Case Study: Trade Discounts

The decision to take, or not to take a trade discount is based on a comparison of the costs of the discount to what you earn by taking the discount. If what you earn by taking trade discounts is greater than what it costs you, you should definitely take advantage of the trade discount. This example shows how to determine what you earn by taking a trade discount.

Harry Green, the owner of Green Lawn Service, purchases his lawn fertilizer from a particular supplier that offers a trade discount of 1 percent if Harry pays for the merchandise within 10 days of purchase. Otherwise, the full amount of the invoice is due in 30 days.

The general rule for trade discounts says that Harry should always take advantage of a trade discount of 1 percent or more if the supplier requires full payment within 30 days. If the supplier offers payment terms beyond 30 days, it may be more advantageous to skip the trade discount and delay paying the supplier until the full payment is due. Harry's a little skeptical of the general rule and wants to make the determination himself. In order for Harry to determine if he should take the trade discount, he will need to consider the annualized interest rate earned by taking the trade discount. If this annualized interest rate is greater than interest rate charged to borrow the money from a bank, for example, then the discount is definitely worth taking. The interest rate changed by Harry's lender for a short-term loan is 11 percent. Harry determines the annualized interest rate as follows:

Annualized Interest from the Trade Discount = 1% 100% - 1% × 360 30-10

Annualized Interest from the Trade Discount = 1% 99% × 360 20

Annualized Interest from the Trade Discount = .010101 × 18

Annualized Interest from the Trade Discount = 18.2%

Harry's annualized interest rate earned on the money used to make the early payment is 18.2 percent. Harry should take the trade discount offered by this supplier since it is well above the 11 percent cost of borrowing money.