Trade discount, overdraft and a bulk-stock offer
Mwangi Hardware sells goods worth KSh 800,000 a month: KSh 300,000 cash and KSh 500,000 on credit. Gross margin is 25% of sales and monthly operating expenses are KSh 130,000. Credit purchases are 80% of the cost of goods sold. The main supplier offers terms of 2/10, net 60; Mwangi currently pays on day 60. The bank overdraft costs 12% per annum. Debtors take 45 days, although the stated policy is 30 days. A second supplier offers an extra 1% discount if Mwangi buys three months’ stock at once, but the store can hold only about six weeks’ sales. Mwangi wants to know whether to borrow to take the 2% discount, how much is tied up in debtors, and whether the bulk offer is wise.
1. Calculate the cost of forgoing the 2% discount, compare it with the overdraft cost, and recommend whether Mwangi should borrow to pay within 10 days.
Read the worked answer
Cost of forgoing the discount = (2 ÷ 98) × (365 ÷ 50) = 2.0408% × 7.3 = 14.9% per annum. The overdraft costs 12% per annum, so the trade discount is worth more than the borrowing cost. Borrowing to pay early is financially justified.
Check the cash effect. Monthly sales = KSh 800,000; cost of goods sold = 75% × 800,000 = KSh 600,000; credit purchases = 80% × 600,000 = KSh 480,000. The 2% discount is 2% × 480,000 = KSh 9,600 per month. To take it, Mwangi borrows KSh 480,000 for the 50 days between day 10 and day 60: interest = 480,000 × 12% × 50 ÷ 365 = KSh 7,890. Net monthly gain = 9,600 − 7,890 = KSh 1,710, or about KSh 20,520 a year.
The recommendation is to take the discount, but only if the overdraft is formally arranged and not used to support overdue debtors. The gain is thin, so Mwangi must pay on day 10 reliably; a single missed discount wipes out more than a year’s benefit. He should also ask whether the supplier allows a partial discount on only part of the order, which would reduce the borrowing need.
2. Calculate the amount tied up in debtors at 45 days and at the stated 30-day policy, and explain the financial effect of closing the gap.
Read the worked answer
Credit sales are KSh 500,000 per month. Debtors at 45 days = 500,000 × 45 ÷ 30 = KSh 750,000. At the 30-day policy, debtors = 500,000 × 30 ÷ 30 = KSh 500,000. The excess tied up is KSh 250,000.
At 12% overdraft cost, financing that excess costs 250,000 × 12% = KSh 30,000 a year. That is more than the annual gain from the supplier discount, so debtor control is the larger prize. The money is not lost profit; it is cash that could repay the overdraft or buy stock for cash and earn the 2% discount.
Mwangi should introduce a simple ageing schedule, send statements on day 20, and stop supplying the worst offenders until they pay. He should also check whether the 45-day average is caused by a few large customers or by many small ones; a few large accounts may justify negotiated terms, while many small late payers need a stricter credit limit. Reducing debtor days to 35 would free 500,000 × 10 ÷ 30 = KSh 166,667, saving KSh 20,000 a year at 12%.
3. Evaluate the second supplier’s extra 1% discount for three months’ stock, given the six-week storage limit.
Read the worked answer
Three months’ credit purchases at KSh 480,000 a month = KSh 1,440,000. The extra 1% discount is worth 1% × 1,440,000 = KSh 14,400. However, the store can hold only six weeks’ sales, which is about 1.5 months. Buying three months’ stock means holding an extra 1.5 months, or KSh 720,000 at cost, outside the normal storage cycle. Financing that extra stock for 1.5 months at 12% costs 720,000 × 12% × 1.5 ÷ 12 = KSh 10,800. The net financial gain is only KSh 14,400 − 10,800 = KSh 3,600, before storage, insurance, damage and obsolescence.
Given the space constraint, the offer is weak. Stock would have to be stacked in aisles or off-site, increasing handling and breakage risk. Hardware lines also change slowly, but some items may be discontinued. The extra 1% is not enough to compensate for tying up cash when the overdraft is already in use.
A better response is to negotiate a smaller bulk order, say six weeks’ stock, for a 0.5% extra discount, or to accept the offer only for fast-moving lines with predictable demand. The decision should not be based on the headline 1% but on the net gain after financing and storage costs, which is small and could easily become negative.