Time to get paid
Current value of that payment commitment
Friday, December 17, 2010
TOTAL COST - TIME VALUE OF MONEY.
Money has a time value. The discussion of the time value of money usually comes up when one talks about investment. Accounting books discuss the time value of money around the value of receiving payment now versus receiving payment at some time in the future. In Procurement we make payments. Terms may require investment in inventory. We may also have situations where the Supplier is responsible to pay damages that may have a time value of money impact.
There is basically two different ways to look at the time value of money:
1) Comparison of receiving a dollar now versus receiving a dollar later
which is referred to as "present value".
2) Determining what we would have to invest now to receive a dollar at
a later date which is referred to as "discounting" or discounted cash flow.
Most calculators with MBA type functions will allow you to easily compute either present value or discounted value. To calculate the present value you would use the formula:
Present Value = -----------------------
( 1 + Interest Rate)
"n" is the number of years
Example: If the interest rate was 12% and the period was three years the calculation would look like:
------------------------- = ---------- = .71179
1.12 x 1.12 x 1.12 1.4049
This means that a payment made in three years would be worth seventy one cents in today’s money.
A company should have three money values that you should be aware of:
1. The "cost of money" is the rate you are paying or would have to pay if you borrowed.
2. The "value of Money" is the rate of return that you would achieve if you invested that money. The value of money is higher that the cost of money.
3. The "cost of Inventory" is the the "value of money" plus the carrying cost for the inventory.
The "value of money should be used in calculating the present value of items involving payments, credits, amortizing one time expenses, etc. The "cost of inventory" should be used in calculating the present value of items affecting inventory such as minimum order quantities, increased safety stock as a result of quality problems, extended lead times, etc.
Rates can be either "Nominal" (interest is not compounded) or "Effective" (with interest compounded). The values set by your company for cost of money, value of money and cost of inventory should be an effective rate so that you do not have to deal with the effect of compounding interest in calculations.
Sometimes the issue of time value of money exists in the subtleties of the language used or the changes Suppliers try to negotiate. For example compare the same commitment, but with one word inserted:
“Supplier will pay all damages awarded.”
What’s the difference?
The difference is when you will get paid. In the first sentence, once damages are awarded the Supplier must pay. In the second sentence, payment will occur at some point in the future after the Supplier no longer has any possible appeals so the award is final. You will still get paid the award amount, but on a net present value basis you will get less. Using a 12% value of money, here’s what that future payment would be worth from a net present value perspective based upon when it is paid.
The simple reason for the difference is the “compounding effect”. The compounding effect means that over time you will make interest or a return on your previously earned interest or return, so that return compounds over time. If you keep money you get the benefit of the compounding. If the Supplier keeps the money they get the benefit and that reduces the value to you.