Should you give customers prompt-pay discounts? When suppliers offer discounts to you, should you take them even if you must borrow? Here’s how to do some quick math with your own real numbers to get the answers.
Customer Discounts – When cash flow is tight and receivables are slow, offering a discount to your customers for prompt payment may appear to be an attractive solution to the problem. In most cases, however, discounts are an economically unwise choice. Here’s the math.
To make the calculations simple, use a nice round sales figure such as $100,000. Do the following:
1) Calculate the cost of the discount by multiplying the discount percentage times the sales amount. A 1% discount on $100,000 equals $1,000.
2) If you borrow money on a line of credit, calculate the daily cost of borrowing money. In this case, we would need to borrow $100,000 and we’ll assume a 9.5% borrowing rate of $9,500 per year. To get the daily interest cost, divide $9,500 by 365 days for a daily cost of $26.03.
3) Calculate the number of days the customer would need to withhold payment to equal the discount. In this case, we divide $1,000 (the discount) by $26.03 (daily interest cost) for a result of 38 days.
What this calculation tells us is that the customer must delay payment for more than 38 days for our discount to be cost effective! In all likelihood, most of your customers are not that late and the ones who are probably wouldn’t have the cash to be able to take advantage of your discount!
If your company is in the fortunate position of not borrowing money, perform the same calculation, but use your savings rate of interest in lieu of a borrowing rate. For instance, at a 5% savings rate, the daily lost interest is $13.70 ($100,000 x 5% divided by 365). If you give a $1,000 discount, now a customer would have to be 73 days late for you to break even!
Sometimes it’s easier to think of discounts in terms of annualized equivalent interest costs. Here’s how two popular discounts stack up:
1%/10, net 30 = 18.4%
2%/10, net 30 = 37.2%
Notice that a 2% net 10 discount is equivalent to paying 37.2% in interest. Ouch!
Before you rule out discounts entirely, however, there is one time when they can make economic sense. If you can raise the price of your products by the discount amount or more, and then get your money in the door faster with the perceived discount, you have a winner!
Supplier Discounts – As you may suspect by now, your company is almost always ahead of the game by paying suppliers early to gain their discount. We use the same calculations to check out our savings:
1) Calculate discount amount.
2) Calculate daily cost to borrow the funds (or lost savings rate).
3) Divide discount amount by daily cost of borrowing/lost savings to determine breakeven point.
4) Pay supplier early if breakeven days are in excess of supplier non-discount terms. (For instance, with a $100,000 purchase, a supplier discount of 1% net 10 and a 9.5% borrowing rate, as long as supplier normal terms are shorter than 38 days, you should take advantage of the 1% discount.
This example of a clean and simple net 10 is not what stumps marketers. It’s when the terms get a little trickier that the math gets a bit more difficult. For instance, if you sell home heating oil burners, lubricants or tires, you may see some interesting terms out there. There may be a 30/60/90 day payment option with a 2% net 10 or 1% net 30 offer. Don’t let the terms deter you from doing the math.
Again, start with calculating each discount. Then calculate your cost of borrowing if you took advantage of the shorter terms.
The math is a bit more complicated in this example because the normal supplier terms call for a $33,333 payment at the end of each month. Therefore, you need to calculate the daily interest cost for $100,000 and for $66,666 and for $33,333. You’ll also need to be careful that you have the right number of days calculated at each dollar amount.
After you do one or two of these calculations, you’ll find that even the most complex supplier payment offerings take you less than 10 minutes to calculate and decide. That little bit of time spent may save your company tens of thousands of dollars each year!
Once you see the cash and profit benefit of trade discounts, get a little more aggressive with requesting discounts from vendors. The worst they can do is say no. Nothing ventured, nothing gained!
So, in summary, the general rule of thumb with discounts is take them, but don’t give them.