Connect with us

# Should I Take Discounts? [Cost Of Credit Ratio]

Published

on

The Cost Of Credit is used to determine the cost of not–taking–a–discount–offered–by–a–supplier. It is used by the purchasing department as a negotiating tool so that a company can receive a net return on early payments to suppliers. It is also used extensively by the accounts payable staff to verify that the early payment terms offered by suppliers continue to be valid as the company’s cost of capital changes. Further, the sales staff uses the calculation in its dealings with the purchasing staffs of other companies, who are also interested in obtaining better early payment discounts.

Formulation: Determine the proportion of a full year to which the discount period applies. This is the number of days between the end of the early payment period and the date when the payment would normally be due at full price, divided into 360 days. This is the time period over which the discount rate earned by a company is applied. Next, subtract the offered discount percentage from 100%, and divide the result into the discount percentage. This is the effective interest rate that a company will be earning when it takes a supplier-offered discount. Finally, multiply the effective interest rate by the proportion of the full year to which the discount period applies. This yields the annualized cost of the credit being offered by a supplier through its early payment discount.

The formula is:

Discount %/(100-Discount %) × (360/Full allowed payment days–Discount days)

Case Example:

A supplier of the LieDharma Aeronautics Company is offering early payment terms of 2/15 net 40, which is a discount of 2% if paid within 15 days, with regular payment due after 40 days. LieDharma’s cost of capital is 14%. The accounts payable manager needs to decide if it is economically sensible to take advantage of the discount.

The calculation is:

Discount %/(100 – Discount %) × (360/(Full allowed payment days – Discount days))
= 2%/(100% – 2%) × (360/(40 – 15))
= 2%/(98%) × (360/25)
= .0204 × 14.4
= 29.4% Cost of credit

Result of Analysis: Since the cost of credit of 29.4% is substantially higher than the corporate cost of capital of 14%, this is a good idea. So, the accounts payable manager authorized taking the early payment discount.

Cautions:

Typically, the cost of credit is compared to a company’s cost of capital, which is a blended rate composed of the cost of all corporate debt and equity. In reality, taking a discount tends to be an incremental decision related to the immediate cost of invested funds.

For example, an accounts payable manager will draw down cash from a short-term cash supply, typically invested in a money market fund, to take advantage of an early payment discount. This means that the incremental investment trade-off is a few percent of interest earned in the money market fund, rather than the much higher cost of capital for the entire company.

Purchase Discounts Taken To Total Discounts

Few accounting activities can be shown to directly save money, but taking early payment discounts that has been planned when the purchasing initiation made is one of them. In many cases, accounting department is often not well informed. That is why a controller or Finance and Accounting Manager should build a strong link between the Purchasing Department and the Accounting Department. The best way to do this is by providing a proper system, clear procedure and policy.

From the accounting perspective, taking early payment discounts means examining incoming invoices from suppliers to see if a discount is offered, determining if the discount is economical, and scheduling it for early payment. Comparing the proportion of purchase discounts taken to total discounts available can show how effective the accounts payable staff has been at saving money for the company. Any measurement result less than 100% should be considered unacceptable. Those task hould be done either it is required or not.

Formulation: Divide total purchase discounts taken by the total amount of economical discounts available. The information needed for the numerator is generally simple to collect, because a typical accounting system will store the amount of the discount in a separate line item in the chart of accounts.

The Challenge: is in deriving the information needed for the denominator, since this information is not stored anywhere.

Solution: One can query the supplier database in an automated accounting system to see which suppliers are listed as having discounts, but this will ignore any suppliers for whom the accounts payable staff has missed the presence of discounts on their invoices. Consequently, a better approach is to supplement the review of the existing accounts payable database with an ongoing audit sample of supplier invoices, to see what other invoiced discounts have been missed. Also, all offered discounts with terms so poor that they should be excluded from the denominator (since they are not viable discounts).

The formula is:

Example: The internal auditing staff of the LieDharma Company has been asked to calculate the accounting department’s ability to take all purchase discounts offered by suppliers. The auditors compile the information about discounts shown below:

The internal auditing staff finds that four of the five potential discounts were taken, but that one discount was taken that was not economically viable. Consequently, they choose to exclude the non-economically viable discount from the numerator, since this figure should only relate to the total number of economically viable discounts available that are noted in the numerator.

The Calculation:

Also, since the company’s automated accounts payable system is set up for continuing early payments to Raster Builders (whose discount is not economically viable), the internal auditors inform the accounts payable supervisor and controller of this problem, so that the payment record for this supplier can be altered.

Cautions: The results of this measurement can be misleading if invoices are sent outside of the accounting department for approvals, since a delayed approval can take longer than the required payment date on a discount.

The same problem arises for centralized accounts payable departments that service many company locations, because invoices may be sent to outlying locations by suppliers, which builds in a time delay while these locations send the invoices to the central accounts payable location.

If the approvals problem is evident, the accounts payable function can be restructured so that all invoices are logged into the system for payment before they are sent back out for approvals, and then they can be paid on the required date without having to wait for an overdue approval.

If delays are caused by a centralized accounts payable system, then the accounting staff can contact suppliers to have them change their “bill to” addresses to match that of the accounts payable center.

Percentage Of Payment Discounts Missed

This is the same measurement shown in the last section, except that its focus is on the proportion of valid discounts not paid, rather than paid. It is most effective when presented alongside a detailed listing of specific discount-related payment problems, with the reasons why those discounts were missed.

Formulation: Divide the number of payment discounts missed by the total number of valid payment discounts available. An alternative is to divide the dollar volume of payments missed by the total dollar volume of payment discounts available, which focuses attention on the presence of large missed discounts.

The formula:

Example: The LieDharma Company has missed taking several purchase discounts. To bring the issue to the attention of the controller, the assistant controller decides to calculate the percentage of payment discounts missed. Here is the relevant information:

1. Total number of discounts available = 142
2. Total number of discounts missed = 6
3. Total dollars of discounts available = \$91,500
4. Total dollars of discounts missed = \$31,250

The Calculation: If the controller chooses to calculate the measurement based on the number of discounts missed, the result will be:

The measurement appears to show that the number of discounts missed is a small issue. However, the assistant controller sees that, contained within the small number of missed discounts, is a very large dollar volume of lost discounts. Consequently, the assistant controller prepares the following alternative measurement, which clearly shows the dollar value of the problem:

Cautions: The same cautions apply as were described for the last measurement (the purchase discounts taken to total discounts formula).

Are you looking for easy accounting tutorial? Established since 2007, Accounting-Financial-Tax.com hosts more than 1300 articles (still growing), and has helped millions accounting student, teacher, junior accountants and small business owners, worldwide.