Mysterious Business Math – Trade Discounts

I went to a little country grade school in a suburb of Portland Oregon, Pleasant Valley, for grades 1 – 8 and enjoyed almost all of it. I wasn’t the smartest kid in school; that was my friend Gail, but I did pretty well with mostly “A’s” except in penmanship and PE. Back then they had no problem ranking students based on their grades. I will never forget the paper “grade” train that hung on the wall in my first grade classroom. We were assigned a train car based on our grades on different projects; the better you did; the closer to the engine you moved. No one wanted to be the caboose. All of us moved from car to car except Gail... she was ALWAYS the engineer, and try as we might, no one could get the consistently perfect scores Gail did. It seemed she was a math wizard, could spell anything in the dictionary, was Swedish, had long blond braids, and was as nice as she was pretty and smart. Don’t forget, this was first grade and already Gail was reading and doing math. All of us knew that super smart kid growing up but the rest of us mortals had to work hard and put in serious effort to move up.

There are advantages and disadvantages of going to a country grade school. After one day of algebra in 8th grade, the teacher picked up the books and returned to the old ones because he didn’t understand it well enough to teach it. Only Gail sat in the corner learning algebra. When I hit high school I went from being an “A” student in math to a “D” student in Algebra. That was a real kick in the teeth to my self-image. I had never had a “D” before in my life and now I was no longer one of the “smart kids”. And struggle I did, from that point forward through linear algebra and calculus, right up until a business math class where they put dollar signs in front of the numbers and all of a sudden things started getting interesting to me again. My point is that for a subject to be motivating and hold your attention it has to be meaningful to you and have a purpose. Eventually math had a purpose for me because it told me whether or not I was being smart in my business and making good decisions that would move my business forward.

Having a passion for your business is so very important. Some parts of our businesses we enjoy more than others but regardless of that, we still have to do the functions that maybe aren’t so much fun in order to be successful. Life is too short and you need to enjoy the trip each and every day so if there are some shortcuts that help us make those not so fun parts easier, then all the better. Most of us in this industry are alike in one key way; we want to do well, by doing good. We are green and proud of it, and it isn’t enough to just make money, we have to use our power for good to improve things and make healthy, quality products. But if you are to sustain your business and grow your dream you need to understand how your business makes money so you can make good decisions.

For example, do you know how to figure out whether or not you should pay early if a vendor offers you “trade terms”? Let’s say for example a vendor offers you terms of “2% 10 Days, Net 30 Days”. This means that the vendor expects to be paid 100% of what you owe in 30 days, but if you pay within 10 days, they are willing to discount the invoice by 2%. Is it a good idea to take advantage of that discount? What does this really mean? You are paying the bill 20 days early (in 10 days rather than 30 days), and if you have multiple vendors that offer a discount, even if you have to borrow money to pay early, you would be way ahead, especially at today’s low interest rates. If you receive a 2% discount every 20 days that equals a 36% return on your investment in that year. Right now you’re thinking that can’t possibly be right, so let’s do the math:

There are 365 days in a year, or about 18, 20 day periods (18 x 20 days = 360 days)
Earning 2% 18 times during the year (18 x 2%) = 36%
Even at 1% 10 Days, Net 30 it still makes sense:
(18 x 1%) = 18% on an annualized basis

Formula: Discount = List Price x Discount Rate

Looking at the Other Side
We can see we want to take discounts if they are offered, but what if someone asks you to offer payment terms when you sell to them? You need to think really hard about it and do the math. If you have a wholesale account for your products and because they buy about every 20 days they are asking for payment terms of 2% 10 days, Net 30 Days. You think you are doing really well, selling on your website but you know that if you could just get one good wholesale account, it would allow you to make bigger batches of your products, buy in larger quantities, and maybe take your business to the next level. The wholesale account will buy $1,000 every 20 days or $18,000 a year in product. This would more than double your total annual sales to equal $30,000 per year and the profit you make could be used to supplement your household income and grow your business. Do you offer the trade discount or not?

On your $30,000 in sales you have to buy your ingredients and packaging, allocate some cost for your time buying, filling, labeling, packaging, etc., and that leaves you about a 30% Gross Margin (sales – cost of goods – mfg. labor). Then you have your expenses such as freight, electricity, pots, pumps, utensils, and let us not forget insurance, legal and accounting, and any other normal business cost you would generally incur. You are making 16.67% of your sales in net income = $5,000/$30,000 before the 2% discount on your wholesale account. After the discount you are making 15.47% = $4,640/$30,000 so in fact, the 2% discount on part of your sales is 7.2% of your net profit at the end of the day $360/$5,000 when all is said and done. Keep in mind you haven’t paid your income taxes yet and that is going to take a serious chunk of your profits as well.

So what is the moral to the story? Always take trade discounts but don’t give them unless you do the math and there is a very good reason to do it. If that wholesale account will allow you to buy in bigger quantities and you can save 10% on the purchase price of one or more of your key ingredients because of the volume, then do the math…maybe it will make sense. As I always say, business is a math problem.

Here is an online calculator that you can play with that will allow you to put in the days to pay to take the discount, the discount percentage, and the normal due days. It uses the actual 365 days in a year rather than the rough, easy math approach I used above to come up with 36% annualized. I hope you find this both interesting and helpful.

Comments

[Jane]

BIG THANK YOU to Diane!

[Gale]

Great article, Dianne! I could relate to the struggles with the small school, and algebra, too! And yes, dollar signs turned out to be my burning interest for many years - I developed my own bookkeeping business, because I thought balance sheets were 'fun'. Fast forward to this time in my life, and I find my math skills rusty. Thank you for the clear example provided on taking/giving a discount.