How to Build A Better Business Model Using Switching Costs

June 29, 2017
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Many of the “new” businesses we see popping up these days aren’t actually all that new. Instead, they’re selling something familiar with a brand new twist that makes all the difference.

Take Uber for example. The service they provide is essentially identical to any taxi company that uses a mobile application. The difference is that Uber drivers aren’t formal employees, they’re just people with cars and a bit of spare time. Using this model Uber has become one of the world’s largest transportation companies all without owning any vehicles of their own. Uber flipped the transportation business model and became one of the hottest new tech companies in the process.

Uber provides almost the same service as a taxi but with a very different business model

The thing is, not all business models are created equal - some are just plain stronger than their industry competition (think Netflix vs. Blockbuster). Last year, Nabila Armarsy of Strategyzer discussed some of the common themes that take a business model from distinctive to disruptive. Over the next few weeks we’ll expand on some of these themes (and explore some new ones as well) by breaking down the tips and tricks for how you can build your own innovative business model and turn your industry on its head in the process.

Switching costs aren't the only way to build a better business model

            Recurring revenues, just like switching costs help build a better business modelCrowdsourcing, just like switching costs helps build a better business modelscalability, just like switching costs help build a better business model

The first of these themes is switching costs - a strong but subtle business model mechanic that can go a long way towards retaining the customers you’ve worked so hard to acquire. Brands whose business models include switching costs often enjoy customer relationships that grow stronger and last longer and by the end of this post, you’ll know why.

This post will cover what switching costs are, how switching costs work and how you can use them to better your business

 

What Are Switching Costs?

While switching costs might sound like a niche business term, they actually show up all the time in our everyday lives. Investopedia tells us that switching costs are any cost that a customer incurs as a result of changing brands or products, however switching costs aren’t just limited to products and services.

Switching costs are the costs a customer incurs as a result of changing brands, suppliers or products

The job you work, the home you live in, and even the relationships you are in all have their own built in switching costs, and some are more costly than others. For example, if you changed jobs you’d be giving up your seniority at your current position, and if you moved homes you’d have to learn a new route to work. These are both examples of small switching costs which might make you think twice before changing your lifestyle on a whim.

Cancellation fees and onboarding costs are two other examples that often come to mind. The thing is, switching costs don’t have to be financial. They can also cost time and effort, or even be psychological.

Before we jump into how switching costs can help build a better business model, it might be helpful to discuss a few examples of switching costs you might not have considered.

Switching costs can be time, effort, and, even emotions

1. Learning Curves Are a Switching Cost

How annoying is it when you get a new phone or laptop and for that first little while everything feels strangely alien? Things that you used to be able to do with the flick of a finger now require video tutorials on YouTube. What you’re experiencing is a learning curve as a switching cost, and it can be a very powerful effect.

I recently experienced this in my own life, when I found myself in the market for a new vehicle after a car accident. A new vehicle isn’t a cheap purchase,  and as such I was determined to do all of the necessary research to make the best possible decision.

Customer learning is an important part of customer psychology. Learn more about it in our free guide

Eventually my research narrowed down to two options: the newer model of my previous vehicle and a competing offer from a different brand. While the functionality and price points of the two vehicles were almost identical, for me there wasn’t even a choice to be made. In spite of my research I constantly found myself thinking about how well I knew my Nissan, how the Bluetooth worked, the gas release, when to switch into sport mode and exactly what every button on my front dash was for. I ended up picking the Nissan and haven’t looked back.

This is the perfect example of a learning curve switching cost at work.  In the end, the effort required to learn a new product makes sticking with the existing brand more attractive.

2. Opportunity Costs Are Switching Costs

Opportunity costs are the benefits an individual would have received but gives up in order to take another course of action. If that sounds like a mouthful, just remember the basic principle is that for every choice you make, there are other options you didn’t take and opportunity costs measure the difference between the results you take and the ones you don’t.

Opportunity switching costs are the benefits that an individual would have received but gives up by taking another aciton

An example of an opportunity switching cost would be deciding whether or not to leave your job for another one if you feel like you’re up for a promotion soon. It’s an opportunity cost because it can be forfeited by taking a particular choice of action (accepting the new job) but it’s also a switching cost because it exerts motivational pressure to stay with your current job.

3. Personalization is a Switching Cost

Personalization isn’t just a great way to connect with your customers - it can also be a switching cost when used correctly. One of the best brand examples of a personalization switching cost is Spotify.

Spotify allows users to stream an almost limitless catalogue of music and tracks each user’s listening habits. After a while Spotify has a pretty good idea of your music likes and dislikes and they turn that data into additional customer value. Spotify curates new music playlists that match a user’s tastes and then recommends it to the user. The brand also notes your favorite artists and gives you a heads up if they release new music or throw a concert in your area. At the end of each calendar year, Spotify even puts together a playlist of your musical highlights from the year.

Netflix and Spotify are two great examples of using personalization as a switching cost

At this point, Spotify might know my music taste better than even I do. This means that switching to another streaming service wouldn’t just mean learning a new interface or rebuilding my saved playlists, it would mean giving up all the data that Spotify uses to improve my listening experience every day. Something I’d think twice before giving up.

Sunk costs are another powerful example of switching costs in action. Read more about them here!

 

Why Do Switching Costs Build a Better Business Model?

Now that we’ve covered the basic “what” of switching costs, it’s time to move into the “why”. Switching costs can help brands build stronger, more resilient business models and there are two key reasons why.

