Switching costs build moats and retain customers

The term “economic moat” describes a company’s ability to maintain its competitive advantages and defend its long-term profitability. This moat investing education series explores the five primary sources of moat, according to Morningstar: 1) switching costs; 2) intangible assets; 3) network effect; 4) cost advantage; 5) efficient scale. Each week, we’ll write a new blog focused on each of these sources of moat.

Here we explore the concept of switching costs.

Customers get locked-in by switching costs

Switching costs are present when a customer’s cost of switching to a new supplier exceeds the value they would enjoy from making the switch. Switching costs endow the incumbent supplier or provider with pricing power that can, in turn, lead to economic profits.

Switching costs: When it would be too expensive or troublesome to switch away from a company's products, that company often enjoys pricing power.

Not just monetary in nature, switching costs can also be measured by the effort, time, and psychological toll it takes to switch to a competitor.

Switching costs provide a company with the leverage to increase prices and deliver hefty profits over time. They are a key competitive advantage and are evident in a range of industries, from banks, to computer software/hardware, to telecoms, among others.

An early example: Gillette razor blades – designed to create brand attachment

King Camp Gillette, the inventor of the first mass produced safety razor, was one of the first entrepreneurs to optimise the switching cost approach to lock in customers. In 1902, Gillette developed and began selling inexpensive razors with disposable blades that he had patented. This ensured Gillette a constant high demand for blades, as customers who considered other blades quickly realised that they would incur the cost of a new razor as well.

Switching costs in action

Stryker is a top-tier competitor in a number of medical markets. These include orthopedic implants, surgical equipment, endoscopy, and neurovascular devices. Since switching costs can be significant for surgeons when it comes to orthopedic implants, this is, according to Morningstar, one of Stryker’s “moatiest divisions” in support of the company’s wide economic moat.

Salesforce.com is a leader in providing cloud-based solutions that address many aspects of customer acquisition and retention. According to Morningstar, its salesforce automation application is “mission-critical software that helps drive revenue for users.” Morningstar notes the high organisational risk of moving away from the platform, as well as the time, expense, and lost productivity associated with the implementation of a new application.