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Switching Costs

The costs incurred from switching brands, products, services, or suppliers

What are Switching Costs?

Switching costs are costs that a consumer incurs from switching brands, products, services, or suppliers. Switching cost is also known as switching barrier.

 

Switching Costs

 

Understanding Switching Costs

Switching costs commonly refer to the financial costs incurred by a consumer when they switch brands, products, services, or suppliers. However, it is important to note such costs also include non-financial ones. Other costs such as psychological, time, and effort-based costs are also part of switching costs.

For example, consider an individual who currently pays $50 per month for her phone bill. The individual notices that another service provider is providing the same phone plan for a monthly cost of $45.

In the example above, the individual will save $5 if she switches phone plans. However, there are a number of switching costs to consider, such as:

  • Time costs: Whether a significant amount of time must be used to switch phone plans (i.e., driving to the store or waiting for an available store representative);
  • Psychological costs: Whether the new phone plan would be better than the existing phone plan (i.e., whether the new phone plan offers better city-wide signal coverage); and
  • Effort-based costs: Whether the individual must exert significant effort to switch phone plans (i.e., whether a lot of paperwork must be completed).

 

High and Low Switching Costs

Switching costs can be “high” or “low.” The higher the cost of switching, the less likely an individual would be willing to switch brands, products, services, or suppliers. To consumers, the higher the switching cost, the less value the consumer is deriving from switching to another brand, product, service, or supplier.

 

Strategies Employed by Companies

Let’s see now how companies formulate strategies to increase switching costs for consumers to dissuade the latter from switching brands, products, services, or suppliers. For companies, it is in their best interest to try and create the highest switching costs for consumers. If a company is able to cause consumers to incur higher costs, it is considered a competitive advantage for the company.

Recall the example above regarding an individual switching to a cheaper phone plan. If the individual needs to exert significant effort and time into switching to the cheaper phone plan (i.e., higher switching costs), the individual may not choose to switch phone plans even if it is $5 cheaper than the individual’s current phone plan.

There are a number of strategies employed by companies to increase the switching costs incurred by consumers. For example:

  1. Charging a high cancellation fee for service cancellations;
  2. Incorporating a lengthy cancellation process for service cancellations; and
  3. Requiring significant paperwork for service cancellations.

 

However, it is important to note that although companies can create high switching costs, competitors can help consumers alleviate such high costs by bearing a portion of the total cost. For example, a company can impose a high cancellation fee for their services, but a competitor can offer to pay the cancellation fee for the consumer if the latter agrees to switch over.

 

Practical Example: The QWERTY Keyboard

A notable example of a product with high switching costs is the QWERTY keyboard layout. According to studies, the QWERTY keyboard layout may not be the most efficient keyboard (in terms of typing speed) compared to a DVORAK keyboard layout.

However, the DVORAK keyboard layout is not popular with consumers, due to the higher switching costs associated (in terms of the time and effort required to learn a new keyboard layout) with transitioning from a QWERTY keyboard to a DVORAK keyboard.

 

More Resources

CFI is the official provider of the Financial Modeling and Valuation Analyst (FMVA)™ certification program, designed to transform anyone into a world-class financial analyst.

To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below:

  • Bargaining Power of Suppliers
  • Brand Equity
  • Products and Services
  • Types of Customers

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