The True Value Of Cost Switching
Revenue is the driving force behind any successful business and revenue is driven by customers. As anyone who has ever run a business will tell you, the most valuable customers are those that stick with you. It’s very difficult to grow a company when you have to consistently generate new business.
Depending on what study you read and what industry you are in, acquiring a new customer is anywhere from 5 to 25 times more expensive than retaining an existing one.
So how do businesses retain customers?
Having a great product is a good starting point. Having great customer service is another. You’ll all have experienced this if you’ve ever had a problem at a restaurant. The savvy restaurant owner will deal with a complaint by handing out complimentary drinks or desserts to the table to ensure that you leave a happy customer, willing to leave a good review, and hopefully returning at some point in the future. Getting you in the door in the first place is only the start of your business relationship. The key job now is to maximize that relationship. There are even ratios like LTV/CAC which measures a customer's lifetime value (LTV) compared to the cost to acquire that customer (CAC).
Another way businesses retain customers is through switching costs. These occur when switching to a competing product will take some added effort or potentially incur some financial cost. Some businesses have zero or very low switching costs. For example, it doesn’t cost anything to switch to a new type of detergent. The worst-case scenario is that the new detergent isn’t quite as good as the one you previously used, in which case you just switch back. Other businesses have quite high switching costs though — even some that you may have never considered.
We all have a bank account. We’ve probably had that account for many years. The reason banks work so hard to get customers (particularly at a young age) is that there are a huge amount of switching costs associated with changing your bank account. Firstly, you have to remove all your funds and transfer them to another bank. That may not seem like a huge obstacle but think about the implications of that. Now you have to get new cards which can take time to organize. You also have to make sure that all the services you pay for related to that card are updated — your online subscriptions for example. It’s a lot of work. Then you need to ensure that all your direct debits are reconfigured to come from your new account.
It may not be costly financially, but it's an organizational mess, and one mistake could mean you miss paying your rent, or your credit card balance, and that leads to further problems down the line.
The same could be said for something like Facebook. Many people as they get older will find they stop using social networks like Facebook so much. But over the years you’ve collected a lot of photos and friends on the platform. While there is no financial cost to closing your account, you’ll have lost something. So the majority of people just leave it as is despite all the data and privacy concerns.
On a business to business level, this is magnified, as any decisions that cost the company money are heavily scrutinized and need to be approved by various stakeholders. On top of that, a decision that could affect service and damage the company’s ability to conduct business will likely be out of the question in many cases.
Perhaps the best example of this is Oracle, whose databases are integral to the running of many enterprises. Switching to a competitor's database may be in the best interest of the company going forward, but the cost of doing so would be so disruptive and costly at the time that many managers wouldn’t even consider it. That’s a very powerful position for Oracle to be in. They can effectively raise prices year after year without much fear that they’ll lose customers.
High switching costs are therefore a great moat for businesses, protecting their revenue streams and pricing power from competitors. In times like the ones we currently face, companies that can retain customers will have a huge advantage over those that can’t.
It’s particularly important when it comes to SaaS businesses as switching from cloud-based applications to other cloud-based applications is pretty straightforward with no hardware infrastructure required. Instead, SaaS companies try to become mission-critical to the functionality of the business to the point where moving to a competitor would be too disruptive. When assessing this, there are a number of things we can look for.
The first is customer retention. You’ll rarely see this number given out as is. Instead, we often get told about dollar-based retention, which is a measure of how much the revenue the business has generated from clients they had 12 months ago. Obviously we want to see this number over 100% as it shows that customers now are spending more rather than less. That’s a positive sign that the customer is happy with the product and is possibly expanding it to other teams or business segments.
Another very positive sign is a company’s ability to cross or upsell multiple products to the same client. Typically a business will purchase one product to try it out before looking at other offerings. One product may be easy enough to replace within an organization, but if you have multiple products that integrate, it’s much stickier. Some companies will show this in their quarterly reports as a percentage of clients with two or more products. Seeing this number grow year over year is a great sign of a company’s economic moat.
Finally — and this is a bit more analog — but many companies will include customer testimonials on their websites. It’s a way to attract new businesses and show off the success that other companies have had with using their products. These can be quite informative and show how companies from different industries employ the same solutions to suit their needs. A glowing testimonial from a Fortune 500 executive can be a great sign that the company is winning and retaining high-spending customers.
We’ll try to dig into a few more signs of economic moats over the next few weeks as we analyze what businesses have the best chance to stay afloat for the duration of this crisis.