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Extra Profits: The Magic of Purchase Discounts
Using shopping discounts is a recipe for success in any economy. Mixing up a scoop of “good business practices,” a dash of “strengthening supplier relationships,” and a dash of “profits” creates a dish sure to fatten your bottom line. If your business isn’t already doing so, paying your supplier invoices early enough to take advantage of purchase discounts is a quick and easy way to get to the next level.
WHAT IS A PURCHASE DISCOUNT?
A purchase discount is money taken from a supplier’s invoice when paid within a specified time period. Discounts are usually expressed as a percentage, with 1% being the most commonly used and rates of 0.5%, 1.5% and 2% being seen in standard practice. So a $100 invoice would only cost your company $99 if the supplier offers a 1% discount and your accounting department pays the invoice during the discount period. Most suppliers who offer credit terms allow an invoice to be paid within 30 days, expressed in business parlance as ‘Net 30’. If a supplier offers a 1% discount for their customers to pay within 10 days, it will be expressed as “1% 10 Net 30”. So “1.5% 15 Net 45” means the invoice is due within 45 days, but the supplier will allow you to take 1.5% off the invoice if you pay within 15 days
Another deviation is to express the terms of the credit as dates on the calendar. So “2% 5th Net 25th” means that the bill is due on the 25th of the month, but a 2% discount is offered as long as the bill is paid on the 5th of the month.
INVEST YOUR COMPANY’S MONEY FOR AN 18% RETURN?
The typical argument against taking advantage of purchase discounts is the value of cash. You can argue that keeping cash in your business longer far outweighs the measly 1% that a purchase discount generates. The math proves otherwise. Take for example the most common credit terms of 1% 10 Net 30. Remember that this gives you a 1% discount for paying 20 days before the cycle. Note, however, that banks quote their returns based on an annual percentage rate (APY), not a 20-day rate. The math for putting the 20-day investment in terms of an APY begins by dividing it by a 360-day period (known as the banker’s year). Simple division of 360/20 equals 18, showing that the actual discount is “worth” 18 times its face value. So a 1% discount rate yields the equivalent of 18% APY.
HOW CAN YOUR COMPANY HELP?
The beauty of taking advantage of shopping discounts, if you don’t already, is how easy it is to get started. Think about how you do business now. Most likely, the accounting department pays your suppliers every month. Don’t change this! Pay them every 30 days; you just have to start paying during the discount period. As an example: If your supplier offers credit terms of 1.5% 7th Net 27th, you will normally pay on the 27th of each month, assuming you do a respectable business. The payment would then be resubmitted in another 30 days on the 27th and so on month after month. Use the purchase discount by paying on the 7th of each month instead of paying on the 27th of each month. The first time will be a bit difficult as you will have to pay on the 27th of this month and again about 10 days later on the 7th of the following month. But, this is a one-time procedural change. After that short-term pain, you’ve realized long-term gains for your company. Also, your company is back on a monthly payment schedule, now paying on the 7th of each month instead of the 27th.
While borrowing from a line of credit or credit card should only be used as a last resort, you have to ask yourself if paying the 4.75% APR (average rate on the line of credit ) or 12% (average credit card rate) to save 18% APY.
ARE CREDIT TERMS NEGOTIABLE?
Credit terms are absolutely negotiable! Depending on your volume and loyalty to a supplier, you may be able to negotiate a special discount rate for your business. A 3% discount is incredibly rare. A 2% discount, however, is not out of the question for extremely loyal customers. You won’t know until you ask!
WHY DO SUPPLIERS OFFER DISCOUNTS?
Cash is king in every business, not just yours. Suppliers are also companies. They need cash to make payroll, pay the water bill and keep the lights on. Their cash flow model is further complicated by the number of companies that go out of business, file for bankruptcy, or simply don’t pay on time. So they’re willing to give their company an incentive to make sure cash flows into their bank accounts so they can pay their bills.
HOW DO PURCHASE DISCOUNTS GENERATE PROFITS?
Under accounting rules (known as: Generally Accepted Accounting Principles, or “GAAP”), purchase discounts are a “top line” number and are treated as revenue. Unlike other income, however, every penny of purchase discount income flows directly into the “bottom line,” known as net profit. You don’t need an accounting degree to understand this phenomenon.
In very simple terms, from your company’s current income statement (aka profit and loss statement), the flow of dollars is as follows. Revenue is received from your customers (‘upline’). Direct expenses, such as labor and materials, are subtracted from revenue to arrive at gross profit (‘Bottom Line’). Indirect expenses such as mobile phones, lights, insurance, office staff, etc. are subtracted from gross profit to calculate net profit (‘bottom line’).
Given the above, add the additional revenue stream from purchase discounts to the income statement as revenue. There are no additional direct costs generated by the advance payment to suppliers; so this goes through the Direct Expenses part of the statement to gross profit. Similarly, there are no additional indirect costs arising from the advance payment; therefore, the purchase discount amount flows directly to the net profit line.
HOW MUCH PROFIT?
Even small businesses can measure their added profits in the thousands of dollars with this simple change in payment policy. It’s not uncommon for a small business with 10-20 employees to have $1 million in annual revenue. Since materials represent an average of 40% of revenue in many industries, your company’s average annual materials costs will be around $400,000. So a 1% discount acquired throughout the year generates a return of $4,000 in new found profits! If your material purchases are higher or the discount rate you negotiate is better, the impact on your bottom line would be much greater. Also, when you consider that this “once hidden but now found” money is generated year after year by making a one-time 20-day change in payment policy, the results are amazing. As an added bonus, your suppliers will quickly move you up a few notches on their “best customer list.”
A simple improvement to exercising purchase discounts today will see your company reap additional profits, strengthen supplier relationships, and leverage corporate best practices for years to come.
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