Suppliers offer their customers purchase discounts in exchange for paying their bills early. It is important to track purchase discounts taken, since they directly improve profits by reducing the amount paid to suppliers. In order to track whether purchase discounts are actually being taken, the accounting staff must:
- Review supplier invoices to see if they offer early payment discounts.
- See if it is economical to accept the discount terms offered.
- Pay the invoice early, in exchange for the offered discount terms.
The key point to measure is whether those terms that are considered economical to accept were actually taken. If the offered terms were not economical, there is no need to track them.
To calculate the percentage of purchase discounts taken, divide the total amount of purchase discounts taken by the total amount of discounts available that are considered economical to take. The formula is:
Total purchase discounts taken ÷ Total economical discounts available
Note that this measurement does not involve the number of purchase discount transactions, but rather the dollar amount of purchase discount transactions. The difference is that if you track the number of discount transactions taken, it could reveal (for example) a high 90% success rate, but the one discount that the accounting department forgot to take was for an enormous amount. Thus, measuring based on the dollar amount of purchase discounts taken, the same situation might (for example) have revealed a 10% success rate. To be more precise, the formula is:
Total dollar amount of purchase discounts taken ÷ Total dollar amount of economical discounts available
The information required for the numerator can be taken from the accounting records. However, it can be much more difficult to compile the information in the denominator. A possible source is the vendor master file.
If the proportion of purchase discounts taken is too low, it may be necessary to restructure the payables process to ensure that early payment deals are dealt with more promptly. A common reconfiguration of the system is to log all incoming invoices directly into the accounting system, prior to sending them out for approvals. Another option is to centralize accounts payable for a multi-location company, and have suppliers send their invoices straight to the central location for more rapid processing.