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Extra Profits: The Magic of Purchase Discounts

Using shopping discounts is a recipe for success in any economy. Mixing a scoop of “best business practices”, a pinch of “supplier relationship building”, and a dollop of “benefits” creates a dish that is sure to fatten your bottom line. If your business isn’t already, paying supplier invoices early enough to take advantage of purchase 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 from a supplier’s invoice when paying within a certain period of time. Discounts are normally expressed as a percentage, with 1% being the most commonly used and the rates of 0.5%, 1.5% and 2% all being seen in common practice. So a $100 invoice would only cost your business $99 if the vendor offered a 1% discount and your accounting department paid the invoice during the discount period. Most suppliers who offer credit terms allow payment of an invoice within 30 days, expressed in business jargon as “Net 30”. If a supplier offers a 1% discount to its customers to pay within 10 days, this will be expressed as “1% 10 Net 30”. So “1.5% 15 Net 45” means the invoice is due within 45 days, but the supplier will allow you to withdraw 1.5% of the invoice if you pay within 15 days.

Another derogation is to express credit terms as dates on the calendar. So “2% 5th Net 25th” means 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 AN 18% RETURN?

The typical argument against taking advantage of shopping discounts is the cash value. You can argue that keeping money in your business longer far outweighs the measly 1% that a purchase discount generates. The math shows otherwise. Take, for example, the most common credit terms of 1% 10 Net 30. Remember that this gives you a 1% discount if you pay 20 days earlier in the cycle. Note, however, that banks report their returns based on an annual percentage rate of return (APY), not a 20-day rate. The calculation to put the 20 day investment in terms of APY begins by dividing into a 360 day period (called the bank year). A simple division of 360 / 20 equals 18, which shows that the actual discount is “worth” 18 times more than its face value. Thus, a discount rate of 1% produces the equivalent of 18% APY.

HOW CAN YOUR COMPANY AFFORD 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 pays your vendors monthly. Don’t change that! Pay them every 30 days – just start paying during the discount period. For example: if your supplier offers credit terms of 1.5% on the 7th net on the 27th, you would normally pay on the 27th of each month, assuming you are running a respectable business. Payment would then be resubmitted in another 30 days on the 27th and so on, month after month. Use the purchase discount by paying on the 7th day of each month instead of paying on the 27th day of each month. The first time will be a bit difficult since you will have to pay on the 27th of that 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 have made long-term gains for your business. Additionally, your business is back on a monthly payroll schedule, now paying on the 7th of each month instead of the 27th.

Although borrowing on a line of credit or a credit card should only be used as a last resort, you should consider whether it is worth paying 4.75% APR (average line of credit rate) or 12% APR (average credit card rate) to save 18% APY.

ARE THE CREDIT CONDITIONS NEGOTIABLE?

Credit terms are absolutely negotiable! Depending on your volume and loyalty to a vendor, 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 excluded 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 businesses. They need money to pay the payroll, pay the water bill and keep the lights on. Their cash flow model is further complicated by the number of companies that go bankrupt, declare bankruptcy, or simply don’t pay on time. So they’re willing to offer your business an incentive to make sure cash is flowing 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 “higher” number and are treated as revenue. Unlike other income, however, every penny of shopping discount income goes directly to the “end result,” known as net profit. No need to be a graduate in accounting 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 customers (“top line”). Direct expenses, such as labor and materials, are subtracted from revenue to arrive at gross profit (“middle line”). Indirect expenses, such as cell phones, lights, insurance, office staff, etc., are subtracted from the gross profit to calculate the net profit (“bottom line”).

With the above in mind, add the additional revenue stream from purchase discounts to the income statement as revenue. There are no additional direct expenses generated by the advance payment of suppliers; thus, it goes through the Direct Expenses portion of the Gross Profit statement. Similarly, there are no additional indirect expenses incurred in case of advance payment; thus, the purchase discount amount goes directly to the net profit line.

HOW MANY BENEFITS?

Even small businesses can measure their incremental profits in the thousands with this simple payment policy change. It is not uncommon for a small business with 10 to 20 employees to have annual revenues of $1 million. Since materials represent an average of 40% of revenue in many industries, your company’s average annual materials costs will be around $400,000. Thus, a 1% purchase discount taken throughout the year returns $4,000 in new found profits! If your material purchases are higher or the discount rate you negotiate is better, the impact on the bottom line will be much greater. Plus, if you consider that this “once hidden, but now found” money is generated year after year by just changing the 20-day payment policy once, the results are staggering. As a bonus, your suppliers will quickly move you up a few notches on their “top customer list”.

A simple upgrade to exercise purchase discounts today will allow your business to realize additional profits, strengthen supplier relationships, and utilize better business practice for years to come.

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