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How to calculate the cost of not taking a discount
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How to calculate the cost of not taking a discount

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Business are often offered a discount by their suppliers if they will pay earlier than arranged for goods already supplied but sometimes, it's better for the business not to take that discount. This ...

Business are often offered a discount by their suppliers if they will pay earlier than arranged for goods already supplied but sometimes, it's better for the business not to take that discount. This presentation shows how to calculate whether to take the discount or not.

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How to calculate the cost of not taking a discount How to calculate the cost of not taking a discount Presentation Transcript

  • How to calculate the costof not taking an earlysettlement discountfrombusinessbankingcoach.comin association with
  • Suppliers sometimes offer discounts to theircustomers for early payment of trade debtsoutstanding – but there are times when it’sbetter not to take themWhat? How canit be better notto take adiscount?
  • Here’s the scenario;A business has bought product from itssupplier and the supplier allows 30 dayscredit.But there is an option - the invoice includesthis phrase: Terms 2/10 net 30 daysThat means if youpay me in 10days instead of30, I’ll give you adiscount of 2%
  • To put that another way,the business will pay the full amount ofthe invoice, i.e. 2% more than it needsto, if it waits for the full 30 days period toelapse before making payment insteadof paying within the 10 day period.So there is a cost to the business of nottaking that discount.
  • Now, suppose that thebusiness wants to takeadvantage of thediscount but doesn’thave cash available.It will have to use anoverdraft to pay theamount owing
  • The question is;“which option will becheaper – use theoverdraft and payearly to get thediscount ........or forgetthe discount and savethe interest cost of theoverdraft?”
  • Luckily, there’s an easy formula to work thatout. All you need to know is;The discount on offer – in our scenario that’s2%How many days there are between the earlypayment date and the normal due date – inour scenario that’s 20 days (30 daysoriginally minus the 10 days new period toqualify for the discount)
  • The formula then is;2x365= 37.24%98 20Thepercentagediscount100% minus thepercentagediscountNumber of daysbetween earlypayment date andnormal due date
  • So this tells us that the annualised costof not taking the discount is 37.24%
  • The business then needs to comparethat with the interest rate charged on itsoverdraftWhichever rate is lower is the best forthe business from a cost point of view
  • So, in our scenario,the cost of not taking the discount is 37.24%the interest cost of an overdraft is, let’s say,15%The lower of the two is theinterest cost of theoverdraft so that’s the bestoption – use the overdraftto get the discount
  • .............provided that thecash will not be neededby the business for anyother purposeThat’s correct!