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Understanding innovation in services has always been complicated by the intangibilityof the underlying offering and hence the ease of imitation by rivals. Thisstudy extends the transaction cost approach by investigating how the switching costscreated by the interaction between a service firm and its customers impact the levelof innovation activity by the organization. Using data obtained from a sample of221 service firms, the findings suggest that when organizations structure their serviceproduction processes in a manner that requires a high degree of direct face-to-faceinteraction with the customer, the resulting impact is an increase in customer switchingcosts. This, in turn, acts as competitive protection for these firms, inducing themto pursue greater levels of innovation. In addition, we found that certain combinationsof customer-firm interaction and innovation activity led to superior performance.