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Extra Profits: The Magic of Purchase Discounts
Using purchase discounts is a recipe for success in any economy. Mixing in “good business practices,” a pinch of “strengthening supplier relationships” and a dash of “profitability” is sure to fatten your bottom line. If your company isn’t already doing so, paying supplier bills early to take advantage of purchase discounts is a quick and easy way to get to the next level.
What is a purchase discount?
A purchase discount is money taken off a supplier’s bill when payment is made within a certain time frame. Discounts are usually 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, if a supplier offers a 1% discount and your accounting department pays the bill during the discount period, a $100 bill will cost your firm $99. Most suppliers who offer credit terms allow the bill to be paid within 30 days, known as “net 30” in business parlance. If a supplier offers a 1% discount to its customers for payment within 10 days, this will be expressed as “1% 10 net 30”. So, “1.5% 15 Net 45” means the bill is due within 45 days, but the supplier will allow you to take a 1.5% discount if you pay within 15 days.
Another deviation is to express credit terms as dates on a calendar. So, “2% 5th Net 25th” means the bill is due on the 25th of the month but a 2% discount is offered if the bill is paid on the 5th of the month.
Would you invest your company’s money for an 18% return?
A common argument against taking advantage of purchase discounts is the value of cash on hand. You could argue that keeping cash in your company for a long time outweighs the skimpy 1% generated by purchase discounts. The math shows otherwise. For example, take the most common credit terms of 1% 10 Net 30. Remember, this gives you a 1% discount if you pay 20 days before the cycle. Note, however, that banks state their returns based on the annual percentage yield (APY) rate, not the 20-day rate. The math for keeping a 20-day investment in terms of APY begins by dividing it by a 360-day period (known as a banker’s year). A simple division of 360 / 20 equals 18, showing that the actual discount is “worth” 18 times its face value. So, a discount rate of 1% produces the equivalent of an 18% APY.
How can your company afford it?
The beauty of taking advantage of the purchase discount, if you’re not already doing so, is how easy it is to get started. Now think about how you do business. Most likely, the accounting department pays your suppliers every month. Don’t change that! Pay them every 30 days – just start paying during the grace period. As an example: if your supplier offers credit terms of 1.5% 7th net 27th, you will normally pay by the 27th of each month, assuming you run a reputable business. Then in another 30 days the payment will be submitted on 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 little difficult as you have to pay on the 27th of this month then again 10 days later on the 7th of the next month. However, this is a one-time procedural change. After this short-term pain, you have realized the long-term benefits for your firm. What’s more, your company is back on a monthly payroll schedule, now paying 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 should ask yourself whether it’s worth saving 18% at 4.75% APR (average credit line rate) or 12% APR (average credit card rate). APY.
Are credit terms negotiable?
Credit terms are absolutely negotiable! Depending on your volume and a supplier’s loyalty, 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 customers. You never 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 water bills and keep the lights on. Their cash flow model is further complicated by the number of companies that go out of business, declare bankruptcy, or fail to pay on time. Therefore, they are willing to incentivize your company to insure that cash flows into their bank accounts so they can pay their bills.
How does the purchase discount generate profit?
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 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. Revenue is derived from your customers (‘top line’). Direct expenses, such as labor and materials, are subtracted from revenue to arrive at gross profit (the ‘middle line’). Indirect expenses, such as cell phones, lights, insurance, office staff, etc., are subtracted from the total profit to calculate the 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 no additional direct costs incurred by paying suppliers early; So, it flows from the direct expense portion of the statement to gross profit. Similarly, there are no additional indirect costs when making an initial payment; So, the purchase discount amount flows directly to the net profit line.
How much profit?
Even small companies can scale their additional profits by thousands of dollars with this simple change in payment policy. It is not unusual for a small firm of 10-20 employees to have $1 million in annual revenue. Since content accounts for an average of 40% of revenue in most industries, your company’s average annual content cost will be in the neighborhood of $400,000. Thus, a 1% purchase discount taken over the entire year returns $4,000 in new found profits! If your content purchases are high or the discount rate you negotiate is good, the impact on the bottom line will be much greater. Additionally, when you consider that this “once hidden, but now found” money is generated by a one-time, 20-day change in payment policy years later, the results are astounding. As an added bonus, your suppliers will instantly move you up a few spots on their “best customers list”.
A simple improvement to using purchase discounts today will allow your company to generate additional profits, strengthen supplier relationships, and leverage corporate best practices for years to come.
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