March 20, 2013
There is still one month left until tax day, but I’m already impatiently awaiting my refund. As usual, I managed to mess up my deductions and lend Uncle Sam some money for free. Interest rates are hovering around historic lows, with a 30 year mortgage at around 3.5% APR. Credit is cheap, so it is easy to ignore right now. Not all of our debt obligations are as cheap as today’s mortgage rates though. The rate on your credit card can fall within a huge range, from 0% to the upper 20s. Maybe you’re still paying off student loans, medical bills, a vehicle, or a fantastic honeymoon; whatever your debt, an interest rate is associated with it.
If you’re like most Americans, you carry a substantial amount of debt relative to your income. According to Federal Reserve Board statistics the national average debt service ratio (DSR) , the ratio of debt payments to disposable personal income, was around 15.5% in Q4 of 2012. As consumers, we choose to buy things we can’t afford and pay them off over time, causing the total cost of those things to be higher than the initial purchase price.
Conversely, when you get to take something home from the store with no money down and 0% financing, you’re able to have your cake and eat it too. Not only do you get the product you wanted, you can also invest the money for a positive return or use it to pay down your current debts while still enjoying your new washing machine or flashy car. This is all pretty intuitive in your personal finances right? How does this concept extend to B2B pricing adjustment? The Payment Cost adjustment in cost to serve section of the waterfall measures the value of delayed payments.
Many B2B transactions are not paid in advance or COD and therefore credit extended to your customers can be a significant source of profit leakage. To calculate this adjustment you need to settle on one rate to use as your Cost of Capital – which is essential the opportunity cost of cash at your company. Treasury or finance is usually tasked with maintaining and publishing this rate, and it gets used company wide. For simplicity’s sake, let’s say it’s 12% APR. You can then plug that rate in to determine the cost of various types of payment terms given the same invoice amount.
If Invoice Price is $500,000 and you were deciding between giving your customer 90 days to pay (Net 90) or a 2% discount if payment received within ten days otherwise payment 30 days after invoice date (2% 10 Net 30) which one is most profitable?
A) Net 90 Terms: $500,000 X 12%/365 days X 90 days =$14,794 Payment Cost
2% 10 Net 30, is actually two different offers:
B) 2% 10: $500,000 X 12%/365 days X 10 days + 2% ($500,000) = $1,643+$10,000 discount
C) Net 30: $500,000 X 12%/365 days X 30 days = $4,931
Looking at it this way it is easy to see that C>B>A, but this math works out differently depending on the Cost of Capital I plug in. As that cost increases it makes more and more sense to offer discounts to pay earlier, or to tighten the days to pay.
To close I’d like to wish you a happy tax season and remind you to change your deductions for next year if you’re getting a big refund, and review your customer payment terms. Are they unnecessarily generous and therefore a source of profit leakage?
Source: http://www.federalreserve.gov/releases/housedebt/, Accessed 3/15/13
Additional Information on Payment Terms and their meaning:http://www.nibusinessinfo.co.uk/content/commonly-used-invoice-payment-terms-and-their-meanings
– Christine Carragee