Dynamics of Switching Costs

Jul 6, 2021

Why does enterprise software seem to last forever? Why do companies like SAP have high retention but terrible customer satisfaction? Part of the answer is switching costs.

Switching costs come in many forms. Traditionally, economists have thought about switching costs in three broad groups - financial (costs money to purchase new products), procedural (takes time to learn new products), and relational (takes time to build relationships with new companies).

But switching costs are such a driver of software retention that the category deserves analysis. So here are ways that software companies capture value through switching costs.

  • Data gravity. Data is expensive and difficult to move. The cost is realized through egress and ingress charges and the time and effort required to transfer the data. Companies like Snowflake have built their entire business on solving this problem.
  • Integration Surface Area. The larger and deeper an API is, the more difficult it is to replace. Along with data gravity, this switching cost works even with open standards. Monitoring and observability APIs need broad integration to be functional.
  • Proprietary APIs. Proprietary APIs take time to replicate. Companies like Stripe and Twilio abstract connections to legacy infrastructure like payments and communication that require domain expertise and may be closed off to competitors. Historically, the Windows API was a great example of a broad, deep, and proprietary API. Its surface area made applications very sticky to the Windows platform.
  • Identity. Identity has both the qualities of data gravity (users, user groups, authorization rules) and a large integration surface, as most applications need identity.
  • UI/UX. Software requires training to use. Technical and non-technical users both get used to specific workflows and features. Switching software sometimes involves training, documentation, or hiring for particular skills.
  • Bundling. The enterprise sales cycle can be upwards of 6 months. Bundling or expanding current offerings to existing consumers can dramatically shorten the sales cycle and solve distribution. In addition, expanding to new products can increase surface area and add proprietary products that have high retention.

This list is just the start and nowhere near exhaustive. Switching costs aren't discussed enough. If you have any thoughts or comments, don't hesitate to reply by email or message me on Twitter @mattrickard.

Footnote: I don't recommend most business books since they are usually filled with survivorship bias or littered with useless anecdotes. However, one book that I enjoyed was 7 Powers by Hamilton Helmer. It explores persistent sources of competitive advantage, such as network effects or counter-positioning. One chapter is devoted to switching costs.