Early payment discount or trade discount is one of the modes of trade financing. In this arrangement, the buyer pays the supplier less than the invoiced value, at a date earlier than the due date. Prompt payment discounts are an excellent option for the buyer to reduce the cost of goods or services and save money.
They are a great trade financing instrument for offsetting behind-the-scenes overheads involved with the production, ordering costs, and acquiring economic resources. By taking advantage of trade discounts, buyers could also improve their relationships with their suppliers.
In the case of prompt payment discount or trade discount, there are no additional entries made in the company’s books of accounts. Both the purchase as well as the sale is recorded at the discounted amount. The trade discount doesn’t form part of the company’s accounting transaction and hence isn’t entered into the business’s accounting records.
Below is an example demonstrating an accounting for purchase with a trade discount.
Let’s assume Khanna Ltd. purchased 10 chairs from Sachin Ltd. on credit at the list price of Rs. 4,000 per chair and a 10% trade discount is allowed by the seller. Accounting for such purchase transaction would happen as below:
Total retail price = 10 x Rs.4000 = Rs.40,000
Less Trade Discount = 10% of Rs.40,000 = Rs.4,000
Amount to be recorded = retail price – trade discount = Rs.40,000 – Rs.4,000 = Rs.36,000
The entries in the books of the buyer and the seller will be as follows:
In the books of the buyer
|To Sachin Ltd.||Rs.36,000|
In the books of the seller
|To Sales A/c||Rs.36,000|
Trade discounts decrease the base price of the products and services and help the vendor in negotiating the best price with the buyer. As a buyer, there are substantial advantages to negotiating and securing a trade discount from the vendors. The obvious benefit is that of enhanced profit margins. In case a buyer secures a prompt payment discount from a vendor, then that savings goes straight into the company’s Earnings Before Interest, Taxes, Depreciation, and Amortisation (EBITDA).
Businesses seeking prompt payment discounts can be a great way of minimising costs and optimising the company’s profits.
Days Payable Outstanding or DPO is a business metric that measures the number of days a business takes on average to pay its outstanding invoices to its suppliers for purchases that are made on credit. This metric often represents the bargaining power of a buyer in exerting pressure in negotiating favourable vendor terms such as trade discounts, payment date extensions, etc.
The longer the DPO, the longer the buyer holds onto its cash. Higher DPOs implies that the buyer isn’t able to avail of trade discounts provided by its vendors.
|Particulars||ABC Ltd. (Rs)||XYZ Ltd. (Rs)|
|Average Accounts Payable||16,00,000||14,00,000|
|Cost of Goods Sold||80,00,000||90,00,000|
In the above example, we have the financials of two businesses viz. ABC Ltd. and XYZ Ltd.
Let’s calculate their DPO
ABC Ltd. = 16,00,000/80,00,000 * 365
= 73 Days
XYZ Ltd = 14,00,000/90,00,000*365
= 57 Days
From the above example, ABC Ltd. having higher DPO may be missing out on early payment discounts provided by its vendors. However, the lower DPO of XYZ Ltd. indicates that it is paying its suppliers early to benefit from prompt payment discounts, thus securing an attractive return on its excess cash. Since trade discount reduces the amount payable for a buyer, it leads to a reduction in days payable as well.