What it means
A trade or volume discount is applied before the invoice is raised, so the accounts only ever see the net figure. If a list price of $100 is discounted 20% for a wholesale customer, revenue is recorded at $80 and there is no separate discount expense.
This makes trade discounts invisible in the accounts and easy to give away without anyone noticing the cumulative cost. A settlement or early payment discount works differently, because it is offered after the invoice is issued and depends on the customer's behaviour.
The classic terms are written as 2/10 net 30, meaning the buyer may deduct 2% if they pay within 10 days, otherwise the full amount is due in 30 days. The seller should treat that 2% as the price of getting cash 20 days early, and it is a startlingly high price when annualised.
The buyer should run the same calculation in reverse: if their cost of borrowing is lower than the annualised value of the discount, taking it is one of the easiest returns available. Discounting also damages margin faster than most people expect, because the discount comes entirely out of profit.
A business making a 30% gross margin that gives a 10% discount must sell 50% more units to make the same gross profit, which is why volume promises should be checked against actual volume delivered. The strategic risk is that discounts reset expectations.
Customers who receive a discount once tend to expect it again, and a discount used to close a quarter often becomes the new list price for that account.
In practice
Real-world examples.
Example
A stationery wholesaler offers a 15% trade discount to customers ordering more than 500 units. One customer splits its orders across two sites to stay above the threshold, so the wholesaler adds a group level test to the policy.
Example
A commercial printer offers 2/10 net 30 to improve cash flow. Half its customers take the discount, and the finance director later works out that a bank overdraft would have been far cheaper than the margin given away.
Example
A furniture retailer runs a 20% end of season sale to clear stock ahead of a new range. The discount is planned into the buying margin from the outset, so the clearance still contributes positive gross profit.
Formula
Calculation
Discount amount = invoice value x discount rate
Annualised cost of a settlement discount = (discount % / (100 - discount %)) x (365 / days saved)
Worked example: a supplier invoices $12,000 on terms of 2/10 net 30. The discount is $12,000 x 0.02 = $240, so a customer paying within 10 days settles for $12,000 - $240 = $11,760. The supplier has given up $240 to receive the money 30 - 10 = 20 days earlier. Annualising that gives (2 / 98) x (365 / 20) = 0.0204 x 18.25 = 0.372, or roughly 37.2% a year. Unless the supplier is borrowing at more than 37% a year, this is an expensive way to accelerate cash, and for the customer it is an excellent return on paying early.Case study
Seen in the real world.
Ferndale Tools is an illustrative, fictional supplier of hand tools to independent hardware stores. Its sales team had authority to discount up to 12% without approval, and over three years the average discount crept from 3% to 9% while list prices stayed still.
Revenue looked stable at around $14 million, but gross margin fell from 34% to 27% and nobody could point to the decision that caused it, because trade discounts never appeared as a line in the accounts. The finance director built a simple report showing invoiced price against list price by customer and by salesperson.
In this illustrative case the fix was structural rather than confrontational. Discount authority above 5% moved to a manager, discounts were tied to committed annual volumes rather than promised ones, and margin recovered four percentage points within a year with almost no lost customers.
Watch out
Common mistakes.
- Judging a discount against revenue instead of against gross profit, which badly understates how many extra sales are needed to break even on it.
- Offering settlement discounts without annualising the cost, which routinely turns out to be far more expensive than borrowing the money.
- Letting a discount granted for a one-off reason become permanent, so the discounted price quietly becomes the customer's expected price.
Questions
People also ask.
How do I record a settlement discount in the accounts?
The sale is recorded at the full invoiced amount and the discount is recognised when taken, either as a reduction of revenue or as a separate discount allowed account, depending on the policy applied.
Is a trade discount shown on the invoice?
Often it is shown as a deduction for clarity, but only the net amount is recorded as revenue in the seller's books.
Should a buyer always take an early payment discount?
Take it whenever the annualised value exceeds your cost of finance and you have the cash, because those returns are usually well above what the money would earn elsewhere.
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