Conceptually, Switching Costs are easy to understand. You build some kind of product that customers find very difficult to rip out. In his chapter on Switching Costs in 7 Powers, author and investor Hamilton Helmer likens Switching Costs to ‘addition’.
Helmer notes that there are three basic flavours of switching costs (though businesses may enjoy more than one at the same time, naturally):
Financial — This is the ERP systems example — switching from one ERP system to another might result in huge financial losses. HP learnt this the hard way, as they attempted to switch Compaq’s legacy systems to SAP: the switch resulted in a $160M hit in a single financial year.
Procedural — When employees have invested time and effort to learn the particulars of a certain product, there can be a significant cost to retraining them in a different system. This cost includes both organisational discontent and the cost of potential errors.
Relational — In some businesses, switching from one product to another would mean severing ties with with other product users, service providers, and sales or customer service staff members. This is basically the ‘community moat’ that people in open source circles talk about; it is also the case whenever a customer develops affection for a product (or builds their identity as a user around it).
This Power decomposes to:
Benefit: A company with high Switching Costs embedded in its customers can charge higher prices than competitors. This Benefit only accrues if you sell follow-on products to your current customers; no Benefit accrues with potential customers, or if there are no follow-on products.
Barrier: To take you out, a competitor must compensate customers for their Switching Costs. The Power-holder may also reduce their prices temporarily until you stop going after their customers.
The implication here is that Switching Cost moats are a non-exclusive Power. To use SAP as an example, IBM and Oracle are competitors to SAP in the ERP software space, and all three benefit from high customer retention rates and Switching Costs. So you could say that the enterprise ERP market sits at sort of a stalemate — at least with regard to existing, locked-in customers. Every customer of SAP or IBM or Oracle ERP products are locked in, and the market share doesn’t shift. Which then means that you gain no financial benefit if no additional related sales are made to the customer!
The net result is that whenever you have a high Switching Costs environment, you’ll get:
A land-grab for new customers as the market is growing,
And then a switch to a build or buy strategy for integrated add-on products, to sell to your captive install base. This explains why SAP and Oracle become hugely acquisitive in their later years — and why they buy so many adjacent enterprise software products to sell to their customers.
As a result, one of the more interesting questions when reading Switching Cost case studies is “how are they built during the land-grab phase?” Customers don’t willingly subject themselves to Switching Costs. Something … interesting has to happen for them to do so.