Extra Benefits: The Magic of Shopping Discounts
The use of purchase discounts is a recipe for success in any economy. Mixing a dollop of “good business practices,” a sprinkle of “strengthen supplier relationships,” and a sprinkle of “profits” creates a dish that is sure to fatten up your bottom line. If your business isn’t already, paying vendor bills early enough to take advantage of purchase discounts is a quick and easy way to get to the next level.
WHAT IS A PURCHASE DISCOUNT?
A purchase discount is money taken off a supplier’s bill when you pay within a certain period of time. Discounts are typically expressed as a percentage, with 1% being the most commonly used and rates of 0.5%, 1.5% and 2% all seen in standard practice. Therefore, a $100 invoice would only cost your company $99 if the supplier offers a 1% discount and your accounting department pays the invoice during the discount period. Most providers that offer credit terms allow an invoice to be paid within 30 days, expressed in business jargon as “Net 30”. If a vendor offers a 1% discount for their customers to pay within 10 days, this would be expressed as “1% 10 Net 30”. So “1.5% 15 Net 45” means the bill is due within 45 days, but the provider will allow you to deduct 1.5% of the bill if you pay within 15 days.
Another deviation is to express credit terms as calendar dates. So “2% 5th Net 25th” means the invoice is due on the 25th of the month, but a 2% discount is offered as long as the invoice is paid by the 5th of the month.
WOULD YOU INVEST YOUR COMPANY’S MONEY FOR A RETURN OF 18%?
The typical argument against taking advantage of purchase discounts is the value of available cash. You can argue that keeping cash in your company longer far outweighs the meager 1% that a purchase discount earns. The math shows the opposite. Take, for example, the more common credit terms of 1% 10 Net 30. Remember, this gives you a 1% discount for paying 20 days early in the cycle. Keep in mind, though, that banks set their yields based on an annual percentage yield (APY), not a 20-day rate. The math for putting the 20-day investment in terms of an APY starts with dividing it over a 360-day period (known as a banking year). The simple division of 360/20 equals 18, showing that the actual discount is “worth” 18 times its face value. So a 1% discount rate yields the equivalent of 18% APY.
HOW CAN YOUR COMPANY PAY IT?
The beauty of taking advantage of shopping discounts, if you’re not already doing so, is how easy it is to get started. Think about how you do business now. Most likely, the accounting department pays its vendors every month. Don’t change that! Pay them every 30 days, only start paying during the discount period. As an example: if your supplier offers credit terms of 1.5% 7th Net 27th, you would normally pay on the 27th of each month, assuming you are in reputable business. The payment would be sent again in 30 days plus on the 27th and so on, month after month. Use the purchase discount by paying on the 7th of each month instead of paying on the 27th of each month. The first time will be a bit difficult as you will have to pay on the 27th of this month and then again about 10 days later on the 7th of next month. But, this is a one-time procedural change. After this short-term pain, you have realized long-term gains for your company. Also, your company went back to having a monthly payment schedule, now you pay on the 7th of each month instead of the 27th.
Although borrowing from a line of credit or credit card should only be used as a last resort, you should ask yourself if it is worth paying 4.75% APR (average line of credit rate) or 12% APR (average credit card rate) for save 18% APY.
ARE THE CREDIT CONDITIONS NEGOTIABLE?
Credit terms are absolutely negotiable! Depending on your volume and loyalty to a supplier, you may be able to negotiate a special discount rate for your company. A 3% discount is incredibly rare. However, a 2% discount is not out of the question for extremely loyal customers. You won’t know until you ask!
WHY DO SUPPLIERS OFFER DISCOUNTS?
Cash is king in all businesses, not just yours. Suppliers are also companies. They need cash to pay payroll, pay the water bill and keep the lights on. Their cash flow model is further complicated by the number of businesses that go out of business, file for bankruptcy, or simply don’t pay on time. So they are willing to offer your business an incentive to make sure cash flows into their bank accounts so they can pay their bills.
HOW DO PURCHASE DISCOUNTS MAKE PROFITS?
Under accounting rules (known as: Generally Accepted Accounting Principles or “GAAP”), purchase discounts are a “top line” number and are treated as Revenue. However, unlike other income, every penny of purchase discount income flows directly into the ‘bottom line’, known as net profit. You don’t need an accounting degree to understand this phenomenon.
In very simple terms, from your company’s current income statement (also known as a profit and loss statement), the flow of dollars is as follows. Revenue is received from your customers (‘top line’). Direct Expenses, such as labor and materials, are subtracted from Revenues to obtain Gross Profit (“Middle Line”). Indirect expenses, such as cell phones, lights, insurance, office staff, etc., are subtracted from gross profit to calculate net profit (“bottom line”).
With the above in mind, add the additional revenue stream from purchase discounts to the Income Statement as Revenue. There are no additional Direct Expenses generated by advance payment to suppliers; then, this flows through the Direct Expense portion of the statement to Gross Profit. Likewise, there are no additional Indirect Expenses incurred for the advance payment; therefore, the amount of the purchase discount flows directly to the net income line.
HOW MUCH PROFIT?
Even small businesses can measure their additional earnings in the thousands of dollars with this simple change in payment policy. It’s not uncommon for a small business with 10 to 20 employees to have annual revenues of $1 million. Since materials average 40% of revenue in many industries, your company’s average annual materials costs will be around $400,000. Thus, a 1% discount purchased throughout the year yields a return of $4,000 in new sales. found gains. If your material purchases are higher or the discount rate you negotiate is better, the impact on the bottom line would be much greater. Plus, when you consider that this “once hidden, now found” money is generated year after year by making a one-time 20-day payment policy change, the results are staggering. As a bonus, your vendors will quickly move you up a few levels on their “best customer list.”
A simple upgrade to exercise purchase discounts today will help your business earn extra profit, strengthen supplier relationships, and use corporate best practices for years to come.