Cost-plus pricing for distributors: formula, example, and where it breaks

Cost-plus pricing sets a price by adding a fixed markup to the cost of a product. The formula is price = cost × (1 + markup). A bearing with a landed cost of $11.60 and a 45% markup sells for $16.82. It is the most common way distributors build a price list, because it needs nothing except a cost and a percentage.

Harvard Business Review calls it the most widespread pricing method there is, and it is easy to see why. It is fast, every rep understands it, and when costs go up the price follows. The trouble starts when the percentage stays the same for every item, every customer and every situation.

The cost-plus pricing formula

Two choices decide whether the formula gives you a good price: which cost you start from, and how you pick the markup.

The cost should be landed cost: the supplier price plus freight, duty and handling. A markup on the supplier invoice prices every item below what you think, by exactly the costs you left out. The landed cost guide shows a bearing that looks like a 30% margin and delivers 14.5%.

The markup is usually set by product category, because categories differ in how fast they sell, how much they cost to stock and how hard customers compare prices.

A cost-plus price list example

A power transmission distributor builds its list price from landed cost with one markup per category.

• Bearings, 45%

  6205-2RS: $11.60 landed, $16.82 list.

• Belts, 60%

  A42 V-belt: $6.20 landed, $9.92 list.

• Fittings, 80%

  1/2" hose fitting: $3.10 landed, $5.58 list.

Fast-moving, heavily compared items like bearings get the lowest markup. Small, cheap parts that customers rarely shop around for carry the highest, because the handling cost of a $3 part is almost the same as for a $30 one.

How to choose the markup

A markup should pay for more than the item. It covers the cost of holding the stock, the cost of serving the order and the margin you need on top. Four questions set it for a category:

• How fast does it turn? Stock that sits for six months costs money to hold, so slow movers need a higher markup than fast ones.
• What does a line cost to serve? Picking, packing and invoicing cost about the same for a $3 part as for a $300 one.
• How hard do customers compare? Items buyers check against a competitor every time need a lower markup to win.
• What does the category earn back? Supplier rebates on a category lower its real cost and give room for a lower markup.

Start with your current markups, compare them against these four answers, and change the ones that clearly do not fit. Small moves on the right categories beat a new markup on everything.

Cost-plus by price level

Most distributors then add customer price levels on top, each with its own markup. The same bearing ends up with a different price for each type of buyer.

This is how most ERP price levels are set up, and it is where cost-plus starts to strain. Every account at the same level gets the same price, whether it buys ten bearings a year or ten thousand, pays in 30 days or 90, or would have paid list without a second thought.

Advantages of cost-plus pricing

• It is simple to run: one cost and one percentage per category, so a new item can be priced the day it arrives.
• It is easy to defend. When steel or freight goes up, you can show the customer why the price moved.
• As long as the cost is current, every sale covers what you paid for the item.

For thousands of slow-moving items that sell a few times a year, these advantages win. Nobody has time to study the market for a part that sold twice last quarter.

Where cost-plus pricing breaks

The weakness of cost-plus is that the price knows only your cost. Everything else that should move a price is invisible to it.

Each row is margin lost in one direction or the other. On commodity items you lose deals you could have won at a lower margin. On scarce items you sell at a normal price when the customer would have paid more. Reps fill the gap by discounting from list on every quote, which turns the price list into a starting point for negotiation instead of a price.

When cost-plus is the right choice

Cost-plus is a sound default, and for part of the catalogue it is the right answer:

• The long tail of items that sell a few times a year, where there is no history to learn from.
• New items with no sales yet, where cost is the only fact you have.
• Special orders and drop ships, where the cost is known and the customer expects a fair markup.
• Cost-plus contracts, where an OEM or government account agrees to pay cost plus a fixed percentage and audits it.

For the items that drive most of your revenue, the ones customers compare and reps quote every day, a single markup leaves money on both sides of the table.

Cost-plus vs value-based pricing

Cost-plus starts from what you paid. Value-based pricing starts from what the item is worth to the customer: the cost of a line stopping, the hours a better part saves, how hard it is to find elsewhere. A replacement bearing for a stopped production line is worth far more to the buyer than its cost-plus price, and they would pay it.

Pure value-based pricing is hard in distribution, because the same part goes to very different buyers and you rarely know what each one would pay. In practice, distributors combine the two. Cost-plus sets the floor, and signals that show value, such as urgency, scarcity and a customer's history, move the price above it.

Moving beyond a fixed markup

Distributors rarely throw cost-plus away. They keep landed cost and a minimum margin as the base, then adjust each quote line for the customer, the quantity, the stock position and the competitor price. A pricing engine does this per line and writes down why each adjustment was made, so a rep can see the reason for a price instead of guessing at a discount.

If you set markups today, check the difference between margin and markup first. A 45% markup is a 31% margin, and the two are easy to confuse once targets are set in one and prices in the other.