What is the Switching Cost?

How Does it Work?

When a customer plans to use different products or services from a different supplier, the main thing the customer worries about is the switching cost. When a customer uses a product of a particular supplier, that product comes with a set-up that the customer is installing. When a customer plans to switch, 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 the initial months. So if the collective cost for switching is huge, then the customer gets a bit skeptical about making a move.

Types of Switching Cost

The following are some types:

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#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, 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, the new product must be trained first. This requires time. Old employees may not have sufficient skills 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. There are several switching costs involved in the transaction. The current vendor charges $20,000/month, and a new vendor has quoted $18,000/month. So the company is planning to change its vendor.

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 lot of time will be spent on properly making the new vendor aware of the routes. This may take a few days. So the time cost.

All drivers’ entry 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.

Strategies

Companies try to keep switching costs high to maintain competitiveness in the market. If this cost of a productCost Of A ProductProduct cost refers to all those costs which are incurred by the company in order to create the product of the company or deliver the services to the customers and the same is shown in the financial statement of the company for the period in which they become the part of the cost of the goods that are sold by the company.read more cost is high, 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 service cancellation process involves lots of paperwork, it will discourage the customer from applying for the switch.Charge a higher cancellation fee. If a large cancellation fee is charged, the customers must 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.read more before making the switch.Make unique installation equipment that will not support other products. So if a company produces machinery and the installed set-up 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.

Benefit

It helps companies to stay competitive in the market. As the customer can’t switch the product easily with high switching costs, 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 it works along with the benefits. You may learn more about financing from the following articles –

  • Benefit Cost RatioBackflush CostingCost ClassificationCost Allocation