Case Study: Cost of Trade Discounts

The primary disadvantage of offering trade discounts is the cost to your bottom-line profits associated with the loss of revenues. The following example looks at the bottom line effect of offering trade discounts:

Quick Computer Supply has been experiencing a steady build up in accounts receivable over the last six months. This build up in accounts receivable has put a slight strain on the company's cash flow, since collections are often lagging behind. Quick Computer Supply has decided to look at the possibility of changing its credit terms by offering a trade discount to its customers if their payments are received 10 days after shipment. The company's current credit terms call for full payment within 30 days of shipment. Sarah Quick, founder and CEO has provided the following information:

• Sales have been averaging about $25,000 per month.
• Ms. Quick estimates that about 50 percent of the company's customers will take advantage of a 1 percent discount. She expects 75 percent of the company's customers will take advantage of a 2 percent discount. For analysis purposes, she assumes all customers not taking advantage of the trade discounts will pay within 30 days
• The company's annual carrying costs for its investment in accounts receivable is 11 percent.

With this information, the following analysis is prepared for the company showing the effect on the company's bottom line for each of the possible options.

(A)	(B)	(C)	(D)	(E)	(F)
Credit Terms	% of Customers Taking Discounts	Average Accounts Receivable (Note 1)	11% Annual Carrying Costs (C x 11%)	Cost of Trade Discounts (Note 2)	Effect on the Bottom Line (D + E)
no discount	N/A	$25,000	$2,750	----	($2,750)
1/10 Net 30	50%	16,666	1,833	1,500	(3,333)
2/10 Net 30	75%	8,333	917	4,500	(5,417)

Note 1: Average accounts receivable is computed as a weighted average of the accounts receivable for the month.

Note 2: Cost of the trade discount is computed as follows: ((percent of customers taking discount x monthly sales) x discount percentage) x 12

Determining whether or not to allow trade discounts requires Ms. Quick to look at the information from two different perspectives: the bottom line perspective, and the cash flow perspective. The option that strikes a balance between these two perspectives will help increase the company's cash flow without sacrificing the company's bottom line profits.

Bottom line perspective. Ms. Quick sees that offering no discounts has the smallest impact on the bottom line, reducing the company's profits by $2,750. Offering a 2 percent discount is the most costly, reducing the company's bottom line by $5,417.

Cash flow perspective. From the cash flow perspective, a lower average investment in accounts receivable means a quicker inflow of cash for the company. Offering the 2 percent discount significantly reduces the companies average investment in accounts receivable. This option would have the most favorable impact on cash flow problems.

Combining the two different perspectives indicates that offering no discounts is the most profitable, but it does nothing to increase cash flow. Offering a 2 percent discount would significantly increase the company's cash flow, but at the expense of the company's bottom line profit. Ms. Quick determined that offering a 1 percent discount strikes a comfortable balance between the two perspectives. Offering a 1 percent discount reduces the company's bottom line by only $583: a small sacrifice for an increase in the company's cash flow. At the same time, this option increases the company's cash flow by $8,334.