A lubes vendor recently announced they will be changing their terms from 30/60/90 to net 60, but will still offer a 1% discount for payment in ten days. If you were their marketer, how would you pay? How do you calculate the best deal?
The most accurate way to calculate vendor terms on a multi-payment option like 30/60/90 is by calculating daily costs. Whether you are a retailer or wholesaler, the same principles will apply. Using the data from the lubes vendor example, here’s how we can calculate the best deal.
Let’s use the following assumptions:
• Product Purchased – $15,000
• Bank Line Interest Rate – 8%
• Company Target ROI – 15%
We can look at the money cost in two different ways that may impact our decision. First, we can calculate the costs and benefits using the company’s borrowing rate on its bank line at an 8% interest rate. If the company has no potential investment projects that it needs cash for, this would be the correct calculation.
However, if the company is, let’s say, in the middle of acquiring another account or perhaps even acquiring a competitor company where the cash can produce a 15% return, then we need to use that higher opportunity cost of capital.
Here are the calculations and money flow over the 90 day period in question. The 1% discount on $15,000 is $150. Therefore, the company would pay $14,850 on day 10. If they choose 30/60/90, they pay $5,000 on day 30, $5,000 on day 60, and the remaining $5,000 on day 90. So now we look at the cash flow differences on a day-by-day basis.
Day 1 to 10 $0
Day 11 to 30 $14,850
Day 31 to 60 $9,850
Day 61 to 90 $4,850
Using the bank line rate, the daily rate is .022% (8% divided by 365). Applying this daily rate to the cash flow difference gives us a benefit of $162.36 [(.00022 x 20 days x 14,850) + (.00022 x 30 days x 9,850) + (.00022 x 30 days x 4,850)]. The benefit almost doubles using a 15% rate. In either case, the marketer should take the 1% net 10. If the marketer could only make, say 5% on those funds however, he should take the discount.
To compute equivalent interest rates on discounts where the payment is due in one lump sum, the formula is as follows:
Rate = Discount % x 360
(100% – Discount %) (Reg. – Dis. Days)
In this formula, the last denominator is regular terms less discount terms, so, a 1% net 10 or 60 would equal (.01/.99) times (360/50) or 7.27% equivalent interest rate. In this case, he should forgo the discount. A 1% net 30, however, is equal to over 20% interest, which is why it’s almost always beneficial to take advantage of supplier discounts, except when dealing with extended terms. By using this formula, you’ll always know your equivalent interest rate and can make a sound decision.