A trade discount is the amount by which a manufacturer reduces the retail price of a product when it sells to a reseller, rather than to the end customer. The reseller then charges the full retail price to its customers in order to earn a profit on the difference between the amount by which the manufacturer sold the product to it and the price at which it then sells the product to the final customer. The reseller does not necessarily resell at the suggested retail price; selling at a discount is a common practice, if the reseller wishes to gain market share or clear out excess inventory.
Why companies give Trade Discounts
The trade discount may be stated as a specific dollar reduction from the retail price, or it may be a percentage discount. The trade discount customarily increases in size if the reseller purchases in larger quantities. A trade discount may also be unusually large if the manufacturer is trying to establish a new distribution channel, or if a retailer has a great deal of distribution power, and can demand the extra discount.
A manufacturer may attempt to establish its own distribution channel, such as a company website, so that it can avoid the trade discount and charge the full retail price directly to customers. This can cause disruption in the distributor network, and also may not increase company profits, since the company must now fulfill customer orders directly and provide customer service, as well as maintain the distribution channel.
The seller would not record a trade discount in its accounting records. Instead, it would only record revenue in the amount invoiced to the customer. If the seller were to record the retail price as well as a trade discount on an invoice to a reseller, this would create an unusually high gross sales amount in the income statement that might mislead any readers of the financial statements into thinking that the manufacturer has higher sales volume than is really the case (Q. Zhang, M. Dong 2014).
It is referred to as a discount, allowed to customers by the seller at the time of making the payment of purchases, as a reduction in the invoice price of the commodity. A cash discount is used by the sellers to facilitate a prompt payment and thereby to avoid the credit risk. Both the buyers and sellers keep a proper record of such discount in their books of accounts.
A trade discount is one that is allowed by the wholesaler to the retailer, calculated on the list price of the product, whereas cash discount is allowed to stimulate instant payment of the goods purchased. The main difference between trade discount and cash discount is that ledger account is opened for a cash discount, but not for a trade discount. One of the easiest ways to increase sales and so boost profit, used by various traders, businessman, and shopkeepers all around the world, is to offer a discount. It is simply a reduction in the selling price of the goods, which not only attracts customers, but also persuades them to make more sales. It is classified as trade discount and cash discount (B. Sarkar 2013).
Differences between Trade Discount and Cash Discount
The given concepts are similar but not identical:
- Trade discount is given on the catalogue price of the goods while the cash discount is given on the invoice price.
- Trade discount is granted with the aim of increasing the sales in bulk quantity, whereas Cash discount is granted to facilitate a quick payment.
- Trade discount is allowed to all customers while the Cash discount is allowed to those customers, who purchase goods in cash.
- In the case of Trade Discount, no entry is made in the books of accounts, while the proper entry is made in the books of accounts for the cash discount.
- A trade discount is shown as a deduction in the invoice. Conversely, a cash discount is not shown at all.
- The cash discount may differ with the time period, within which payment is made by the customer. On the contrary, trade discount may differ with the quantity of goods purchased and amount of purchases.
- Trade discount is allowed at the time of purchase while the cash discount is allowed at the time when the payment is made.
The ultimate objective of every organization is to increase the sales revenue, and these two discounts are the primary tool to achieve it. Usually, the customers are habitual of bargaining and by giving them these discounts, enable a firm to achieve its objectives and sustain the customer for his brand. Thus, it will be a win-win situation for both the customer and the organisation. Although trade discounts increase the purchase quantities, it also increases the credit risk of the firm. Also, more and more cash discounts decrease the firm's profit margin. Hence, both the discounts along with their benefits have certain flaws that need to be taken care of while giving the discounts (J.H. Cochrane 2010).
- Cochrane J.H. (2010),Discount Rates, NBER, December 2010.
- Sarkar B. (2013), An Inventory Model with Finite Replenishment Rate, Trade Credit Policy and Price-Discount Offer, Journal of Industrial Engineering, Volume 2013.
- Zhang Q., Dong M. (2014). Supply chain coordination with trade credit and quantity discount incorporating default risk, Int. J. Production Economics, March 2014.
Author: Maria Drzazga