By Brandon Rakszawski
Director of Product Management
Powerful moats can be built on switching costs, which lock customers into a company’s unique ecosystem and make it expensive to move.
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. 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 optimize 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 realized that they would incur the cost of a new razor as well.
Switching Costs in Action
Stryker Corp. (SYK) 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. Morningstar adds, “Relative to other specialists, an orthopedic surgeon’s skill and experience can play an outsize role in the clinical outcome for the patient. These factors leave surgeons reluctant to train and master multiple instrumentation systems.”
Salesforce.com Inc. (CRM) 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 organizational risk of moving away from the platform, as well as the time, expense, and lost productivity associated with the implementation of a new application.
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Originally published by VanEck on 27 September 2022.
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DISCLOSURE
Company-specific information based on Morningstar analyst notes last updated as follows: Stryker Corp.: 7/27/2022; Salesforce.com, Inc.: 5/31/2022.
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