The cost of credit is a financial calculation that is done to find out the cost of the discount that a business is going to offer on an early payment. The cost of credit is used to find out by the account payable department to find out whether offering an early payment discount is cost effective for the business or not. The purchase department of the buyer also tries to find out that discount offered by the seller on early payments is worth negotiating and mentioning in a sales transaction.
In most of the cases an early payment is made by the buyer in the situation where the cost of credit is high and the buyer has excessive money to make an early payment. However the ultimate deciding factor is the availability of cash as compared to the cost of the credit. The cost of credit can be determined by using following steps:-
- First of all a percentage of 360 day year is calculated to the year at which the discount is going to be applied. The discount period is the period that starts from the day of the purchase to the last day at which the discount is still valid
- In the next step the discount rate is subtracted from 100. For example if the discount rate offered is 2 percent subtracting it from 100 it will return 98 percent. Now the discounted rate is divided by 100 – discounted rate as for above example 2 %/ 98% that becomes 0.0204.
- Multiply the results of above mentioned steps to calculate the annualized cost of credit.
The formula can be shown as under:-
Discount % (100 – Discount %)x 360 /Allowed payment days – Discount Days)