“The products or services that a company sells may be hard for customers to give up, which creates customer switching costs that give the firm pricing power.” —Pat Dorsey, The Little Book that Builds Wealth
Switching Costs: Questions to Ask
Here are a few checklist questions—from The Five Rules for Successful Stock Investing, written by Pat Dorsey—to consider when trying to assess the evidence of the presence of customer switching costs (emphasis added).
⁍ Does the firm’s product require a significant amount of client training? If so, customers will be reluctant to switch and incur lost productivity during the training period.
⁍ Is the firm’s products or service tightly integrated into customers’ businesses? Firms don’t change vendors of mission-critical products often because the costs of a botched switch may far outweigh the benefits of using the new product or service.
⁍ Is the firm’s product or service an industry standard? Customers may feel pressure from their own clients—or their peers—to continue using a well-known and well-respected product or service.
⁍ Is the benefit to be gained from switching small relative to the cost of switching? Bank customers, for example, often endure slightly higher fees because the lower fees they might get from moving to a competing bank are of less value than the potential hassle of moving their account.
⁍ Does the firm tend to sign long-term contracts with clients? This is often a sign that the client does not want to frequently switch vendors.
A few notes from the same chapter—Economic Moats—worthy to keep in mind when analyzing switching costs are:
- Customer lock-in, or creating high customer switching costs, is possibly the subtlest type of competitive advantage. Uncovering it requires a deep understanding of a firm’s operations.
- Costs to switch comes from making it difficult—in terms of either money or time—for a customer to switch to a competing product, you can charge your customers more and make more money—simple in theory, but difficult in practice.
- Knowing exactly what makes it tough for a customer to switch from one firm to another can be difficult to find out.
- Can be very powerful, which is why firms with high customer switching costs often have wide economic moats.
- A switching cost does not have to be monetary—in fact, it rarely is. Much more frequently, what deters customers from dropping a product or service in favor of a competing product or service is time.
- Often, learning how to use a product or service can require significant investment of time, which means the benefits of a competing product have to be very large to induce a switch.
- A customer might switch brands of tomato sauce because one tastes just a little better than the other, but a word-processing program would have to carry huge advantages over an incumbent program to induce a consumer to throw away the accumulated knowledge and spend time learning the new program.
Manual of Ideas Interview with Pat Dorsey
We’ll end this post with an excerpt from a Manual of Ideas interview with Pat Dorsey. In this interview the different kinds of competitive advantages (or economic moats) are discussed. Excerpt below is about the competitive advantage usually called switching costs.
MOI: Now moving onto switching costs, you talk about three different subcategories. Can you give a sense of what they are?
Dorsey: You can incorporate yourself into a business model. You become part and parcel of the company. You have databases, data processors. That’s a typical example there where the usage of a data processing system or a database with enterprise software, like SAP, it becomes part of the fabric of someone’s business and so tearing it out is like ripping the organ out of a person. Very difficult to do and so your switching costs become very high and your pricing power thus becomes good as well. You usually raise prices a few percentage points a year. The other way to do it is to basically give away the product and make money off the service relationship. You see this in elevators, for example. They don’t give them away, but you make much better margin if you’re Cohen or Schindler or Otis on the aftermarket stream.
In aerospace, you actually do give away the product. You literally provide the engine part or the brake system for a regional aircraft for free. You just give it away to the OEM and then you make 38-40% margins on the aftermarket as long as that plane is flying. One way you take a hit here and so if production’s really increasing for that kind of a business, you actually see a margin hit, but then of course, what they’re buying a 20- to 30-year-long annuity stream.
MOI: When it comes to switching costs, it seems to me that this integration with client processes would be a better type of switching cost moat than the one you just described. Is that fair?
Dorsey: No, I think they’re two sides of the same coin. If I’m selling an Oracle database, for example, it’s very hard to rip it out of my business, but also if I have a plane that has standardized on a brake from Meggitt, which is a UK aerospace company that we own, and they make the carbon pads for the brakes, well, I can’t change that brake without getting the entire brake system recertified by the aircraft manufacturer and the aviation authorities. That’s a pretty hard thing to do, so it’s not necessarily a better moat. Just on one, you’re making money from the renewals and the service revenue in the Oracle model. In the aircraft model, you’re making your money from part sales for the most part. The switching costs are pretty high on both fronts and the interesting thing there is the customer, people often know it.
If you look at aerospace, for example, you often have these 38-40% margins, but your returns on capital are only in the low teens because typically you have to pay a very high entry fee to become part of the program. If I want to supply brakes to Bombardier Jets, I need to pay Bombardier a pretty big hunk of change to get on that platform. If I’m MTU Aero, which makes critical subsystems for jet engines, I need to pay Pratt & Whitney a big chunk of change that sits on the balance sheet as an intangible. That drives down returns on capital. The 38-40% margin sounds great, but then the entry cost is quite high, but you get some certainty with that. Like most things in life, there’s no such thing as a free lunch. You give with one hand and you take with the other.
MOI: Of course, it’s nice to provide benefit to the customer that’s much greater than the cost. You talk about the switching-coast-based moat that come from a high benefit-to-cost-ratio…
Dorsey: You can think of a case where part of the value chain of a product chain or service delivers of value of the end product, but doesn’t cost a lot. Think about a critical ingredient for a piece of snack food that might be made by a Symrise or a DSM or Kerry, one of the food and flavoring companies. Without that key ingredient, the food tastes different and so the customer isn’t going to like it very much, but the total cost of getting that package of Cheetos on the shelf of a convenience store, it’s not really high and so if the ingredient maker want to raise prices a little bit, you don’t really worry about it a whole lot. Same think, the classic example we’ve seen in the U.S. was a company called Ecolab. Ecolab basically provides food safety training and hand soap dispensers and suchlike to restaurants. If you think about it, this doesn’t sound very exciting, but if you’re a restaurant owner, having a clean kitchen is the cost of doing business.
No one’s going to go to your restaurant because you have a cleaner kitchen, but they will definitely not go if the kitchen is dirty or if the health authorities certify you. That’s not a big part of you cost structure; it’s a think you have to get done, so if Ecolab says, “We’re going to raise your prices 3% this year for making sure your kitchen is clean, your employees are up to certification for the various things that they need to be certified on and you’ve got soap in all the right places,” you say, “The guy who sells me beef just raised prices 5%. I’m not worried about this,” and you just pay them and move on.
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“As you can see, switching costs are a valuable competitive advantage because a company can extract more money out of its customers if those customers are unlikely to move to a competitor. 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.” —Pat Dorsey, The Little Book that Builds Wealth
Source: The Little Book that Builds Wealth