Definition
The term purchase discounts ratio refers to a calculation that allows a company to understand if it is taking advantage of supplier discounts. Purchase discounts are typically offered if payment is received in a predetermined timeframe and the ratio should be very close to 100%.
Calculation
Purchase Discounts Ratio = Purchase Discounts Taken / Purchase Discounts Offered
Where:
Purchase discounts taken is the total dollar value of purchases associated with offers of purchase discounts.
Purchase discounts offered is the total of all economic purchase discounts provided by suppliers. This includes all instance where the money saved by taking the discount is greater than the opportunity cost associated with a later payment. Nearly all discounts offered by suppliers will be economically viable candidates.
Explanation
Accounting and finance metrics allow a company's internal analysts to understand how well its accounting and finance departments are operating. This is usually assessed by examining metrics such as error rates, transactions processed, discounts taken, and turnaround times. Accounting and finance metrics allow the company's management team to identify areas where changes can be made that will improve their key operating metrics. One of the ways to learn if the accounting department is capitalizing on vendor-offered discounts is by calculating the purchase discounts ratio.
Suppliers typically offer their customers a discount on the purchase price of their goods if prompt payment is received. Discounts are almost always profitable, meaning the company will save more money by paying early than the opportunity cost of holding onto the funds longer. Taking advantage of these discounts is one of the few ways the accounting department (accounts payable) can demonstrate they are able to directly save a company money.
The purchase discounts to discounts offered ratio measures the effectiveness of the accounts payable department. Since this metric uses economic discounts in both the numerator and denominator, the value should be 100%; anything less should be considered unacceptable.
Example
The CFO of Company ABC wanted to understand how effective her accounts payable department was at processing payments. She asked the company's continuous improvement to kick off a green belt project aimed at determining if the department was taking advantage of discounts offered by vendors. After examining the process, the green belt separated the discounts into two categories: those that are economically viable versus those that should not be paid early. The results of her findings appear below:
Economically viable discounts offered: $312,500
Purchase discounts taken on the economically viable offers: $293,200
From this information the purchase discounts ratio was calculated as:
= $293,200 / $312,500, or 0.938
Based on the above finding, the company lost $19,300 in discounts. After sharing this information with her project champion and sponsor, the green belt identified ways to ensure economically viable discounts were always taken in the future as well as an ongoing measurement system to monitor results of the improvement effort.
Related Terms
revenue to stock price ratio, capitalization ratio, stock options to common shares ratio
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