invoice price is a cost to the customer—and, effectively, a return to the firm for this trade credit. Consider a customer that purchases an item for $100, on terms of 2/10, net 30. This means if they pay within 10 days, they receive a 2% discount, paying only $98 (the cash price). If they pay on day 11, they pay $100. Is the seller losing $2 if the customer pays on day 10? Yes and no. We have to assume that the seller would not establish a dis- count as a means of cutting price. Rather, a firm establishes the full invoice price to reflect the profit from selling the item and a return from extending credit.1
Suppose the Discount Warehouse revises its credit terms, which had been payment in full in 30 days, and introduces a discount of 2% for accounts paid within 10 days. And suppose Discount’s contribution margin is 20%. To analyze the effect of these changes, we have to project the increase in Discount’s future sales and how soon Discount’s customers will pay.
1 If the customer pays within the discount period, there is a cost to the firm—the op- portunity cost of not getting the cash at the exact date of the sale but rather some time later. With the terms 2/10 net 30, if the customer pays on the tenth day, the sell- er has just given a 10-day interest-free loan to the customer. This is part of the car- rying cost of accounts receivable, which we will discuss in a moment.
MANAGING WORKING CAPITAL
Let’s first assume that Discount does not change its sales prices. And let’s assume that Discount’s sales will increase by $100,000 to $1,100,000, with 30% paying within ten days and the rest paying within thirty days. The benefit from this discount is the increased contribution toward before tax profit of $100,000 × 20% = $20,000. The cost of the discount is the forgone profit of 2% on 30% of the $1.1 million sales, or $6,600.
Now let’s assume that Discount changes its sales prices when it institutes the discount so that the profit margin (available to cover the firm’s fixed costs) after the discount is still 20%:
Contribution margin(1 – 0.02) = 20% 0.20
Contribution margin = – = 20.408%(1 – 0.02)
If sales increase to $1.1 million, the benefit is the difference is the profit,
Before the discount = 20% of $1,000,000 = $200,000 After the discount = 20.408% of $1,100,000 = $224,488
so the incremental benefit is $24,488. And the cost, in terms of the dis- counts taken is 2% of 30% of $1,100,000, or $6,600.
While we haven’t taken into consideration the other costs involved (such as the carrying cost of the accounts and bad debts), we see that we get a different picture of the benefits and costs of discounts depending on what the firm does to the price of its goods and services when the discount is instituted. So what appears to be the “cost” from the discounts doesn’t give us the whole picture, because the firm most likely changes its contri- bution margin at the same time to include compensation for granting credit. In that way, it increases the benefit from the change in the policy.
There are a number of costs of credit in addition to the cost of the dis- count. These costs include:
- The carrying cost of tying-up funds in accounts receivable instead of investing them elsewhere.
- The cost of administering and collecting the accounts.
- The risk of bad debts.
The carrying cost is similar to the holding cost that we looked at for cash balances: the product of the opportunity cost of investing in accounts receivable and the investment in the accounts. The opportunity