Friday, November 18, 2011

Is payment terms or price more important to the company?

That was a question that someone posed on Linked In. While I have already written a number of posts that are involved with this, I thought I would post my response to that question as it pulls those prior posts together.

Every company has a "cost of money" and a "value of money". Cost of money is what it would cost the company to borrow money. The “value of money” is the return you could make if you invested it. Money also has a "time value" that is usually expressed as either "Net Present Value" or “Discounted Cash Flow". The "time value of money" takes into account the fact that whoever in the relationship holds the money, gets the compounding benefit of that money just like you would get compounding interest in a savings account.

Payment terms are all about the time value of money. The longer you hold it, the more benefit you get. The sooner you have to pay it or the longer you have to wait for a supplier to pay you, the less the benefit to you.

The simplest example I can give is if your company's value of money was 12%. Each month you were able to hold it, you would save an additional 1% plus the compounding value. Each month sooner that you have to pay, it costs you 1% plus compounding,

Where you use that is in price negotiations. Tell the supplier you are including the time value of money in the total cost of doing business with them. To be competitive with other suppliers, if they are demanding shorter payment terms they will need to be that much cheaper to offset the cost of the payment terms they want. In our example if the supplier wanted 30 days when you want 90 and other suppliers will give ninety, you would tell them that they need to be at least 2.083% less than the other suppliers (1% for 1 month and 1% for month 2, plus 1/12 of 1% for the compounding on that 2nd month).

Both are price and payment terms interrelated so both are of equal importance. What you lose by a shorter payment term, you want to be offset by paying a reduce price. What you gain by a longer payment term you do not want to pay any more in the price than what that time value is worth to your company.

When a Company’s financial group provides an amount of discount that would be needed for a buyer to accept a prompt payment discount, they would go through the same process where they determine whether from a time value of money perspective the discount is worth accepting.

If you learned from this post, think about how much more you could learn from the book.
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