Stock Shastra #8: ‘High Switching Costs’- a recipe for companies to hold customers for life

Earlier we have spoken about three competitive advantages a company can have: great brands, patents/secrets and exclusive control. Another powerful moat that can translate into higher profits & sales is ‘High Switching Costs’.

So, what do you mean by switching costs?

Almost all of us use computers. And the two software products almost all of us use are Microsoft Windows and Office. If a new alternate, even significantly better in terms of features, ease of use etc is launched, would people use it instead of these. Most people would not. What keeps us from doing this?
The costs involved. Is it only the monetary cost, we are talking about? No. It would definitely require significant amount of money to shift, especially for a company, but what’s more important is the psychological cost. Switching will mean dealing with the unknown – to a software which we don’t know much about. What could be more frightening? Learning it, using it and getting familiar with it will take a lot of time, pain and effort. Add to this the innumerable applications which work well on Windows; we will forever worry whether the new one will work as well. Considering all this you would rather stick with Windows and Office and keep purchasing their latest upgrades, sometimes grudgingly. Microsoft has a big competitive advantage, that of “Switching costs”- the costs that a consumer incurs – monetary, psychological, time and effort-based – which makes switching from the product almost impossible.
Switching as a moat works for complicated products which may take time to learn how to use, as well as for something we all use everyday…the morning newspaper. If you think changing your current morning newspaper, which hardly costs anything, is a simple decision, ask someone who has moved e.g. from Chennai to Mumbai. You just don’t enjoy your morning ritual anymore. The reason, you have got used to your newspaper, its type-setting, layout, what comes on which page etc; changing it throws your mind out of gear.

But, how can this advantage translate into higher profits & sales for the company?

The answer to this is Stock Shastra #8: ‘High Switching Costs’- a recipe for companies to hold customers for life
A company has switching cost as its competitive advantage, when clients find the cost/effort of switching from any of its product/service not worth the trouble. If switching would mean developing a new system, educating employees to use it, investing time with the new vendor, developing capabilities that are not core to the business, or simply changing an entrenched habit, chances are that customers will not switch. Also, if customers are happy with the products and services of their current suppliers, they are inclined to give additional business to the same suppliers than work with new ones. Usually such additional business comes with higher margins. Hence,
having the advantage of switching cost ensures repeat business and new business from the same customer. This results in higher sales and profits. Such companies are also able to pass on cost increases to the customer either through price escalation clauses or renegotiations, thereby protecting margins.

Which companies in India have this advantage?

Today, IT systems form the backbone of operations for most companies. Any company would like to have a stable and reliable system. Changing from one service provider to another could lead to serious problems putting the entire business in a tizzy. IT Companies like Infosys and TCS get around 95% of their business as repeat business from the same customers. The costs involved in implementation of the system and training of employees – sometimes across the globe, make it difficult for customers of these companies to shift from them. Check out more about how this advantage works for Infosys in our Company Shastra

Computer education companies like Educomp Solutions which provide digital education to schools also have this advantage with products like Smart Class. These products require hardware, devices & equipment to be installed in the school. It also involves training teachers. Obviously, shifting to any other product will not only require re-installing, but also the effort of learning it again. Educomp is another company which gets a major chunk of its revenues from repeat business, through renewals

Similarly, once you have installed a security system in your house/office, you would prefer to not shift from it. One such company is Micro Technologies. It provides security systems for offices, buildings, computer systems, homes, vehicles etc

Back to our morning newspaper. Deccan Chronicle, Jagran Prakashan (Dainik Jagran), DB Corp (Dainik Bhaskar) and HT Media (Hindustan Times) all have switching cost as a moat.

In Stock Shastra #9 we will talk about another interesting moat, Price – Having products priced so competitively that almost no one can compete

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  5. Nandita - 24. Jun, 2010

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