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Extra Profits: The Magic of Purchase Discounts
Utilizing purchase discounts is a recipe for success in any economy. Mixing a scoop of “good business practices,” a pinch of “strengthening supplier relations,” and a dollop of “profits” creates a dish that is sure to fatten your bottom line. If your company is not doing so already, paying supplier bills early enough to take advantage of purchase discounts is a quick and easy way to move to the next level.
WHAT IS A PURCHASE DISCOUNT?
A purchase discount is money taken off a supplier’s bill when paying within a certain time frame. Discounts are normally 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. Thus, a bill for $100 would only cost your firm $99 if the supplier offered a 1% discount and your accounting department paid the bill during the discount period. Most suppliers that offer credit terms allow a bill to be paid within 30 days, expressed in business lingo as “Net 30.” If a supplier offers a 1% discount for their clients to pay within 10 days, this would be expressed as “1% 10 Net 30.” So, “1.5% 15 Net 45” means that the bill is due within 45 days, but the supplier will allow you to take 1.5% off the bill if you pay within 15 days.
Another deviation is to express the credit terms as dates on the calendar. Thus, “2% 5th Net 25th” means the bill is due on the 25th of the month but a 2% discount is offered as long as the bill is paid by the 5th of the month.
WOULD YOU INVEST YOUR COMPANY’S MONEY FOR AN 18% RETURN?
The typical argument against taking advantage of purchase discounts is the value of cash on hand. You may argue that keeping the cash in your company longer far outweighs the skimpy 1% that a purchase discount generates. The math shows otherwise. Take, for example, the most common credit terms of 1% 10 Net 30. Remember, this gives you a 1% discount for paying 20 days earlier in the cycle. Notice, however, that banks state their returns based on an Annual Percentage Yield (APY) rate, not on a 20 day rate. The math to put the 20 day investment in terms of an APY starts with dividing into a 360 day period (known as a banker’s year). Simple division of 360 / 20 equals 18, showing that the actual discount is “worth” 18 times more than its face value. So, a discount rate of 1% produces the equivalent of 18% APY.
HOW CAN YOUR COMPANY AFFORD IT?
The beauty of taking advantage of purchase discounts, if you’re not doing so already, is how easy it is to get started. Think of how you do business now. Most likely, the accounting department pays your suppliers every month. Don’t change that! Pay them every 30 days – just 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 by the 27th of each month, assuming you run a respectable business. Payment would then again be submitted in 30 more days on the 27th and so on, month after month. Use the purchase discount by paying on the 7th day each month instead of paying on the 27th day each month. The first time will be a little difficult since you will have to pay on the 27th this month then again about 10 days later on the 7th of the next month. But, this is a one-time procedural change. After this short-term pain, you have realized long-term gains for your firm. What’s more, your company is back on a monthly pay schedule, now paying on the 7th of each month instead of the 27th.
Although borrowing from a credit line or credit card should only be used as a last resort, you must ask yourself if it is worth paying 4.75% APR (average credit line rate) or 12% APR (average credit card rate) to save 18% APY.
ARE CREDIT TERMS NEGOTIABLE?
Credit terms are absolutely negotiable! Based 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. A 2% discount, however, is not out of the question for extremely loyal clients. You won’t know until you ask!
WHY DO SUPPLIERS OFFER DISCOUNTS?
Cash is king in every business, not just yours. Suppliers are businesses, too. They need cash to make payroll, pay the water bill, and to keep the lights on. Their cash flow model is further complicated by the number of companies going out of business, declaring bankruptcy, or simply not paying on time. They are, therefore, willing to offer your company an incentive to insure cash is flowing into their bank accounts so they can pay their bills.
HOW DO PURCHASE DISCOUNTS GENERATE PROFIT?
Under the rules of accounting (known as: Generally Accepted Accounting Principles, or “GAAP”) purchase discounts are a ‘top line’ number and are treated as Revenue. Unlike other income, however, every penny of purchase discount revenue flows directly to the ‘bottom line’, known as Net Profit. It doesn’t take an accounting degree to understand this phenomenon.
In very simple terms, from your company’s current Income Statement (AKA Profit and Loss Statement), the dollar flow is as follows. Revenues are received from your clients (‘top line’). Direct Expenses, such as labor and materials, are subtracted from Revenue to derive Gross Profit (‘Middle Line’). Indirect Expenses, such as cell phones, lights, insurance, office staff, etc., are subtracted for Gross Profits to calculate Net Profit (‘bottom line’).
With the above in mind, add the additional revenue stream of purchase discounts to the Income Statement as Revenue. There are not additional Direct Expenses generated by paying suppliers early; so, this flows through the Direct Expenses portion of the statement to Gross Profit. Similarly, there are not additional Indirect Expenses incurred by paying early; so, the purchase discount amount flows straight to the Net Profit line.
HOW MUCH PROFIT?
Even small companies can measure their added profits in the thousands of dollars with this simple change in payment policy. It is not uncommon for a small firm of 10-20 employees to have annual revenues of $1 million. Since materials average 40% of revenues in many industries, your company’s average annual materials costs will be in the neighborhood of $400,000. Thus, a 1% purchased discount taken during the entire year yields a $4,000 return in new found profits! If your material purchases are higher or the discount rate you negotiate is better, the impact to the bottom line would be much larger. Additionally, when you consider that this “once hidden, but now found” money is generated year after year by making a one time, 20 day change in payment policy, the results are astounding. As an added bonus, your suppliers will quickly move you up a few notches on their “best clients list.”
One simple improvement to exercise purchase discounts today will have your company earning extra profits, strengthening supplier relations, and utilizing a corporate best practice for years to come.
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