7 Powers: The Foundations of Business Strategy 3/4
4/ Switching costs addiction
Any serious investment is a sunk cost and replacing it with another sunk cost is not the winning proposition.
Migrations have huge uncertainties in terms of timing, costs and process disruptions.
High switching costs lead to constant price increases.
Switching costs occur when a consumer values compatibility across multiple purchases from a specific firm over time (repeat purchases or complementary).
Benefit. High switching costs allow the firm to charge higher prices for subsequent purchases for existing customers. (no benefit from potential customers or if there are no follow-on products).
Barrier. To ensure the switch, competitors must compensate customers for switching costs. But the incumbent can lower the prices accordingly (there are several ways of doing it) to put the contender at a price disadvantage. Share gain for a contender becomes prohibitively expensive.
It’s a non-exclusive power type and is not immune to disruptive shifts on technology (cloud being a good example). So, the firm will need to put some eggs in the new technology basket, too. (see the “3/ Counter-positioning” chapter)
Theoretically can lead to Network Effects due to high adoption of the core platform and the plugins, or even to the Branding effects.
Types of switching costs
Financial. Clearly monetary costs (TCO or list prices).
Procedural. Arise from the loss of familiarity with the current product or from the risk and uncertainty of the adoption of the new product. Leads to employees doing new jobs or existing jobs differently. Database migrations and ensuring data integrity are a big concern.
Relational. Breaking of emotional bonds built though the use of the product and through interactions with other users and service providers. These relationships have mutual positive feelings for everyone involved and will have to be rebuilt with a new vendor. Users may revolt and even leave the firm.
Switching costs multipliers
The more firms use the switching costs as a defence mechanism, the easier it is to calculate the cost to spend on acquiring a customer from a competitor (CAC) and the customer’s LTV. (clearly – an arbitrage)
The strategy is to capture the customer before CAC starts looking more like an LTV.
Must have follow-on products to monetize the customer (plugins, bolt-ons, platinum service packages, etc.).
Integration of tools deep into the customers’ processes and performing extensive training helps to keep the customers on top of the relationship benefit.
Branding is an asset that communicates information and evokes positive emotions to the customer, leading to an increased willingness to pay for the product.
Benefit. Charge a higher price due to:
Good feelings – branded experiences are more desirable
Uncertainty reduction – a brand is a promise of quality (among many other things)
The benefit from branding doesn’t depend on prior ownership —> no switching costs. [MK: Except, maybe, with designer clothes when a “look” has to be reassembled with the new brand lineup.]
Barrier. A strong brand can only be created over a lengthy period of reinforcing actions [time and actions being the key barrier]. Such long period of time creates uncertainty over the effective outcomes for contenders.
Branding – Challenges and Characteristics
Brand dilution. Releasing products deviating from or damaging the brand image. Dilution resets the brand longevity clock.
Counterfeiting. Can damage the brand if not countered.
Changing consumer preferences. Like with computer games that became adult pastime, Nintendo still sticks to the family-friendly games, as otherwise the brand will be diluted or damaged.
Geographic boundaries. Many “premium” brands are premium only outside their domestic territories.
Narrowness. Scale economies can help with brand power because the larger the company’s sales volumes, the more expensive the branding campaign can be (spreading the costs across millions and billions of produced units).
Non-exclusivity. Direct competitors can all target the same segment and earn outsized returns.
Types of Goods with Branding Potential
Justifying the price premium. With B2B there are more objective deliverables and the SLAs. For consumers with a sense of identity good feelings are the driver. And there has to be some way to signal the exclusion of alternative identities.
The “uncertainty reduction” part of the branding power is driven by the high perceived costs of uncertainty relative to the cost of the good. Something people are not happy buying (medicine, food, transport, etc.).
The branding premium is only sustainable if the goods are durable, otherwise the benefit will be arbitraged.