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Trade Discounts
The business of purchasing goods and reselling them for a higher price has been around since the dawn of civilization. This type of business is referred to as merchandising, and those who deal in this type of business are known as merchants. There are two main types of merchants; wholesalers and retailers. Wholesalers purchase merchandise from manufacturers and sell it for a higher price to retailers, usually in bulk quantities. Retailers then resell these goods at a higher price to the final consumer. There are, however, instances where a merchandiser is both a wholesaler and a retailer. These two activities may be operated as one business unit or as two separate business segments. Since merchandisers must advertise a common price to avoid confusion, they usually advertise the retail price in their catalogues, while allowing for a trade discount to other traders or resellers. The trade discount constitutes the difference between the retail price and the price offered to the reseller, and is usually represented as a percentage of the retail price.
There are also cases where a manufacturer is both a wholesaler and a retailer. The same principle applies here. Manufacturers usually have what is known as a recommended retail price (RRP), which is the price charged to the final consumer. They, however, allow resellers to buy their products at a lower price, so that the resellers may make a profit. The difference between the recommended retail price and the price charged to a reseller is also known as a trade discount. Resellers, however, do not always sell the products at the recommended retail price. In order to gain a bigger market share, they may opt to reduce their prices by allowing their customers a discount on the products. The practice is also common with traders who want to clear their inventory.
The computation of a trade discount depends on the information available. In most cases, the available information is the retail price and the percentage of trade discount. This is because the wholesalers and manufacturers who sell their products in both wholesale and retail terms represent the trade discount as a percentage ‘off’ the retail price. Below are the formulae for calculating trade discount and the price charged to the reseller;
Trade discount = Percentage of trade discount*the retail price
Price charged to reseller = Retail price – (Retail price*percentage of trade discount)
For recording purposes, a trade discount should not be included in the books of accounts. The reason for this is because a trade discount is not considered to be an actual discount given to the trader. The purpose for having a trade discount is to ensure that the manufacturer or wholesaler advertises a common price, which is the retail price, while also offering resellers a different price, without necessarily displaying two separate prices. The reseller who buys merchandise at a trade discount should, therefore, consider that the price they receive the goods at is the actual price, since resellers are invoiced at the reduced price. This reduced price constitutes the purchase price for accounting purposes. The case is, however, different for sales discounts, which are given as incentives to pay for merchandise in time. Sales discounts must be recorded as an income to the purchaser and an expense to the seller.
Manufacturers and wholesalers who sell at a trade discount should also not record the trade discount in their books of accounts. This is because the reduced price at which they sell to resellers constitutes the actual price invoiced to trade customers. The invoice amount therefore constitutes the actual sales price. The exchange agreement is, after all, negotiated at the lower price.
A trade discount is offered for several reasons. The first, which is the most common, is that sellers who sell merchandise to resellers and final customers like to advertise a common price. The easiest way to do so is to record the wholesale price as a percentage off the retail price. The other reason is to offer incentives to resellers. Resellers can only engage in business if it is profitable. The wholesaler must therefore sell the merchandise to them at a price which will allow them to retain a markup. This may be done in order to take advantage of resellers’ unique distribution channels such as supermarkets and shops in remote areas which may be able to reach customers better than the manufacturer or wholesaler would.
Resellers also purchase merchandise in large quantities. This means that wholesalers and manufacturers can to sell to them at a reduced cost and still make a profit. Resellers are also able to break down the bulk of products to suit the final consumer’s quantity needs. Wholesalers may also see it beneficial to sell their merchandise through a reseller because the reseller is able to provide after sales services to the customer. If the cost saved by selling through a reseller exceeds the amount of discount offered, wholesalers and manufacturers will opt to offer a trade discount to resellers to attract them into their distribution channel.
Manufacturers and wholesalers may sometimes feel that the amount offered to resellers as trade discount is too high. They may, therefore, resort to selling their merchandise directly to the final consumer. According to AccountingTools (2013), this may not be a good idea because it disrupts the distribution channel. This practice may also lead to higher costs to the company because now the manufacturer is required to maintain the distributon channel, provide customer service such as after sales services and take care of individual customer orders.
References
AccountingTools. (2013, May 12). What is a trade discount? Retrieved May 31, 2013, from http://www.accountingtools.com/questions-and-answers/what-is-a-trade-discount.html
Principlesofaccounting.com. (2011). Chapter Five: Special Issues for Merchants. Retrieved May 31, 2013, from http://www.principlesofaccounting.com/chapter5/chapter5.html
Walther, L. M., & Skousen, C. J. (2009). Current Assets. Retrieved May 31, 2013, from http://bookboon.com/en/current-assets-ebook
Wild, J., Shaw, K., & Chiappetta, B. (2011). Fundamental Accounting Principles (20th Ed.). New York: McGraw-Hill/Irwin.
