Purchase Discount

A purchase discount is a reduction in the price a buyer pays for goods or services, offered by the supplier as a reward for paying an invoice before the normal due date. The terms are usually printed on the invoice in a short form such as "2/10, net 30," meaning the buyer may deduct 2 percent if it pays within 10 days, and otherwise must pay the full amount within 30 days. From the seller's side, the same reduction is a sales discount; the general idea is covered in the entry on the early payment discount.

In the buyer's accounts, a purchase discount reduces the cost of the goods acquired. For a merchandiser, it therefore lowers inventory and, ultimately, cost of goods sold. Purchase discounts should not be confused with trade discounts, which are reductions from a supplier's list price given to certain customers and are simply deducted before the purchase is recorded.

There are two methods:

• Gross method: the purchase and the related accounts payable are recorded at the full invoice amount. If the buyer pays within the discount period, the discount is credited to a purchase discounts account (periodic system) or to inventory (perpetual system).
• Net method: the purchase is recorded at the invoice amount minus the discount, on the assumption that the discount will be taken. If the buyer pays late, the extra amount is debited to a purchase discounts lost account, which is treated as a finance cost.

The net method highlights discounts that are missed, which can be a useful signal of weak cash management, while the gross method is simpler and more common in small businesses.

On 1 March, a hardware store buys $10,000 of tools on terms of 2/10, net 30, and uses the gross method with a perpetual inventory system.

• 1 March: debit inventory $10,000; credit accounts payable $10,000.
• If paid on 9 March: debit accounts payable $10,000; credit cash $9,800; credit inventory $200.
• If paid on 31 March: debit accounts payable $10,000; credit cash $10,000.

Under the net method, the purchase would be recorded at $9,800. A payment on 31 March would then require a debit to accounts payable of $9,800 and to purchase discounts lost of $200, with a credit to cash of $10,000.

Skipping a discount is effectively borrowing from the supplier for the extra days at a high rate. The implied annual rate is:

• $d$ is the discount rate as a decimal.
• $N$ is the number of days until the full amount is due.
• $D$ is the number of days in the discount period.

For terms of 2/10, net 30, the rate is 0.02 divided by 0.98, times 365 divided by 20, which is about 37.2 percent a year. Unless the business can earn more than that on its cash, or has no other source of short-term funds, taking the discount is usually the better choice; even borrowing on a bank line of credit at 8 percent to pay early would save money.

Purchase discounts affect working capital management. Paying early shortens days payable outstanding, which uses cash sooner, so treasury teams weigh the discount against their cash position. Many companies use automated payables systems to capture every available discount, and some use dynamic discounting or supply chain finance programs, in which a bank pays the supplier early in exchange for a discount. In the cost of goods sold calculation under the periodic system, purchase discounts are subtracted from purchases along with returns and allowances, producing net purchases and then the cost of goods purchased. The specific terms offered by each supplier are set out under its credit terms.