1. Switching Costs Motivate Customers Through Loss Aversion

Switching costs play to a fundamental psychological principle called loss aversion. This principle explains that the effects and emotions human beings experience from a loss are much more severe than those we experience from a matching gain. Simply put, we are wired to avoid losses whenever possible and when we do lose, it hurts a lot.

Humans are up to twice as sensitive to losses as we are to gains

What this means for brands is that customers are very driven to protect themselves from loss, whether real or perceived, and switching costs represent a loss. In all of the examples we explored in the previous section, there is an element of loss at play. With learning curves there is a loss of control; with opportunity costs a customer is afraid of losing potential; and with personalization there’s a loss of comfort.

With financial switching costs the loss is even clearer. Brands that implement cancellation fees can effectively trap customers through the motivational power of financial loss. When we’re scared of losing out, loss aversion triggers our brains to protect our assets and savvy businesses can use this motivation to differentiate their brand experiences.

2. Switching Costs Provide Customers Incremental Value

While humans are very motivated by loss aversion, switching costs shouldn’t be used as a scare tactic or a customer prison. Some brands view switching costs as a way to hold their customers captive but they’re missing the real power of switching costs.

Switching costs shouldn't be viewed as a prison but as a customer palace instead

Switching costs only work because they provide the customer with something they genuinely value. Switching costs are a way to increase the value of your own product, service, and brand experience as a whole. By giving your customers a little extra, you’re giving them something to lose if they switch, but also something to love if they stay. This mindset can help build genuine customer relationships.

The secret to switching costs is to lower them when customers are switching to your brand and raise them when customers are switching from your brand. Some of the things that can help a customer transition to you from a competitor are the things that will actually keep them committed to your brand when those competitors try to win them back.

The trick to switching costs is to lower them for customers switching to you and raise them for customers switching away

For example, if your product has a really intuitive user interface and is designed with your user in mind, then it’s probably pretty easy to use and, more importantly, easy to learn. This lowers the learning switching cost from your competitors and makes it more likely that a customer will actually switch to your product. In turn, your ease of use actually raises the learning curve switching cost for an existing customer because competitive offerings will seem that much more cumbersome and challenging in comparison.

 

How Rewards Programs Create Valuable Switching Costs

Learning what switching costs are and why they work so well is a great start, but the real value comes when you learn how to use them for your own brand. One of the easiest and most effective ways to put switching costs to work for your business is through a rewards program, but don’t just take my word for it! Here are three big ways rewards programs can create valuable switching costs.

Action without study is fatal. Study without action is futile

1. Points Programs Create Value Customers Won't Want to Lose

Points programs are quite possibly the oldest type of rewards program. In a tale as old as time, customers complete actions the brand has deemed valuable and in return they are awarded points that can be redeemed for discounts, coupons, or experiences the brand would like to give back to its customers. These valuable actions can be anything from simple purchases, leaving a product review, sharing on social media, or even celebrating a birthday!

While points programs may seem pretty simple, they create a lot of value for the brands that use them and the customers who participate in them. By giving customers points for every purchase brands can fuel the motivational effect of switching costs by giving their customers something to lose by moving to a competitor.

switching costs are just one retention tools. This free guide has the rest!

A first time customer who participates in a points program will be motivated to return by loss aversion in order to avoid “wasting” their points. As that customer engages in repeat purchases, the effect only gets stronger. Each purchase gives them more points which creates more value for your program and a higher cost of switching to a competitive offering. In essence, a points program uses switching costs to become the ultimate customer acquisition and retention tool.

2. VIP Programs Are the Ultimate Opportunity Switching Cost

VIP programs provide customers with elite experiences that can connect them emotionally to your brand. These programs allow brands to show their most valued customers how much they matter through bonus perks, special rewards, and many other exclusive experiences.

VIP programs also create amazing opportunity switching costs. Like we discussed earlier, opportunity costs are all about potential; they measure what you could have had if you’d chosen another option or taken another path. This idea of potential is exactly what makes VIP programs so powerful. When customers join the Starbucks rewards program, they do so with the goal of eventually being elevated to Gold Card status and all the prestige that comes along with it.

VIP programs create opportunity switching costs

When a customer enters your VIP program, you’ve created immediate value for them with the perks they can receive in your entry level tier. In addition, you’ve created potential value through what they can achieve as a member of your higher tiers. If that customer wanted to switch to a competitive offering, they’d have to consider the value they already have with your program and they value they hope to have in the future. In other words, they’d have to consider the opportunity switching costs created by your VIP program.

3. A Great Explainer Page Lowers Learning Curve Switching Costs

The previous two examples have shown us great ways that a rewards program can help raise the switching costs a customer perceives when they think about moving to a competitor. However, it’s also important to be able to lower switching costs when a new customer is thinking about trying out your brand, and that’s where a great explainer page comes in.

Explainer pages help your customer figure out what your rewards program is all about and can be the first step to converting a new program member. That’s why it’s so important that your explainer page gives new customers a warm welcome that makes them want to explore the value your program has to offer.

Great explainer pages lower learning curve switching costs

In addition to welcoming customers, explainer pages can also lower the learning curve required to join your program. When a great explainer page is paired with a clean, friendly, and mobile optimized user interface, customers have no reason not to give your product a try. Moral of the story: if a customer is considering your brand and your program, a clear explanation and intuitive UI can help your brand stay ahead of the (learning) curve.

 

If Your Model Doesn't Have Switching Costs, Switch it Up!

Switching costs are an important business model mechanic that can help brands build better customer relationships and defend themselves from competition. We’ve covered what they are, why they work and how you can get switching costs working for your brand, so what’re you waiting for? If your business model doesn’t come with a healthy dose of switching costs, you’re going to want to switch it up!