9.20 “Trade Credit”: Relevant Costs
The customer sometimes must decide when to pay the supplier under the terms of sale offered. For instance, if the customer is offered terms such as “2/10, net 30,” a decision must be made whether to take the discount and pay sooner, or forego the discount and pay later. We will analyze this decision by quantifying the cost of foregoing the discount, which is:
[(D%) ÷ (100 – D%)] ×[360 ÷ (Full Credit Days – Discount Days)]
For example, if a company is offered 2/10, net 30, the cost of foregoing the discount is:
[(2 ÷ 98)] × [(360) ÷ (20)] = 0.367
Essentially, the customer must consider the added $2 cost beyond the $98 base alternative, adjusted for time, hence 2/98. One way of thinking about time is to say, in this case, that there are 360/20, or 18 added 20-day periods in a year (consisting of twelve thirty-day intervals), during which , if the discount is foregone, the customer will pay an additional 2/98ths. (The foregoing assumes that purchases are made every day, hence 18 annual periods of 20 days each, i.e., 360 ÷ 20, turn over in the course of a year.)
By the way, 2/98 is the mathematical equivalent of [(100 ÷ 98) – 1]. This may help to clarify the notion.
In any event, this means that if the firm can borrow funds at a cost < .367, it should take the discount and borrow – if it needs funds to make payment.
The above formula does not consider the Time Value of Money (TVM). That is, we must account for the compounding of the cost over the year by employing the concept: (1 + R) n
Cost = [(1.0) + (2 ÷ 98)] 360/20 – 1.0 = .439
Of course, given the short time frame, time value of money analysis may be trivial.
Note that if a buyer “stretches” the payment beyond 30 days, the cost of foregoing the trade discount decreases, but so too does the company’s creditability. For example, if payments are made in 40 days, the cost of foregoing the discount, using the first formula, becomes less:
[(2 ÷ 98)] × [(360) ÷ (30)] = 0.24
In short, there is no one correct way of doing the foregoing; all the foregoing calculations must be taken with a grain of salt. Still, it is quite apparent that foregoing the discount is ill-advised.
Conclusion: It would pay for the firm to borrow $98, pay the bank interest for the 20 days, and save the nominal 2%.