing and profitability).

Switching costs are important in securing a first mover’s position. In their absence, an entrant that offers a superior product or a deep discount might quickly usurp the market lead.

Given these economic benefits, companies often seek to deliberately increase switching costs, either through contractual or technological means. Apple, for example, has employed proprietary digital rights management software, locking in its customers by making it difficult for them to transfer iTunes Store purchases to rival media players. However, efforts to increase switching costs are not likely to escape the notice of prospective customers, who will fear hold-up in the form of a “low then high” pricing strategy. Anticipation of lock-in can represent a significant barrier to adoption for a new product. To ease customers’ concerns about lock-in, firms sometimes license their products to “second source” rival suppliers.

Technical Appendix: Switching Costs and Pricing Leverage

This appendix is only likely to be of interest to readers who want to dig deeper into the economic foundations of business models. To see how switching costs can impact firms’ pricing flexibility and their motivation to race for scale, consider the following example, adapted from my note “Racing to Acquire Customers.”

Assume that two firms, Alpha and Beta, offer identical products. A typical customer purchases one unit of either firm’s product in period 1, then requires a replacement unit in period 2. The variable cost of producing one unit is the same for both firms: $100. In a perfectly competitive market without any switching costs, Alpha and Beta would both price their products at $100 in periods 1 and 2. If either firm tried to raise its price, the other could steal all of its customers by slightly undercutting the new, higher price.

Now assume that each firm has a base of customers that it acquired in period 1, but these customers would incur a $50 cost by switching suppliers in period 2. Assume further that during period 2 the firms are able to offer one price to their existing customers and—in an effort to steal share—a different, lower price to their rival’s customers (e.g., a “special promotion”).
If Alpha wanted to steal Beta’s customers in period 2, it would have to compensate those customers—in the form of a lower promotional price—for the $50 switching cost they would incur. However, Alpha must also recover its $100 variable cost, so the lowest possible price it could offer in period 2 to Beta’s customers and still break even would be $150. If, in response, Beta set its period 2 price for existing customers at $149.99, its existing customers would not bother to switch to Alpha’s product. Beta would retain all of its existing customers and earn a period 2 profit equal to $49.99 from each of them.
Finally, imagine that a new, first-time buyer—as yet unaffiliated with either Alpha or Beta—enters the market during period 2. Like other customers, this first-time buyer will wish to purchase a replacement unit—albeit during period 3. Also, like other existing customers, the first-time buyer will face a $50 switching cost after he commits to a vendor.

Assuming once again that Alpha and Beta can offer different prices to existing versus new customers, what price would they offer to this new, first-time buyer during period 2? Following the logic above (and ignoring the time value of money), we can see that the lowest period 2 price that each firm could afford to offer would be $50.01. Whoever secures this new customer would then raise their period 3 price for this customer to $149.99. Total revenue across the two periods would equal $200, as would total cost, and net profit across the two periods would be zero.

In this manner, switching costs allow firms to raise prices to their existing customers, but the resulting profit opportunity also motivates them to race to acquire first-time buyers. In a competitive market, deep discounts or heavy marketing spending to attract these first-time buyers will dissipate any above-normal profits that otherwise would accrue due to switching costs.