Most businesses will use discounts and price reductions at some point in their business journey. For a growing business, discounts can be a way to attract business, clear excess inventory, differentiate between market segments or encourage prompt payment of invoices.
Discounts are often thought to be the exclusive preserve of retail businesses. In the retail context, discounts are a key tool to encourage customers to purchase more product. In the distribution and wholesale environments, discounting typically takes on a different form. Let’s look at trade discounting and cash discounting, the two main ways that vendors discount goods and services sold in the business-to-business (B2B) environment.
What is a trade discount?
A trade discount is essentially a percentage reduction on the wholesale list price. Wholesalers deal with a wide range of clients with varying order quantities, relationships and terms of trade. Despite this, it is easier for a wholesaler to publish a single price list which it can then use to set prices for each customer.
A business’ price list will typically quote one price for each product – this price is, generally speaking, the highest price that a customer will be charged. Businesses will, of course, wish to differentiate their pricing by customer, for example, a loyal, frequent customer with high order volumes can expect to receive better pricing than an occasional customer. The trade discount is the tool that businesses use to adjust pricing to match a particular customer. A retail customer may pay 100% of the list price, a frequent customer may pay 85% of the list price and a related party, such as another group entity, may only pay at a cost recovery rate.
What is a cash discount?
While trade discounts are offered to certain suppliers, a cash discount is a conditional discount offered to customers who pay invoices in advance of the invoice due date. Cash discounts may reduce the amount payable by a percentage of the total invoice or by a fixed amount. Invoices are typically due within a month of issue; a cash discount may reduce the amount payable by 5% if payment is received within five business days of the invoice being issued.
Although a 5% early payment discount might seem significant, the amount of any discount can be built into base pricing. The advantage of using cash discounts is that the business receives payment sooner, allowing it to invest the money received into the business sooner. Cash discounts also reduce non-payment risk – if a company pays your invoice early in the month and then realises it cannot pay all its creditors later in the month, you may be spared having to write off the amount not paid.
Accounting Treatment of Trade and Cash Discounts
A trade discount does not fit into the accounting record. This is because a trade discount can be viewed as a way of changing the sale price – it is deducted from the list price before the customer is invoiced. On the other hand, with cash discounts, the total invoice payable is entered as a credit on the ledger and balanced by two debits – the actual payment received and the relevant discount. For example, a sale worth $10,000 may be subject to an early payment incentive of $500 – a credit is entered for $10,000 and two debits for the actual payment of $9500 and the early payment discount of $500.