What is Switching Cost?
Switching cost refers to the cost that is incurred by a customer while changing a service, product, supplier and is not limited to just the financial cost, but can also be psychological cost, time cost, etc. Every shift that a customer makes comes with a cost, so it should be evaluated properly before making the switch.
How Does it Work?
When a customer plans to use different products or services from a different supplier, then the main thing that the customer is worried about is the switching cost. When a customer is using a product of a particular supplier, then that product comes with a set-up that is being installed by the customer. When a customer plans to switch, then it will have to use a different set-up from the new supplier, which will involve the training process and hence loss in productivity for initial months. So if the collective cost for switching if huge, then the customer gets a bit skeptical about making a move.
Types of Switching Cost
The following are some types:
#1 – Financial Cost
When a switch is made, the customer needs to reinstall the setup of the new supplier. This requires money and also space. If the old facility is not big enough for the new installment, then the customer will have to manage a bigger place for the set-up.
#2 – The Cost of Time
When a customer switches to a new product, then the new product needs to be trained first. This requires time. Old employees may not have sufficient skill to run the product. So new skilled employees will have to be hired. All these are time-consuming.
#3 – The Cost of Risk
The old machinery was already running and was producing finished products. The new machinery is not yet operational. Whether the new machinery will serve the purpose is still unknown. So there is a risk.
Example of Switching Cost
Company ABC is planning to change its car vendor. The company needs 90 operational cars for its employees to commute. The current vendor charges $20,000/month, and a new vendor has given a quotation of $18,000/month. So the company is planning to change the vendor. There are several switching costs involved in the transaction.
The current vendor provides well-maintained cars, so it is comfortable for the employees. Now the company is not sure about the cars that the new vendor will provide. So psychological cost is involved.
A huge amount of time will be spent on making the new vendor aware of the routes properly. This may take a few days. So the time cost.
The entry of all the drivers needs to be done along with background checks. So the operational cost is involved.
Adding all the above costs will lead to a huge switching cost, and in the end, it depends on the company, whether they are ready to incur the cost.
Companies try to keep switching costs high, just to maintain competitiveness in the market. If this cost of a product is high, then it gets difficult for customers to switch easily, thus keeping demand at the proper level. So few strategies that companies apply are:
- The lengthy process to switch. If the process of cancellation of service involves lots of paper works, then it will discourage the customer from applying for the switch.
- Charge a higher cancellation fee. If a large cancellation fee is charged, then the customers will have to do a thorough cost-benefit analysisCost-benefit AnalysisCost-benefit analysis is the technique used by the companies to arrive at a critical decision after working out the potential returns of a particular action and considering its overall costs. Some of these models include Net Present Value, Benefit-Cost Ratio etc. before making the switch.
- Make unique installation equipment that will not support other products. So if a company produces machinery and the set-up that is installed is different than market standards, then the customer will have to buy a new set of installation equipment if they plan to switch. This increases the switching cost.
It helps companies to stay competitive in the market. As the customer can’t switch the product easily with high switching costs, so the demand for their product is safe.
This has been a guide to switching costs and its definition. Here we discuss types, examples, strategies, and how does it work along with the benefits. You may learn more about financing from the following articles –