Description: The cost of credit is used to determine the cost of not taking a discount offered by a supplier. It is used by the purchasing department as a negotiating tool, so that a company can receive a net return on early payments to suppliers. It is also used extensively by the accounts payable staff to verify that the early payment terms offered by suppliers continue to be valid as the company’s cost of capital changes. Further, the sales staff uses the calculation in its dealings with the purchasing staffs of other companies, who are also interested in obtaining better early payment discounts.
Formula: Determine the proportion of a full year to which the discount period applies. This is the number of days between the end of the early payment period and the date when the payment would normally be due at full price, divided into 360 days. This is the time period over which the discount rate earned by a company is applied. Next, subtract the offered discount percentage from 100%, and divide the result into the discount percentage. This is the effective interest rate that a company will be earning when it takes a supplier-offered discount. Finally, multiply the effective interest rate by the proportion of the full year to which the discount period applies. This yields the annualized cost of the credit being offered by a supplier through its early payment discount. The formula is as follows:
Discount %/(100-Discount %) x (360/Full Allowed Payment Days – Discount Days)
Cautions: Typically, the cost of credit is compared to a company’s cost of capital, which is a blended rate comprised of the cost of all corporate debt and equity. In reality, taking a discount tends to be an incremental decision related to the immediate cost of invested funds. For example, an accounts payable manager will draw down cash from a short-term cash supply, typically invested in a money market fund, in order to take advantage of an early payment discount. This means that the incremental investment trade-off is a few percent of interest earned in the money market fund, rather than the much higher cost of capital for the entire company.