What we learn from Apple

I have a Creative MP3 player, and I recently bought a Samsung player for my son.  I bought my Creative a few years ago.  It was priced at a similar price point to the comparable iPod, but had a couple of extra features the iPod didn’t – FM radio and a voice recorder.  It had the same memory capacity, better video display and these two extra features.  Yet the iPod outsold it.

You see, when you buy an iPod, you’re not just committing to the player.  You also commit to the iTunes store.  And once you commit to the iTunes store, you’re locked in.  Because up until this year, the songs sold through iTunes had digital rights management (DRM) restrictions which were designed to stop these songs being shared.  But because the songs were encoded in a format unique to Apple, it made it difficult for an iPod user to replace their iPod with anything but an iPod.  Why?  Because the songs won’t play on the new player unless it’s an iPod.

When I buy songs through iTunes, I have to burn them to disc and then rip them to the MP3 format before I can add them to my MP3 player.  But if I had an iPod, they’d be ready to play immediately.

The restrictions have been relaxed now, but if I have a library of DRM music, I need to pay extra to upgrade each track if I want to remove the DRM restrictions.

By creating a complete system of buying and then playing music, Apple has created some barriers around its customers that make it difficult for them to move elsewhere.  The simple fact is this…if I have an iPod and it needs to be replaced, it’s too hard to look to any other players, even if they have better features.

This is an example of switching costs.  It costs me too much in time, money or some other commodity to change.  Because of this, I stay.

Creating Switching Costs

When I did my MBA I was introduce to Porter’s Five Forces analysis.  Within this framework was this concept of switching costs. 

Where there is little diversification, and a product is seen as a commodity, then the buying decision is primarily based on price and service.  The sellers embark on price cutting strategies, or offer higher levels of service to win the sale.  Both these strategies could end up costing more over the long term.

Where a product is differentiated and there is little perceived competition, it can command a higher price.  Because it appears different to its competition, consumers are less likely to move elsewhere because they’re not convinced they’re going to receive the same value somewhere else.

Porter, in his book Competitive Strategy outlines some major sources of switching costs:

• Costs of modifying products to match a new supplier’s product;
• Costs of testing or certifying a new supplier’s product to ensure substituability;
• Investments in retraining employees;
• Investments required in new ancillary equipment that is necessary to use a new supplier’s products (tools, test equipment, etc);
• Cost of establishing new logistical arrangements;
• Psychic costs of severing a relationship.

                                           Porter, Competitive Strategy pg 114

This blog is aimed at people who sell services.  If you’re good at selling your product, you should be aware of the relevant switching costs for your product.  This can be helpful if you’re trying to win a new client (so you can understand possible impediments to the sale proceeding) and it can also help you keep clients.

For many clients, the depth of the relationship is a huge switching cost.  Consider the client of an accountant.  They’ve probably spent years with the one accountant, and that accountant probably knows a lot about their personal and financial affairs.  If they switched to a cheaper accountant, whilst they may save some money, they’d see a massive cost in having to build a relationship with someone new.  There’s also the fear of making a mistake – ‘what if we move to this new accountant and we don’t like them?’.

In the above example we can see that in a service environment, cost may not be the deciding factor.  The important thing is to understand what is.

What Are Your Switching Costs?

Have a think about your product or service.  What are some of the switching costs that may inhibit a client moving to you from somewhere else.  How can you reduce the perceived level of pain of those costs?

What about your existing clients?  What are some things you can do to make yourself invaluable to them so they won’t leave you and go elsewhere?

In many cases, switching costs are not financial in nature.  They may be intangible, they may be time-based and they may be relational-based.

I’m not advocating being dishonest and locking clients in to service agreements that stop them from going elsewhere.  This is about respecting your clients, but also respecting yourself and having enough faith in your services that you’re confident in differentiating yourself from the crowd.

What do you think about switching costs?  Do you have any examples to share?  Leave a comment below.

I’ve heard clients speak about their accountants and say something like “My accountant is very good.  I get a tax refund of around $1,000 each year”. 

Does this mean he’s done a good job?  Did the accountant actually do anything to influence the $1,000 tax refund, or would the client have received the same refund regardless of who prepared their tax return? 

Is it right to judge them based on results that are largely outside of their control.

A couple of weeks ago I was visiting a lawyer who commented he’d had a small win earlier that week.  One of his clients was being sued for $3M but my friend managed to negotiate so they could settle for ‘only’ $2.5M.  Only $2.5M!  In the eyes of his clients, he’d achieved a very good result and perhaps in that case it was fair to judge his value based on that result.

We get it in our financial planning business.  I’ve had clients say “I’m really happy with my adviser – the funds we’re invested into did really well last year”.  “Really well “ – compared to what? 

What if they made 15%?  Would that be good?  What if other similar funds made 20%?  Would that make the comparison different?

Ultimately, it’s the wrong measure and I make sure I tell clients that.  There’s no way I want them to judge my value based on things that are out of my control.  If I take credit for the years that their investments rise in value, I’d better also take the blame when the decline.  No way!

When I see a new client, I ask them a couple of questions to help them focus on how they’re going to judge the success of the relationship.  Some questions I like to ask are:

• What would you like to achieve from our meeting today?
• If we were sitting here five years from now, what would need to have happened to make you feel that our professional relationship had been worthwhile?
• What are you looking for from us?
• How do you envisage we can work together?
• How will you be making a decision about who to work with?

I love the last question.  I usually ask it if a client indicates they’re shopping around.  I explain to them that I’m happy to prepare some recommendations, but it would help me greatly if they told me how they were going to make their final decision.

They’ll generally start to talk about things like price, returns, fund selection etc, but eventually they’ll decide things like trust, confidence and peace of mind are more important.

Being upfront with clients about what you will and won’t be responsible for is the only way to ensure realistic expectations are set and can be managed.

I believe it all comes down to being able to define your value to the client…on your terms.  Be open about the things you can and can’t control.  Take credit for the things you’ve done for them.  Don’t be afraid to ask questions about what they value in the relationship.

How do you do it?  What things do you say to clients to ensure their expectations are realistic and manageable?