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Cost of Credit Formula

Description: The cost of credit formula 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)

Example: A supplier of the Newman Astronautics Company is offering early payment terms of 2/15 net 40, which is a discount of 2% if paid within fifteen days, with regular payment due after forty days.  Newman’s cost of capital is 14%.  The accounts payable manager needs to decide if it is economically viable to take advantage of the discount.  The calculation is as follows:

Discount %/(100-Discount %) x (360/(Full Allowed Payment Days – Discount Days))

= 2% /(100%-2%) x (360/(40 – 15))

= 2% / (98%) x (360/25)

= .0204 x 14.4

= 29.4% Cost of Credit

Since the cost of credit of 29.4% is substantially higher than the corporate cost of capital of 14%, this is an eminently good idea.  The accounts payable manager authorized taking the early payment discount.

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.