What is a cash discount and how is it cal­cu­lated?

Every en­tre­pren­eur is pleased when they see that their customers have paid the invoices made out to them. In order to provide an incentive for this, many service providers and dis­trib­ut­ors offer a price reduction as a certain per­cent­age of the invoice total. This reduction is called a cash discount.

The situation involves an agreement between the seller and the buyer. The former allows the latter to subtract a specific sum from the agreed-upon invoice amount, as long as the invoice is paid by a specific deadline.

A cash discount can also be called an early payment discount or prompt payment discount. Although this article has already defined cash discounts above, un­der­stand­ing the concept involves un­der­stand­ing related terms, as well. Here are three terms you should know:

Thirty-day-long payment periods are common in the UK. In some ex­cep­tion­al cases, they can even be up to 60 or 90 days. However, in order to provide customers with a more at­tract­ive offer, some suppliers and service providers grant cash discounts. The average discount period is 10 days.

There are also graduated discount per­cent­ages, in which the discount per­cent­age changes depending on the discount period. In brief, a cash discount is the price reduction that is granted when a customer pays their invoice within a limited time period.

The name, cash discount, may be somewhat confusing when it comes to the payment process. Though cash discounts are granted when the payments are made in cash, they are also granted when payments are made via credit transfer, as long as this happens within the discount period. This means that paying in cash is not required in order to receive a cash discount.

Those who have the op­por­tun­ity to receive a cash discount should use it, because this strategy allows you to save money without any ad­di­tion­al ex­pendit­ures. That being said, if you have a more tax-efficient means to use this cash, you should choose that option, instead.

A cash discount is always deducted from the gross amount of the invoice. This reduces the purchase price, which is a sig­ni­fic­ant advantage for the paying business in the trans­ac­tion. The de­duct­ible prior tax is thus also reduced when the cash discount is sub­trac­ted.

The cash discount formula is as follows:

• Price of goods: £100
• 10% cash discount (£10)
• Price of goods after discount: £90
• Vat amount: £18 (£90 X 20%)
• Gross invoice total: £108, instead of £120

The following example displays the origins of the cash discount example:

An agreement for a cash discount reads: “14 days, 2% discount per­cent­age, 30 days total” (also written as “2/14, Net 30”). This means that if the customer pays the invoice within the first 14 days after the date the invoice was created (in other words, within the discount period), the payment amount in question is reduced by 2%. The customer thus only has to pay 98% of it. If the customer does not make a payment until after the first 14 days are over, however, the customer would need to pay the full invoice amount.

A sales price cal­cu­la­tion is crucial in order for a business to offer its products or services at a price that allows it to make a profit. This cal­cu­la­tion naturally has to take the cash discount into account, so that the minimum price limit can be chosen in a way that guar­an­tees the returns exceed the costs. The most popular methods for cal­cu­lat­ing the list sales price that makes the required profit possible revolve around mark-up pricing. Important cal­cu­la­tions in relation to this are the mark-up per­cent­age cal­cu­la­tion, and the cost-plus pricing cal­cu­la­tion.

One form of sales price cal­cu­la­tion is the mark-up per­cent­age cal­cu­la­tion. The mark-up per­cent­age refers to the per­cent­age that is added to the original selling price, so that the business offering a cash discount still makes a profit if the cash discount is used by their customers. You can use the mark-up per­cent­age to arrive at the best sales price, but before you can determine the mark-up per­cent­age, you need to determine the gross profit margin. These cal­cu­la­tions will be shown in the following example.

Example: A luxury toy company sells hand­craf­ted music boxes for £100, though they only cost £75 to produce.

• Gross profit margin = sales price – unit cost

In this case, that would mean the gross profit margin = £25 (£100 - £75). This amount can then be used to determine the mark-up per­cent­age.

• Mark-up per­cent­age = gross profit margin / unit cost

The mark-up per­cent­age would then be 0.33% (£25 / £75). Though the sales price was already mentioned in the initial example de­scrip­tion, it’s included below to il­lus­trate how the sales price relates to the mark-up per­cent­age.

• Sales price = (cost x mark-up per­cent­age) + cost
• £100 = (£75 x 0.33%) + £75

For another visual rep­res­ent­a­tion of this cal­cu­la­tion, see the following video. Please note that the video refers to the unit cost as the purchase price, though they’re the same concept for the purposes of the cal­cu­la­tion.

Once you un­der­stand the basic concept of mark-up per­cent­age cal­cu­la­tions, you can add the factor of cash discount cal­cu­la­tions quite easily. The cash discount affects the sales price, so it’s good to add this factor into all of your cal­cu­la­tions. For example, if the company offers a 2% discount, this would amount to £2 of the £100 total sales price. The sales price would then be £98 (£100 – £2), which would shift the gross profit margins and mark-up per­cent­ages somewhat.

• Gross profit margin = £98 – £75 = £23
• Mark-up per­cent­age = £23/£75 = 0.31%

Of course, it’s also important to keep in mind that this is a sim­pli­fied rendering of the mark-up per­cent­age cal­cu­la­tion. It does not take into account all of the indirect costs that could apply in a real-life scenario, and is instead meant as an overview.

