How do you calculate the value of a discount?
The value of the discount in isolation is known, but as you are paying early, what effect does that have on the actual value of the discount? To calculate it, you need to know the cost of working capital. Simplistically, the cost of working capital is the cost of borrowing money or, for a cash rich organization, the opportunity cost of not investing cash – the interest they could earn. But for many large organizations, while this is a nice easy way to understand it for a non-finance person, the cost of working capital that the treasury team will quote will be vastly different from the bank interest rates. For a wholly owned subsidiary for example, the holding company is often “the bank”. Sometimes the cost of working capital is quoted at a particular rate in order to drive certain behaviors. Whatever, the cost of working capital is the figure that the treasury department says it is
and calculating the value of a discount using this figure is easy.
The formula to use is this:
Value of discount = Discount – (Cost of working capital/365)*Difference in payment terms (in days)
For example, for a supplier that offers a 2% discount for 10 day terms rather than standard 45 days where the buyer cost of working capital is 5% the calculation would look like this:
Value of discount = 2% – (5%/365)*35 = 1.52%
In this example, for invoices worth $1,000,000, the value of the discount is $15,200
Not a lot? Think of it this way. This discount is generated by paying 35 days early. That’s a return of 1.52% in 35 days. To get a treasury manger really excited and to get your finance colleagues interested, turn that into an annual figure. The annualized value is (1.52/35)*365 = 15.85%. That will certainly wake a treasury manager up!Source: purchasinginsight.com