Using shopping discounts is a recipe for success in any economy. Mixing a dollop of “good business practices,” a dash of “strengthening supplier relationships,” and a dash of “profit” creates a plate that is sure to fatten your bottom line. If your business isn’t already doing so, paying vendor bills early enough to take advantage of purchase discounts is a quick and easy way to go to the next level.
WHAT IS A PURCHASE DISCOUNT?
A purchase discount is the money that is deducted from a supplier’s invoice when it is paid within a specified period of time. Discounts are typically expressed as a percentage, with 1% being the most widely used and rates of 0.5%, 1.5%, and 2% are seen in standard practice. Therefore, a $ 100 invoice would only cost your business $ 99 if the supplier offered a 1% discount and your accounting department paid the invoice during the discount period. Most providers offering credit terms allow an invoice to be paid within 30 days, expressed in business jargon as “30 net”. If a supplier 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 invoice is due within 45 days, but the provider will allow you to deduct 1.5% from the invoice if you pay within 15 days.
Another deviation is to express credit terms as dates on the calendar. Therefore, “2% 5th Net 25th” means that the invoice is due on the 25th of the month, but a 2% discount is offered as long as the invoice is paid before the 5th of the month.
WOULD YOU INVEST YOUR COMPANY’S MONEY FOR A PROFITABILITY OF 18%?
The typical argument against taking advantage of purchase discounts is the value of available cash. You can argue that keeping the cash in your business longer far exceeds the meager 1% that generates a purchase discount. The mathematics shows the opposite. Take, for example, the most common credit terms of 1% 10 Net 30. Remember, this gives you a 1% discount for paying 20 days early in the cycle. However, keep in mind that banks set their returns based on an annual rate of return (APY), not a 20-day rate. The math for putting the 20-day investment in APY terms begins with dividing into 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 aren’t already, is how easy it is to get started. Think about how you do business now. Most likely, the accounting department will pay your vendors every month. Don’t change that! Pay them every 30 days, just start paying during the discount period. For example: if your provider offers credit terms of 1.5% 7th Net 27th, you would normally pay before the 27th of each month, assuming you have a 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 seventh day 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 the following month. But this is a one-time procedural change. After this short-term pain, you’ve made long-term benefits for your business. Also, your company has returned to a monthly payment schedule and now pays 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 have to ask yourself whether it is worth paying 4.75% APR (average credit line rate) or 12% APR (average credit card rate) for save 18% APY.
ARE THE CREDIT CONDITIONS NEGOTIABLE?
The credit terms are absolutely negotiable! Depending on your volume and vendor loyalty, you may be able to negotiate a special discount rate for your business. 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 businesses too. They need cash to pay the payroll, pay the water bill, and keep the lights on. Their cash flow model is further complicated by the number of businesses that close, file for bankruptcy, or simply don’t pay on time. Therefore, they are willing to offer your business an incentive to ensure that cash flows into their bank accounts so that they can pay their bills.
HOW DO PURCHASE DISCOUNTS GENERATE PROFITS?
Under accounting rules (known as: Generally Accepted Accounting Principles, or “GAAP”), purchase discounts are a ‘top line’ number and are treated as Income. 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. Income is received from your customers (‘top line’). Direct Expenses, such as labor and materials, are subtracted from Income to derive 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 income stream from the purchase discounts to the Income Statement as Income. There are no additional Direct Expenses generated by the advance payment of suppliers; therefore, this flows through the Direct Expenses portion of the state to Gross Profit. Similarly, 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 thousands of dollars with this simple change in payment policy. It is not uncommon for a small business with 10 to 20 employees to have annual revenues of $ 1 million. With materials averaging 40% of revenue across many industries, your company’s average annual materials costs will be around $ 400,000. Therefore, a 1% purchase discount taken throughout the year yields a return of $ 4,000 in new found earnings. 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 astonishing. As a bonus, your vendors will quickly move you up a few notches on their “best customer list.”
A simple upgrade to purchase discounts today will earn your business additional profit, strengthen supplier relationships, and utilize corporate best practices for years to come.