What is Cost-Based or Cost-Plus Pricing?

A cost-based or cost-plus pricing strategy is when a distributor sets their ERP price based on the cost of the good or service plus a margin. This type of pricing can be used to ensure that the business is making a profit on each sale, while also keeping the prices low enough that their customers will still be interested in purchasing them. It can also be helpful for distributors who are unsure of what their competitors are charging, as they can use their own costs as a baseline and add on an appropriate margin.

Why Do Distributors Use Cost-Based or Cost-Plus Pricing?

When it comes to distribution pricing, cost-based pricing is one of the most popular methods around. This is because it is easy to calculate, objective, and brings predictable margins. It also doesn’t require too much effort to put in place, making it a very attractive option for businesses.

In addition, cost-based pricing is readily justifiable to customers as it’s a very straightforward way of approaching price. If a product costs x to purchase, then the producer must charge x plus a margin to secure a profit. This is a simple concept that most people can understand, making it a more appealing option than some of the more complex pricing strategies out there.

Overall, cost-based pricing is a reliable and straightforward way to set prices. It brings predictability and consistency to margins, while also being easy for customers to understand. This makes it an ideal strategy for many distributors.

The Downsides of Cost-Based or Cost-Plus Pricing

There are several downsides to using cost-based pricing, especially for the employee who is in charge of pricing. The most glaring of which is that it is inward-focused — only taking into consideration internal cost concerns and not considering external factors such as a customer’s willingness to pay a premium.

For example, you may have a source of inexpensive but reliable replacement parts for sophisticated factory machinery. Your customer places a high value on you having the right parts in stock for them when their plant is down. The cost to them will never be anywhere near the value of keeping their factory up and running. You could charge a premium for those parts well above a cost-plus pricing strategy. As such, using a cost-based pricing strategy in this instance would lead to lost revenue. You would be leaving a lot of profit on the table.

Another drawback of cost-based pricing is that it can be inflexible. For example, if production costs increase, the price of the good or service may not be able to be raised due to competition or other market factors. This can lead to lower profits or even losses for the business. Additionally, cost-based pricing can be difficult to scale up or down in response to changes in demand, which can lead to excess inventory or shortages.

Cost-Based or Cost-Plus Pricing is Inaccurate

As we discussed above, most distributors use some form of cost-based pricing in their business believing that this price will cover the cost of purchasing and selling the good or service, as well as generate a profit.

While this may be a sound strategy in theory, there are several factors that can make it difficult to accurately calculate costs. For one, input costs can change over time, making it difficult to estimate future expenses. Additionally, different branches and locations may have different fixed costs, which can be difficult to attribute to specific products or services. And finally, even if costs are correctly estimated, there is always the chance that they will be inaccurate, resulting in lower profits than expected or lost customers altogether.

In short, while cost-based pricing is often a reliable way to set prices, it is not without its drawbacks. Distributors need to be aware of these challenges and take them into account when setting prices. By doing so, they can ensure that their prices are both fair and profitable. This is why price optimization solutions have become so critical in running your distribution system as they give you other options to evaluate market-level pricing and pricing based on customer and product segmentation.

Please visit our solution guide of price optimization solutions to learn more.