Trade discount: how to manage your cash flow

As a source of stress and budgetary imbalance, unpaid bills pose a real threat to a company’s long-term financial health. Consequently, trade discounting is the ideal solution for encouraging customers to make their payments on time, thereby helping to ensure the service provider’s cash flow is managed effectively. How does it work? Find out in this article!

Definition of trade discount

Derived from the Italian word “scontare”, meaning to deduct (or a deduction), a discount refers to an organisation offering a reduction to a customer on condition that the customer pays within a pre-agreed timeframe.

In a commercial context, a trade discount thus binds the supplier (providing goods and/or services) to certain customers of its choosing. It should be distinguished from a bank discount, a process used in particular in the management of commercial paper.

Although not mandatory, a trade discount is often a beneficial strategy for both parties, as it encourages the customer to pay as soon as possible (or even in cash):

• the service provider benefits from greater visibility and better cash flow management;
• the customer receives a rebate that has a positive impact on their cash flow.

Please note: It would be a misnomer to confuse a trade discount with a rebate, a discount or a reduction, as these do not depend on any payment deadline. In fact, a discount is based on order volume and applies only to the relevant line item on the invoice, not to the total amount.

Set a trade discount

Calculation

The discount rate applied under the trade discount is calculated on the total pre-tax amount invoiced. The applicable Value Added Tax (VAT) rate is then applied to this amount.

Good to know: As a reminder, you can find all VAT rates and the conditions under which they apply in our article on the basis, rates and exemptions for Swiss VAT in 2021.

The correct formula is therefore:

Trade discount = (total amount excluding VAT × discount rate) × (1 + VAT)

Example calculation:

1. An item is invoiced at CHF 500 (excl. VAT) at the reduced VAT rate (2.5%).
2. A trade discount of 10% is available, subject to payment in full.
3. The customer pays in cash and thereby claims the trade discount.
4. The total trade discount is calculated as follows:

Trade discount = (500 × 10%) × (1 + 2.5%) = 50 × 102.5% = CHF 51.25.
Please note: Depending on whether you are a supplier or a customer, the amount calculated will be recorded under a different account in your accounts.

Decision criteria

Although trade discounts enable a supplier to build customer loyalty and retain a portion of its customer base whilst improving its cash flow management, each sale sold at a discount results in a loss of revenue which, in the long term, may undermine the company’s profitability.

Whether or not to opt for this solution therefore requires, at the outset, an estimate of the amount offered over the course of the year, and a comparison of this with the losses incurred by a certain percentage of unpaid debts over the same period. Analysing the cash flow statement is therefore essential for this decision-making process.

Good to know: The service provider may set several discount rates for the same service, with the rates decreasing in stages depending on how long it takes the customer to make payment. Payment terms are set at the company’s discretion.

Your industry and your client’s stance on a potential trade discount are also good indicators. So don’t hesitate to discuss the matter with your clients to find out whether such an arrangement might be feasible.

If you opt for a trade discount, you should also be aware that once the discount rate has been set, it is likely to remain stable: any increase would put the business at a disadvantage, whilst any reduction would dissatisfy the customer.

If a trade discount is applied, it must be stated clearly and legibly on the invoice, for example as follows:

“[…] a trade discount of X% granted subject to payment by XX/XX/XXXX”.

Good to know: in the Swiss invoicing process, Swiss customers generally settle their payments within 10 to 30 days. It would therefore make more sense to offer a discount to encourage payment within a shorter timeframe.

Benefits of trade discount

Whilst the benefit of a trade discount seems obvious from the customer’s perspective, as they receive a discount on their order, the benefits are just as significant for the supplier:

• the company avoids numerous unpaid bills and thereby keeps its customers happy;
• the company has more cash available to manage its cash flow;
• The company cultivates strong relationships with its most important business partners.

However, even though a trade discount may seem like an opportunity for the customer to take advantage of, the customer is still free to choose whether or not to meet the agreed payment deadlines. This factor must therefore be taken into account by the service provider!

Despite this, the savings generated by this solution can be so significant for the customer that it is sometimes worth taking out a bank loan to make repayments more manageable. The idea is therefore to compare the bank’s interest rate with the discount rate and the frequency of orders over the course of a year.

Trade discount is therefore a win-win solution, provided that both the supplier and the customer show goodwill. This approach is also applicable to international invoicing.