Latticework of Mental Models: Switching Costs

How many times in last 6 months have you bought something from any of the these websites –

1. Flipkart
2. Amazon
3. Snapdeal

In my case I have used all three, at least once, in last 6 months. With two infants at home, my wife’s favourite online shopping destination is firstcry.com these days. But when it comes to buying diapers, I order from Amazon. Why? Whichever website offers better discount, we go for it. I am not loyal to any particular online store.

Now let me ask you another similar question. How many times have you switched your bank in last 6 months?

In last 1 year? Or in last 5 years?

Well even if another bank comes with an offer of higher savings interest rates, how many people actually take the pains of shifting all their cash and bank deposits to another bank? Very few I guess. My father hasn’t changed his bank in last 30 years.

But why is it that we change our online shopping stores in the blink of an eye but never really change our banks. Even credit cards or demat brokers don’t see too much churning in their customers base. If you talk to bankers, you’ll find that the average turnover rate for deposits is around 15 percent, implying that the average customer keeps his or her account at a bank for six to seven years.

When you think about it, that’s a curiously long time. After all, money is the ultimate commodity, and bank accounts don’t vary a whole lot in terms of their features. Why don’t people switch banks frequently in search of higher interest rates and lower fees?

Because it’s a pain to do that. Switching your bank isn’t as simple as opening another browser window and few clicks to order something online. Changing banks involve lot of efforts and lot of paperwork. I remember my experience in closing a bank account. The process was so cumbersome that I eventually had to get it done through direct help from a friend who was an employee in the bank.

Banks know this, so they take advantage of their customer’s reluctance to leave by giving them a bit less interest and charging them somewhat higher fees than they would if moving a bank account were as easy as buying diapers online.

This pain of changing or switching is called Switching Cost. It’s those one-time inconveniences or expenses a customer incurs in order to switch over from one product to another.

Take a look at the following list –

1. Operating system in your computer
2. DTH set top box.
3. Internet service provider
4. Newspaper

These are all examples of businesses where the cost of switching is high for the customer. You find switching costs when the benefit of changing from Company A’s product to Company B’s product is smaller than the cost of doing so.

You may not think twice before stopping your vehicle on the next fuel pump but you will think 10 times before changing your mobile number or cellphone service provider.

The cost of switching could also be psychological. For example, if you were asked to change the layout of your keyboard, i.e. instead of standard QWERTY keyboard, I asked you to switch to a keyboard where keys are laid out in alphabetical order. You’ll go crazy. There is a huge psychological costs associated with this change. The standard QWERTY keyboard isn’t going anywhere for a long time.

Switching costs make a product or service sticky.

Now, switching costs can be tough to identify because you often need to have a thorough understanding of a customer’s experience – which can be hard if you’re not the customer.

Switching Costs in Business and Investing

As we have seen some businesses have high switching costs, may be due to hassle of switching (banks, DTH), or complexity (PC operating system) or habit (newspapers or QWERTY keyboards). These switching costs generate a very valuable competitive advantages for the business because a company can extract more money out of its customers if those customers are unlikely to move to a competitor.

Microsoft Windows is a great examples which has high switching costs for the customers. Since majority of the world uses Windows operating system, most of the softwares are first built for Windows. Because of which most people are forced to work with Windows since many tools and softwares are available only for Windows platform. This type of switching cost is because of something called network effect which we will cover some other day.

Here’s another example. Smartphone marketplaces like the App Store or the Google Play Store host content and apps that can’t be transferred elsewhere. Android or Apple users will have to give up their purchased music tracks, apps or movies if they want to switch to a competitor.

Consider the case of Indian IT companies. Repeat business for them forms anywhere around 80-95% of their total revenues, suggesting that they benefit from the switching cost advantage, which is ultimately seen in their high margins.

So switching cost is an important source of Moat for a business. Moat is a metaphor used by Warren Buffett to explain the economic characteristics of those businesses which have sustainable competitive advantage. This type of economic moat, by virtue of higher switching costs, can be very powerful and long-lasting.

So what kind of businesses have low switching costs?

Many consumer oriented firms, such as retailers, restaurants, packaged-goods companies, and the like. You can walk from one clothing store to another, or choose a different brand of toothpaste at the grocery store, with almost no effort whatsoever. That makes it very hard for retailers and restaurants to create switching costs in their businesses.

