The cost of credit formula is a calculation used to derive the cost of an early payment discount. The formula is useful for determining whether to offer or take advantage of a discount. The formula can be derived from two perspectives:
- The accounts payable department of the buyer uses it to see if taking an early payment discount is cost effective; this will be the case if the cost of credit implied by the discount is higher than the seller's cost of capital.
- The sales department of the seller and the purchasing department of the buyer. Both parties consider the early payment discount to be an item worth negotiating as part of a sale transaction.
In reality, early payment terms are only taken when the buyer has sufficient cash available to make an early payment, and the cost of credit is high. The availability of cash can be the deciding factor, rather than the cost of credit. For example, if the buyer's cash is tied up in long-term investments, it may not be able to take an early payment discount. This occurs despite the inherent cost of credit generally being quite attractive to the buyer.
Use the following steps to determine the cost of credit for a payment transaction:
- Determine the percentage of a 360-day year to which the discount period will be applied. The discount period is the period between the last day on which the discount terms are still valid and the date when the invoice is normally due. For example, if the discount must be taken within 10 days, with normal payment due in 30 days, then the discount period is 20 days. In this case, divide the 20 day discount period into the 360-day year to arrive at an 18x multiplier.
- Subtract the discount rate from 100%. For example, if a 2% discount is offered, the result is 98%. Then divide the discount percentage by 100% less the discount rate. To continue the example, this is 2%/98%, or 0.0204.
- Multiply the result of each of the preceding steps together to arrive at the annualized cost of credit. To complete the example, we multiply 0.0204 by 18 to arrive at a cost of credit of 36.7% for terms that allow a 2% discount if paid within 10 days, or full payment in 30 days.
- If the cost of credit is higher than the company's incremental cost of capital, take the discount.
The formula is as follows:
Discount %/(100-Discount %) x (360/Allowed payment days – Discount days)
For example, a supplier of Franklin Drilling offers the company 2/15 net 40 payment terms. To translate the shortened description of the payment terms, this means the supplier will allow a 2% discount if paid within 15 days, or a regular payment in 40 days. Franklin's controller uses the following calculation to determine the cost of credit related to these terms:
= 2% /(100%-2%) x (360/(40 – 15))
= 2% / (98%) x (360/25)
= .0204 x 14.4
= 29.4% Cost of credit
The cost of credit inherent in these terms is quite an attractive rate, so the controller elects to pay the supplier's invoice under the early payment discount terms.