Offering discounts to customers for prompt payment increases cash flow quickly, but can be a drag on profits. Before you decide to offer a discount, weigh the costs and benefits.
The usual reason for offering a prompt pay discount is to reduce your investment in accounts receivable, particularly if you must borrow on a bank line of credit to support those receivables.
Let’s look at the economics of offering discounts. We’ll use John Smith Company (JSC) as an example. JSC is considering the following terms on tire sales to customers:
Net 30 days
1% 10, net 30 days
2% 10, net 30 days
We’ll assume that JSC sells $50,000 in tires each month. If JSC offers only a net-30-day option, we must assume that every customer will take at least 30 days to pay. JSC management thinks if they offer the 2%-10-day option, every customer will pay in 10 days because this offer is too good to pass up.
The difficult part of the analysis is projecting how many customers will take advantage of the 1%-10-day option. For illustrative purposes, we’ll assume that 50% of JSC’s customers will take advantage of the 1%-10-day discount and the other 50% will pay at 30 days.
Given these assumptions, the table below summarizes the effect of discounts on the company’s bottom line, if all receivables must be supported with bank debt at Prime + 1 1/2% interest rate.
| John Smith Company | |||||
| Effect of Cash Discounts on Cash Flow and Earnings | |||||
| Selling Terms | % Taking Discounts | Average
A/R |
Annual Carrying Cost (10.5%) | Annual Cost of Discounts | Total
Effect on Earnings |
| Net 30 | 0% | $50,000 | $5,250 | 0 | <$5,250> |
| 1% 10,
Net 30 |
50% | $33,333 | $3,500 | $3,000 | <$6,500> |
| 2% 10,
Net 30 |
100% | $16,666 | $1,750 | $12,000 | <$13,750> |
Note how offering a cash discount, even at 1% 10, lowers the company’s earnings by $6,500 compared with $5,250 using the revolver. Now, if your customers are paying later than 30 days on 30-day terms without a finance charge kicking in, you may want to calculate this extra carrying cost into your formula.
Allowing deeper discounts becomes even more expensive. Notice the severe impact to the bottom line when the discount is increased to 2%.
The other thing to keep in mind when analyzing discounts for your company is selling price. This example assumes that prices are constant, regardless of the particular customer. Since many family businesses price product by customer, depending on the industry, you may be able to get away with a slightly higher price, while still offering the 10-day discount to normally slow-pay customers. In effect, the discounted price is what you would have charged anyway. This is the best of both worlds – you get full price plus payment in 10 days helping your cash flow.
The following information may help you determine when to offer customer discounts or take advantage of supplier discounts in the future. This table shows the annualized percentage rate equivalents for various discounts. By comparing this rate to your own borrowing rate, you can make an informed decision about whether to give or take discounts.
Credit Terms Annualized Cost
1/10, Net 30 18.4%
2/10, Net 30 37.2%
1/10, Net 60 7.4%
2/10, Net 60 14.9%