An al­tern­at­ive to the mark-up per­cent­age cal­cu­la­tion is the cost-plus pricing cal­cu­la­tion. It’s char­ac­ter­ised by the inclusion of various costs related to the pro­duc­tion of a product: the direct material cost, direct labour cost, and overhead cost. The mark-up per­cent­age is then added to these costs, in order to arrive at the sales price. Before working out an example of this formula, it’s necessary to un­der­stand what its parts mean.

While the mark-up per­cent­age was described in the previous section, the other three parts have not yet been discussed. The direct material cost refers to the physical elements that go into creating the product, such as wood and paint on the case of the music box, and the mechanism inside it. The direct labour cost refers to the financial value given to the work it took to create the box, such as the wood­work­ing, painting, and creation and insertion of the music box. Finally, the overhead costs are derived from con­sid­er­ing the extra costs of the man­u­fac­tur­ing process, such as the cost of rent and utilities in the factory where the music boxes are made. Once you un­der­stand those costs, it’s time to put them together into the cost-plus formula:

• Sales price = (direct material costs + variable costs + direct labour costs + overhead costs) x (1 + mark-up per­cent­age)

• If the direct material costs are £45, the direct labour costs are £13, and the overhead costs are £18, while the mark-up per­cent­age remains 0.31% after the cash discount has been taken into account, then the sales price would be:

• Sales price = (£45 + £13 + £18) x (1+ 0.31%) = £99.56, rounded to £100

In the end, the mark-up per­cent­age cal­cu­la­tion and the cost-plus cal­cu­la­tion are simply two strategies for de­term­in­ing which sales price would be best.

It’s common to mistake a cash discount for a cash discount. While a trade discount is sub­trac­ted from the list price, cal­cu­lat­ing the cash discount shouldn’t happen until the final invoice sum has been de­term­ined. The cash discount is only sub­trac­ted from the payment amount if it’s made use of within the discount period, while a trade discount is not dependent on the payment deadline and is taken into account im­me­di­ately.

Fur­ther­more, a trade discount depends on the quantity of goods purchased or amount of purchases made, while a cash discount is (as pre­vi­ously described) based on the time period when the payment is made. Here is an example of a trade discount: A seller charges £0.95 per product for the purchase of 100 products, and only £0.89 per product for a purchase of 200 or more products. Cash discounts, on the other hand, are granted in­de­pend­ently of the quantity of products purchased.

The following table shows a com­par­is­on between a cash discount:

A customer cash discount is being referred to when a business grants its customers a cash discount. This cash discount rep­res­ents a cost element for the business and thus needs to be taken into account when making a sales price cal­cu­la­tion.

When the supplier grants the business a cash discount, it’s a supplier cash discount example. This discount makes a reduction of the pur­chas­ing costs possible.

To determine whether making use of the cash discount is worth it, you should first calculate the effective interest rate of a supplier credit and compare it to the bank’s lending rates. The effective interest rate for a supplier credit is cal­cu­lated with the following formula:

• Discount per­cent­age / (1 – discount per­cent­age) x [360 / (full allowed payment days - discount days)]
• Example: 2% cash discount when payment is made within 3 days, or net 30 days
• 2 / (1 – 2%) x [360 / (30 – 3)] = 27.19% effective interest rate for the supplier credit

If the cal­cu­lated interest rate is greater than the bank’s lending rates, it’s advisable to take out a short-term loan from a bank in order to finance the util­isa­tion of the cash discount.

Making use of the cash discount is be­ne­fi­cial, even if it often only saves a few pounds. The cash discount has several ad­vant­ages for both customers and suppliers.

Advantage for the supplier

The fact that the invoice is paid more quickly by the customer, means that the supplier can address their payment ob­lig­a­tions more quickly, too. The supplier can also use cash discounts to offset possible cash shortages, by arranging a temporary increase of the cash discount. The losses caused by the temporary increase of the cash discount are neg­li­gible compared to the costs that could arise from cash shortages.

Advantage for the customer

Cal­cu­lated over the course of a year, making use of cash discounts can save a re­l­at­ively large amount of money. As the previous example shows, it’s sometimes even worth it to take out a loan from a bank in order to use a cash discount. As long as the effective interest rate for the supplier credit is greater than the interest rate for the bank’s loan, taking on a loan is more cost-efficient.

In some cases it can be quite advisable to take out a short-term loan in order to make use of the supplier’s cash discount – not only as a seller, but also as a private in­di­vidu­al. However, the situation should first be analysed, as it’s possible that the bank’s interest rates are so high that taking out a loan is not worth it.

Example:

The invoice amount that needs to be paid totals £5,000. If the invoice is paid within the first 10 days after the invoice has been received, the customer can deduct a 2% cash discount.

Is it advisable to take out a loan in order to make use of the cash discount?

Profit from making use of the cash discount → £100 - £27.22 = £72.78

A bank loan is often cheaper than a supplier credit, although it’s always necessary to analyse the situation yourself in each case to be sure.

Please note the legal dis­claim­er relating to this article.