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Here’s why understanding switching costs is crucial to good product strategy

Elizabeth Yin

I recently spoke with my business partner Eric Bahn about the importance of selling products that fit into customers’ existing workflows.

That conversation got me thinking how important switching costs can be to the success of products — often in ways that don’t seem obvious at first.

So I’ve written about the relationship between switching costs and product strategy below. I hope you’ll find them helpful:

First, it’s not enough to just have a good product

Of course, it doesn’t hurt to have a good product.

But even if your amazing product solves a dire need better than any other product out there, you’ll never sell anything if customers have to pull out their hair to switch to your product from the product they’re already using.

So before you start selling your amazing product, you need to understand how switching costs impact adoption and retention of your product, because that will determine how — and more importantly, when — you should sell your product.

Switching costs are a two-way street

When it comes to switching, it’s important for entrepreneurs to think in both directions.

This may sound obvious, but it’s really important: When a customer switches products, they switch to one product and they switch away from another product.

  • The cost of switching to a product determines adoption.
  • The cost of switching away from a product determines retention.

The key is to make switching costs work for you, not against you: Ideally, entrepreneurs want low costs of switching to their product and high costs of switching away from their product.

So, what does that look like for actual businesses?

I’ll start by digging into a few examples that are close to home:

Example 1:

At my prior startup, we sold ads. The initial sales process was fast and easy. Why? because marketers were willing to try many different ads. So since the cost of switching to my product was low, my rate of adoption was high.

But on the flip side, many of my customers would move on quickly to the next ad product.

Example 2:

My partner Eric ran a GMAT test preparation startup that offered GMAT coaching on discussion forums. His initial sales process was also easy, because it was easy for students to post questions on numerous forums. Again, the cost of switching to his product was low, so adoption was high.

But his users were more likely to stick with his platform because they got faster and more thorough answers to questions on his platform, and therefore had little reason to leave.

Of course, these are simplified snapshots of just a few businesses.

But switching costs impact all kinds of businesses

Switching costs shape buying decisions for everything from T-shirts to tax software. They can take several different forms:

  • Financial costs, such as “exit fees” or lost reward points.
  • Psychological costs, such as the perceived loss of status or comfort associated with a known brand or product.
  • Procedural costs, such as the time and effort it takes to set up or learn how to use a new product.

Products are “stickiest” among consumers (retention is highest) when they are associated with several different switching costs.

Let’s zoom in on marketing automation software as an example

Marketing automation software is software that helps companies send emails to prospective users, publish content, among other marketing activities. These platforms, like Hubspot or Marketo, are usually tightly integrated across an organization’s entire operation. Potential customers can’t just “try out” a new product without investing a huge amount of time and energy — it’s a product that has enormously high switching costs in both directions.

So marketing automation software companies have 2 main options when it comes to selling their products:

Option 1: Win over existing customers by competing directly against similar products.

This strategy is challenging because:

  • It involves long sales cycles and constant follow-up to get the timing right — when a potential customer is ready to switch and has the time and energy to switch
  • It requires offering a product that’s not just as good as, but often 10x better than competitors’ products to convince customers to switch
  • It still involves a gamble of getting customers to overcome the inertia and risk of switching

Option 2: Find new customers by selling an adjacent product and then expanding.

This strategy is generally preferred to Option 1 because:

  • It doesn’t require customers to rip out software
  • It doesn’t require such precise timing in the sales cycle

HubSpot, who is now a leader in marketing automation, successfully used this second strategy to battle incumbents.

Unlike other marketing automation companies, HubSpot targeted smaller companies who didn’t already have any form of marketing software and then grew with them. They started by offering free products such as “website grading tools” that were small little widgets with fast adoption cycles. And, once clients started signing up, over time they grew their software product offering to eventually go head-to-head with marketing automation behemoths.

Now, HubSpot is a large and diversified software company that sells a variety of sales and marketing software products.

So, how can entrepreneurs use switching costs to their advantage?

HubSpot calls its strategy of up-selling customers products with higher switching costs a “flywheel” approach.

The model works by using products with low switching costs to get customers in the door, and then using other products with higher switching costs to shut that door behind them.

The same principle is applicable to ANY product:

  • If your primary product has a low switching cost, focus on retention by increasing the value (and therefore the switching cost) of your product or by offering other higher-value products.
  • If your primary product has a high switching cost, focus on adoption by reducing the friction it takes for customers to try your product or by offering other products with lower barriers to entry.

Special thanks to Conor Grant on this post!

This article was first published on elizabethyin.com, on May 1, 2020.