09 Dec 2011 How do you calculate the value of dynamic discounting?

There a a few eye-catching headlines that sell the benefits of dynamic discounting. “36% return on capital” for example is pretty eye catching but how does dynamic discounting really work in practice and how do you work out if it is beneficial to take say a 2% discount for payment in 10 days rather than 45?

Being familiar with the value of payment terms and how to calculate it is an important sourcing skill but it is essential when trying to understand the value of dynamic discounting.

What is dynamic discounting?

Dynamic discounting is a sophisticated way of exchanging reduced payment terms for a discount. It’s “dynamic” because it can apply to all or some invoices and buyers and suppliers can negotiate and choose which invoices to discount. It relies heavily on there being fairly robust purchase to pay process in place and it’s fair to say that, from the buyers’ perspective, its a game that only the relatively sophisticated organizations can play. For SAP users look at Taulia. Other may want to look at Ariba‘s solution.

How do you calculate the value of a discount?

The value of the discount in isolation is known, but as you are paying early, what effect does that have on the actual value of the discount? To calculate it, you need to know the cost of working capital. Simplistically, the cost of working capital is the cost of borrowing money or, for a cash rich organization, the opportunity cost of not investing cash – the interest they could earn. But for many large organizations, while this is a nice easy way to understand it for a non-finance person, the cost of working capital that the treasury team will quote will be vastly different from the bank interest rates. For a wholly owned subsidiary for example, the holding company is often “the bank”. Sometimes the cost of working capital is quoted at a particular rate in order to drive certain behaviors. Whatever, the cost of working capital is the figure that the treasury department says it is and calculating the value of a discount using this figure is easy.

The formula to use is this:

Value of discount = Discount – (Cost of working capital/365)*Difference in payment terms (in days)

For example, for a supplier that offers a 2% discount for 10 day terms rather than standard 45 days where the buyer cost of working capital is 5% the calculation would look like this:

Value of discount  = 2% – (5%/365)*35 = 1.52%

In this example, for invoices worth $1,000,000, the value of the discount is $15,200

Not a lot? Think of it this way. This discount is generated by paying 35 days early. That’s a return of 1.52% in 35 days. To get a treasury manger really excited and to get your finance colleagues interested, turn that into an annual figure. The annualized value is (1.52/35)*365 = 15.85%. That will certainly wake a treasury manager up!

 Thanks to Doug Cottington and his piece in the Cap Gemini’s procurement transformation blog for the inspiration for this article.