A(n) discount is applied only if the buyer pays the invoice within a certain number of days.

What is the Cost of Credit Formula?

The cost of credit formula is a calculation used to derive the cost of an early payment discount. The formula is useful for determining whether to offer or take advantage of a discount. The formula can be derived from two perspectives:

• The accounts payable department of the buyer uses it to see if taking an early payment discount is cost effective; this will be the case if the cost of credit implied by the discount is higher than the seller's cost of capital.

• The sales department of the seller and the purchasing department of the buyer. Both parties consider the early payment discount to be an item worth negotiating as part of a sale transaction.

In reality, early payment terms are only taken when the buyer has sufficient cash available to make an early payment, and the cost of credit is high. The availability of cash can be the deciding factor, rather than the cost of credit. For example, if the buyer's cash is tied up in long-term investments, it may not be able to take an early payment discount. This occurs despite the inherent cost of credit generally being quite attractive to the buyer.

How to Calculate the Cost of Credit

Use the following steps to determine the cost of credit for a payment transaction:

1. Determine the percentage of a 360-day year to which the discount period will be applied. The discount period is the period between the last day on which the discount terms are still valid and the date when the invoice is normally due. For example, if the discount must be taken within 10 days, with normal payment due in 30 days, then the discount period is 20 days. In this case, divide the 20 day discount period into the 360-day year to arrive at an 18x multiplier.

2. Subtract the discount rate from 100%. For example, if a 2% discount is offered, the result is 98%. Then divide the discount percentage by 100% less the discount rate. To continue the example, this is 2%/98%, or 0.0204.

3. Multiply the result of each of the preceding steps together to arrive at the annualized cost of credit. To complete the example, we multiply 0.0204 by 18 to arrive at a cost of credit of 36.7% for terms that allow a 2% discount if paid within 10 days, or full payment in 30 days.

4. If the cost of credit is higher than the company's incremental cost of capital, take the discount.

Formula for the Cost of Credit

The formula for the cost of credit is as follows:

Discount %/(100-Discount %) x (360/Allowed payment days – Discount days)

For example, a supplier of Franklin Drilling offers the company 2/15 net 40 payment terms. To translate the shortened description of the payment terms, this means the supplier will allow a 2% discount if paid within 15 days, or a regular payment in 40 days. Franklin's controller uses the following calculation to determine the cost of credit related to these terms:

= 2% /(100%-2%) x (360/(40 – 15))

= 2% / (98%) x (360/25)

= .0204 x 14.4

= 29.4% Cost of credit

The cost of credit inherent in these terms is quite an attractive rate, so the controller elects to pay the supplier's invoice under the early payment discount terms.

An early payment discount – also known as a prompt payment discount or early settlement discount – is a discount that buyers can receive in exchange for paying invoices early. It’s typically calculated as a percentage of the value of the goods and services purchased.

For suppliers, an early payment discount is a way of improving cash flow by speeding up customer payments and thereby reducing their days sales outstanding (DSO). This can have a positive impact on the supplier’s working capital position, providing access to the extra working capital needed to fulfil customer orders or grow the business.

For buyers, early payment discounts mean a lower cost of goods and are likely to represent an attractive return on the company’s cash. By taking advantage of early payment discounts, buyers can also strengthen their supplier relationships.

Early payment discount example

A common early payment discount is expressed as ‘2/10 net 30 days’. This means that the invoice needs to be paid within 30 days – but the buyer will receive a 2% discount on their purchase if they pay the invoice within 10 days. So for an invoice worth $1,000, the buyer can pay $1,000 at 30 days – or alternatively, they can pay $980 within 10 days, thereby achieving a $20 discount.

From the buyer’s point of view, this translates into an attractive return on cash. The cost of credit can be calculated by using the following formula:

• Discount %/(100 – discount %) x 360/(Full allowed payment days – discount days)

So for 2/10 net 30 terms, the cost of credit is calculated as follows:

• 2/(100-2) x 360/(30 – 10)
  = 2/98 x 360/20
  = 36.7%

For the company purchasing goods, 2/10 net 30 days therefore represents a very attractive return on cash of 36.7% – but equally, the discount equates to a high cost of funding from the point of view of the supplier.

Harnessing early payment discounts with dynamic discounting

Traditionally, early payment discounts are initiated by the supplier, which will offer discounts to customers when invoicing for goods or services. However, this type of arrangement lacks both certainty and flexibility.

To return to the example of 2/10 net 30 terms, if the buyer pays the invoice within 11 days instead of within 10 days, they will not be able to access any discount at all. This can make it difficult for some buyers to take advantage of early payment discounts, particularly if manual processes are used to handle invoices. Nor does this approach give suppliers any certainty that their customers will take advantage of the early payment discount on offer.

However, buying companies can also harness early payment discounts in a more flexible way by putting a dynamic discounting program in place. With dynamic discounting, buyers can give their suppliers the opportunity to take early payment on their invoices in exchange for a discount. And unlike traditional early payment discounts, buyers can access a discount any time between the day when the invoice is approved and the agreed maturity date. The discount will vary throughout that period: the earlier the buyer pays the invoice, the greater the discount they will receive.

Dynamic discounting differs from supply chain finance (also known as reverse factoring). With supply chain finance, suppliers can also receive early payment, but the arrangement is financed by a bank or other finance provider.

Benefits of dynamic discounting

Early payment discounts achieved via dynamic discounting can benefit both buyers and suppliers: suppliers receive payment earlier, thereby boosting their working capital position, while buyers pay less for purchases than they otherwise would. The benefits of dynamic discount include the following:

Benefits for suppliers

• Access cash whenever it’s needed, whether for one-off requirements or a steady flow of cash
• Forecast cash flows more accurately by having more certainty over the timing of payment
• Invest in R&D and business growth
• Achieve a lower cost of funding than with other financing options such as factoring

Benefits for buyers

• Achieve cost savings on goods and services
• Earn a risk-free return on surplus cash at a higher rate than with traditional investments
• Strengthen supplier relationships
• Reduce the risk of supply chain disruption

Different flavors of dynamic discounting solutions are available. Some may harness technology such as artificial intelligence (AI) and predictive analytics to maximize the results of a dynamic discounting program, for example by using big data and market information to set the optimum APR for individual suppliers. Some technology partners also enable companies to switch seamlessly between supply chain finance and dynamic discounting as the need arises.

When a new product or service is launched what type of pricing strategy attempts to attract customers quickly by offering a very low price at first?

Which pricing strategy features frequent sales during which prices are lowered for a short time?

Is a pricing method based on the customers demand & the perceived value of the product?

What is not a pricing tactic?