Friday, November 18, 2011

Prompt Payment Discounts

Suppliers may offer buyers prompt payment discounts in the quotes such as 2% 10, Net 30.
The means that if the buyer makes payment in 10 days there is a discount of 2%, otherwise payment is due net thirty days.

When a supplier offers a prompt payment discount that means that they have a cost of money or value of money that is higher than the amount of the discount they offered. In deciding whether to accept a prompt payment discount there are several things buyers need to consider.

The first consideration would be whether the buyer’s company has the available cash to make such a payment. The second is whether from a cost or value of money the buyer’s company has, is it financially worth paying the supplier sooner? Without taking compounding into account, In the example of 2% 10 making payment twenty days early is worth .1% a day (2% divided by 20). On an annualized basis that equates to 36.5%, This should tell you that the supplier has a high need to cash. So if your company’s cost or value of money was less that this, you might consider the prompt payment discount.

The last consideration is the potential impact the prompt payment would have in the event there was a problem with what the supplier delivered. Normally you do not want to make payment before you have the ability to test or inspect what the supplier provided to make sure than it isn’t defective and that it meets the required specifications, scope or work or statement of work.

If making a prompt payment and taking the discount won’t give you the time to do those inspections or tests, the amounts you can lose and the problems that can arise because they already have your money can be substantially more costly that what you may have saved.
The simple fact is you always have more leverage to correct any problems before you make payment rather than after.

This doesn’t mean that I wouldn’t agree to take a prompt payment discount, I would just want to make sure that I trust the supplier to promptly correct any problems. What this also requires is procurement needs to work with your accounts payable group to make sure that they are not automatically take a prompt payment discount without your agreement. You don’t want them creating a problem for you just because a prompt payment discount is on the suppliers invoice and it meets the appropriate rate.

If you learned from this post, think about how much more you could learn from the book.
The book is only US$24.95 plus shipping. The hot-link to is above the date.

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.
The book is only US$24.95 plus shipping. The hot-link to is above the date.