Extra Benefits: The Magic of Shopping Discounts

Using purchase 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 dish that’s sure to fatten your bottom line. If your business isn’t already doing so, paying supplier invoices early enough to take advantage of purchasing discounts is a quick and easy way to take it to the next level.

WHAT IS A PURCHASE DISCOUNT?

A purchase discount is money taken off a supplier’s invoice when you pay within a certain amount of time. Discounts are typically expressed as a percentage, with 1% being most commonly used and rates 0.5%, 1.5%, and 2% all seen in standard practice. Therefore, a $100 invoice would only cost your company $99 if the supplier offers a 1% discount and your accounting department pays the invoice during the discount period. Most providers that offer credit terms allow an invoice to be paid within 30 days, expressed in business jargon as “Net 30.” If a provider 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 bill is due within 45 days, but the provider will allow you to take 1.5% off the bill if you pay within 15 days.

Another deviation is to express credit terms as calendar dates. So “2% 5th Net 25th” means the bill is due on the 25th of the month, but a 2% discount is provided as long as the bill is paid before the 5th of the month.

WOULD YOU INVEST THE MONEY OF YOUR COMPANY 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 cash in your company longer far outweighs the meager 1% that generates a purchase discount. 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 early in the cycle. Keep in mind, however, that banks set their yields based on an Annual Percentage Yield (APY) rate, not a 20-day rate. The math for putting the 20-day investment in terms of an APY begins with dividing it into a 360-day period (known as a banking year). The simple division of 360/20 equals 18, which shows that the real discount is “worth” 18 times its face value. So a discount rate of 1% produces the equivalent of 18% APY.

HOW CAN YOUR COMPANY PAY IT?

The beauty of taking advantage of shopping discounts, if you’re not already doing so, is how easy it is to get started. Think about how you do business now. Most likely, the accounting department pays its vendors every month. Don’t change that! Pay them every 30 days, only start paying during the discount period. As an example: If your provider offers credit terms of 1.5% 7th Net 27th, you would normally pay on the 27th of every month, assuming you run a reputable business. The payment would be sent again in 30 days plus the 27th and so on, month after month. Use the purchase discount by paying on the 7th 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 next month. But, this is a one-time procedural change. After this short-term pain, you’ve made long-term gains for your company. In addition, your company returned to a monthly payment schedule, now paying on the 7th of each month instead of the 27th.

Although a loan from a line of credit or credit card should only be used as a last resort, you should ask yourself if 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 TERMS NEGOTIABLE?

Credit terms are absolutely negotiable! Depending 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. 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 also companies. They need cash to pay the payroll, pay the water bill and keep the lights on. His 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 make sure cash flows into their bank accounts so 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 Revenue. Unlike other income, however, every penny of purchase discount income flows directly to 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 the profit and loss statement), the flow of dollars is as follows. Revenue is received from your customers (‘top line’). Direct Expenses, such as labor and materials, are subtracted from Revenues to obtain 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 purchase discounts to the Income Statement as Income. There are no additional Direct Expenses generated by the advance payment to suppliers; this then flows through the Direct Expense portion of the statement to Gross Profit. Likewise, 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 the 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 revenue of $1 million. Since materials average 40% of revenue in many industries, your company’s average annual material costs will be around $400,000. Thus, a 1% discount purchased throughout the year produces a return of $4,000 in new found gains. 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 staggering. As a bonus, your vendors will quickly move you up a few notches on their “best customer list.”

A simple upgrade to exercising purchase discounts today will earn your business additional profits, strengthen supplier relationships, and utilize best corporate practices for years to come.