What it means
A seller that wants its money sooner can either shorten its terms, which customers resist, or pay for speed with a discount. "2/10 net 30" gives the customer a choice: pay $980 on day 10 or $1,000 on day 30.
The $20 buys the seller 20 days of earlier cash; for the customer, it costs $20 to hold the money for 20 days. The arithmetic decides the matter.
Giving up 2% to hold cash for 20 days is equivalent to borrowing at 2% per 20 days, which is $20 / $980 = 2.04% for the period, or about 37% a year (365 / 20 x 2.04%). A buyer who can borrow at 8% should always take the discount, even if it means drawing on an overdraft to do so; only a buyer whose alternative is far more expensive credit, or who has no access to funds, should decline it.
The same calculation shows why sellers should think carefully: offering 2/10 net 30 is paying 37% a year for 20 days of acceleration. It makes sense for a seller with a high cost of capital, high credit risk, or a working capital constraint, and less sense for one that can borrow cheaply.
Sellers often offer discounts for reasons beyond the arithmetic: they are customary in an industry, customers expect them, they reduce collection effort and bad debt, and they reward the customers the seller most wants to keep. Sellers also face the problem of unearned discounts, where customers pay late and deduct the discount anyway; enforcing the terms (invoicing the shortfall, or refusing the next discount) is a routine and awkward task for credit control.
The accounting has changed. Traditionally, a discount allowed to customers was recorded as an expense when taken, and a discount received from suppliers as income.
Under IFRS 15 and ASC 606, a cash discount offered to customers is variable consideration: the seller estimates at the point of sale how much discount customers will take, based on experience, and recognises revenue net of that estimate, adjusting later if the actual differs. A seller whose customers take the discount 60% of the time on 2/10 terms recognises revenue at 98.8% of invoice value.
Buyers under most frameworks record purchases net of discounts they expect to take, or record the discount received as a reduction of cost when taken; the treatment should be consistent. Cash discounts differ from trade discounts, which are reductions from list price agreed at the time of sale (for volume, for trade customers) and are simply the price; they never appear separately in the accounts.
They also differ from dynamic discounting, in which a buyer's platform offers suppliers early payment at a discount that declines each day, and from supply chain finance, in which a bank pays the supplier early and the buyer pays the bank at term.
In practice
Real-world examples.
Example
A building merchant offers 2.5% for payment within 7 days and finds that its best-capitalised trade customers all take it, improving its cash but costing 2.5% on its most reliable accounts.
Example
A manufacturer uses its bank facility to take every 2/10 discount offered, treating the 37% annualised return as its best available investment.
Example
A retailer deducts a 2% discount on an invoice it pays at day 25 and receives an invoice for the $600 shortfall from a supplier that enforces its terms.
Think of it
“A cash discount is like getting $2 off your $100 grocery bill for paying with cash today instead of charging it.
Formula
Calculation
Annualised Cost of Not Taking a Discount = [Discount % / (100% minus Discount %)] x [365 / (Full term days minus Discount period days)]
Cost to Seller of Offering a Discount = Same formula, from the seller's side, compared with its cost of capital
Worked example, buyer. A company receives an invoice for $50,000 on terms 2/10 net 30. Its overdraft costs 9%.
- Discount = $1,000; pay $49,000 on day 10 or $50,000 on day 30
- Annualised cost of not taking it = (2 / 98) x (365 / 20) = 2.04% x 18.25 = 37.2%
- Cost of borrowing $49,000 on the overdraft for 20 days = $49,000 x 9% x 20 / 365 = $242
- Net benefit of taking the discount = $1,000 minus $242 = $758
The company takes the discount. Across a year of $6,000,000 of purchases from suppliers offering these terms, taking every discount saves $120,000 in discounts less about $29,000 of interest: $91,000 net.
Variant: terms of 1/10 net 60. Annualised cost of not taking = (1 / 99) x (365 / 50) = 1.01% x 7.3 = 7.4%. Below the overdraft rate: the company pays at 60 days and keeps the cash.
Worked example, seller. A wholesaler with annual credit sales of $20,000,000 and DSO of 48 days considers offering 2/10 net 30. It expects 50% of customers by value to take the discount, paying at day 10, and the rest to continue paying at about day 48.
- Cost of discounts = 2% x 50% x $20,000,000 = $200,000 a year
- New average collection period = (0.5 x 10) + (0.5 x 48) = 29 days
- Cash released = ($20,000,000 / 365) x (48 minus 29) = $1,041,000
- Interest saved on the released cash at 8% = $83,000
- Expected reduction in bad debts (the paying-early customers are lower risk anyway, but faster collection reduces exposure) estimated at $30,000
- Net cost = $200,000 minus $83,000 minus $30,000 = $87,000 a year
On the arithmetic the discount is expensive. The wholesaler offers it only to customers who ask and whose business it wants to retain, and instead tightens collection to bring DSO towards 35 days, which releases $712,000 at no cost.
Accounting, seller: in a month with $1,700,000 of invoices on 2/10 terms and an expected 50% take-up, revenue is recognised at $1,700,000 minus (2% x 50% x $1,700,000) = $1,683,000, with a $17,000 refund liability (or reduction of receivables) for expected discounts, adjusted when actual take-up is known.Case study
Seen in the real world.
A regional food distributor had always offered 2/10 net 30 because its founder had, and 70% of its customers by value took the discount. A new finance director calculated that the discounts cost $560,000 a year on $40,000,000 of sales and that, since the discount-taking customers were the large, well-financed ones who would have paid within 30 days anyway, the acceleration was worth perhaps 15 days on their balances, about $250,000 of cash at 7% interest, or $17,000 a year. The company was paying $560,000 for $17,000 of benefit.
Removing the discount, however, would be seen by customers as a 2% price increase. The finance director's solution was to withdraw the discount over eighteen months through the annual price negotiation, offering each large customer a choice between the existing price with no discount or a 1% lower list price with net-30 terms; almost all chose the lower price, which cost the company 1% instead of 2% and simplified its receivables accounting. The discount remained available to small customers as a collection incentive.
Net saving: about $300,000 a year. The finance director's note to the board observed that the discount had been a habit, not a policy, and that it had cost more than the company's entire credit control department.
Watch out
Common mistakes.
- A buyer declining a cash discount because the percentage looks small. Annualised, 2/10 net 30 is worth about 37%; almost any available borrowing is cheaper.
- A seller offering discounts by habit without calculating what the acceleration is worth against its cost of capital.
- Allowing customers to take unearned discounts on late payments, which converts the discount into a permanent price cut.
Questions
People also ask.
Is a cash discount the same as a trade discount?
No. A trade discount is a reduction from list price agreed at sale and is simply the price. A cash discount is conditional on early payment and may or may not be taken.
How are cash discounts accounted for?
Under current revenue standards the seller estimates expected discounts and recognises revenue net of them at the point of sale. The buyer records the discount as a reduction in the cost of the purchase when taken, or nets it if it expects to take it.
Should a business always take cash discounts offered by suppliers?
Almost always, if it can fund the early payment at a rate below the annualised value of the discount, which is usually the case. The exception is when funds are simply unavailable.
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