Creating Switching Costs

There are several ways in which switching costs are created by companies. Here are few examples –

1. Base Product and Consumable trick – Companies lure customers into their ecosystem with a base product and then milk profits from ‘consumables’ that customers are forced to buy. A good example is home printers by companies like HP, Canon and Epson. The printer itself isn’t very expensive but the cartridge is where the company earns real profit. Printer specific cartridge also makes it hard for the customer to switch to other product since the original base product (printer) works only with the consumable (cartridge).
2. Data trick – In this arrangement customers are encouraged to create or purchase content that are exclusively hosted on a platform. ERP software companies like SAP and Oracle enjoy this advantage. If an enterprise has been using Oracle’s database software, a competing database would have to be phenomenally better (or cheaper) than an Oracle database for a company to choose to pay the massive cost of ripping out its Oracle database and installing another one.
3. Learning curve trick – Customers can be discouraged when they have to start over and learn how to use a new product. The ‘learning curve’ trick is centered around offering a great value proposition that’s only accessible to those willing to train to know how to use it. Adobe uses this trick to get customers hooked to their products. Adobe’s Photoshop and Illustrator programs are taught to budding designers in school, and they’re complex enough that switching to another program would mean significant retraining.
4. Servitization trick – In this approach, a company can bundle their products with complementary services provided only to their customers. Rolls Royce creates such switching costs in their ‘power by the hour’ offer. In essence, ‘power by the hour’ consists of leasing jet engines, maintenance and repair services for a flat fee. The real game-changer is that Rolls Royce only charges airlines for the time they use the engine. This experience is outstanding for airlines because it relieves them from the huge pain of losing money when defective engines block planes from flying. By bundling its highly profitable services with its first-class engines into one integrated offer, Rolls Royce makes it harder for airlines to switch to a competitor.
5. Industry standards trick – Sometimes, you are forced to do things because everyone else does it a certain way. That’s another way companies lock customers in. They position themselves as leaders by public acceptance. Their product, or one of their product features, has become the standard in an industry, which makes it very difficult to use something else. Microsoft Office’s Word software is one of them. The .doc format, distinctive to Word documents, has been the industry standard since Microsoft’s early entrance on the word processing software market. Switching costs are high because it is nearly impossible to work with a word processing software that doesn’t create or accept .doc files today. The .pdf format is another widely accepted file format around the world and has enabled Adobe to create switching costs the same way.
6. Exit penalty trick – This arrangement forces customers to use a product for a certain period of time specified in a contract. If the customer wants to exit the contract, he/she has to pay early termination fees. This strategy is commonly used to dissuade customers from switching to a competitor before their contract ends. For example, banks discourage its depositors for breaking fixed deposits prematurely by levying a penalty.

This is how businesses lock in customers. The more customers are locked in, the more likely a company can pass along added costs to them without risking customer loss to a competitor.

Human Brain on Switching

It’s not just businesses which have switching costs. Even human brain has characteristics of high switching costs.

Daniel Levitin, in his book The Organized Mind, writes –

Switching attention comes with a high cost…Our brains evolved to focus on one thing at a time. This enabled our ancestors to hunt animals, to create and fashion tools, to protect their clan from predators and invading neighbors. The attentional filter evolved to help us to stay on task, letting through only information that was important enough to deserve disrupting our train of thought. But a funny thing happened on the way to the twenty-first century: The plethora of information and the technologies that serve it changed the way we use our brains. Multitasking is the enemy of a focused attentional system. Increasingly, we demand that our attentional system try to focus on several things at once, something that it was not evolved to do. We talk on the phone while we’re driving, listening to the radio, looking for a parking place, planning our mom’s birthday party, trying to avoid the road construction signs, and thinking about what’s for lunch. We can’t truly think about or attend to all these things at once, so our brains flit from one to the other, each time with a neurobiological switching cost. The system does not function well that way. Once on a task, our brains function best if we stick to that task.

Higher switching costs may be good for a business but it’s bad for human brain.

So we see that switching costs come in many flavors—tight integration with a customer’s business, monetary costs, and retraining costs, to name just a few. Companies that make it tough for customers to use a competitor’s product or service create switching costs. If customers are less likely to switch, a company can charge more, which helps maintain high returns on capital.

Conclusion

The best way to learn what, how and why things work is to learn from others. Munger says –

I believe in the discipline of mastering the best that other people have ever figured out. I don’t believe in just sitting down and trying to dream it all up yourself. Nobody’s that smart.

When it comes to writing a prescription for gathering worldly wisdom, Charlie advises that the best way is to learn the big ideas, the mental models, that underlie reality.

A mental model is a representation inside your head of an external reality.

So what my attempt in this Latticework series is to share the ideas that are focussed on how our thoughts are influenced and how we make decisions. It’s a gentle nudge for the readers in the direction of discovering tools to improve their thinking.

I would like to quote Publius Terentius who wrote –

Nothing has yet been said that’s not been said before

The ideas in these posts are largely from the works and thoughts of others. I am just a collector of ideas who likes sharing and I always keep reminding myself – The advice we give other is the advice that we ourselves need.

I hope these ideas add value to your decision making process and to your life in general.

Take care and keep learning.