What's 2% Worth?

Let's say you just received an invoice from one of your suppliers. Along with the details and pricing of your purchase, you note that 2%10/N30 is written in the payment terms box.  

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Most of us know that 2%10/N30 is a common discount provided by many suppliers, and that it basically means if you pay within 10 days* you can take 2% off the top of the invoice total. However, if you don't pay within 10 days, the net amount (100%) of the invoice is due within 30 days*.

You think to yourself: "A 2% discount? That's chump change!" 

So the long and short of the story is you decide to pay the full invoice amount in 30 days. 

The question to this scenario is: what did it cost you to not take the discount? Our answer is - by not taking the discount - it cost you an effective annualized rate of interest of 36%! Or, looked at differently, you would have been better off to borrow money from your bank in order to take the discount, as long as the bank didn't charge you an interest rate of more than about 36%.

Wow, now all of a sudden, that 2% discount looks a little different. "So, how'd you come up with the 36% number", you ask?  Good question!

First of all, your supplier gave you the opportunity to take, or not take, the discount. You chose to not take it, so what we're really talking about is "what's your lost opportunity cost?" Here's a simple visual tool you can use to figure out your lost opportunity cost on any set of discounts.  It's a timeline:

Here's what the timeline says:

1. If you had paid within the first 10 days, you would have earned 2%.
2. But, since you didn't pay within 10 days, it cost you 2% to not take the discount.
3. There are 20 days between the discount due date (the 10th day) and the net payment due date (the 30th day).
4. That means you were using your creditor's (supplier's) money for 20 days beyond the standard discount due date, and it cost you 2% for the use of that money for those 20 days.
5. To annualize the cost, you ask yourself: "theoretically, how many 20 day opportunities are there in a year to use someone else's money at the cost of 2% per 20-day use?"

So, as we said above, it cost you an annualized rate of 36% to not take the discount. On the flipside, you might ask yourself where else can you (legally) earn a better return on your investment than about 36%? Can you qualify for a loan at less than Prime + 30%? If you can, and assuming you have the future cash flow to pay it off within a reasonable period of time, you'll usually be money ahead by using credit to take your discounts.

One of the primary points of this example is that we need to think about where we can best use the money that's available to us to run our business. And, to ask questions about "what's this opportunity going to do for us, or to us, if we do or don't take advantage of the opportunity?" - and then be able to answer the question with at least a 'gut feel', if not a conceptual understanding, of the consequences of our decisions.

*The common interpretation of a payment due date, unless specifically noted otherwise on the invoice, is that the payment is due within a certain number of days from the date of invoice.  However, it could also be due within a certain time after date of shipment, after the date of order, after date of delivery, and so on.  It's important to fully understand your supplier's definitions of payment terms.