Switching Costs are defined as the value loss expected by a customer that would be incurred from switching to an alternate supplier for additional purchases and they arise when a customer values compatibility across multiple purchases from a specific company over time, either repeat purchases or purchases of complementary goods. 

Switching costs can exist in hardware businesses, such as GE’s dominant locked-in position in creating jet engines for Boeing, or software businesses, particularly enterprise software and systems of record - Salesforce’s lock-in with customers as they build their entire sales process on the CRM. 

Benefit of Switching Costs

A company with embedded Switching Costs can charge a higher price as they have more real and/or perceived value to their customers. The benefits of Switching Costs are all on the value side - superior deliverables, affective valence, and uncertainty reduction:

• By becoming the system of record, enterprise software products can continue to add on more products and services and ultimately provide superior deliverables given the suite of integrated offerings. 

• Moreover, products such as Salesforce become the defacto CRM for many industries and regardless of whether or not their core product is actually superior to the competition, most companies will still use Salesforce because of that built-up reputation - that affective valence. 

• Finally, the uncertainty reduction with a product like Salesforce is powerful - a company may be tempted to use a hot new upstart CRM but the risk is too high, they know what they are getting with Salesforce, know it will be around “forever”, and can scale with them.

Barriers of Switching Costs to challengers

A competitor must figure out a way to overcome these Switching Costs, either through offering materially more value for a similar price or having a significantly reduced price, or some combination. Meanwhile, the Power holder can easily adjust prices to swat away any challengers. Ultimately, just like with Scale and Network Economies, the barrier is the attractive cost/benefit of share gains for the challenger.

Yet again, early stage companies will not yet have achieved Switching Costs as a Power; however, the prospect of them can be readily apparent. For example, enterprise software companies in nascent industries or industries with low software adoption will almost certainly create Switching Cost Power if they achieve scale. Convex and Tyba and two enterprise software companies that I’ve invested in and I am confident they will build this Power. HyPoint, who makes hydrogen fuel cells for aviation, will also have Switching Costs as their partners are building their entire hydrogen aviation platforms around HyPoint’s technology. 

Up next, Warren Buffett’s favorite Power - Branding…