0:00
Today, we're here to talk about purchase discounts and using the gross price method and the net price method
0:10
And I'm going to tell you which one of those drives me crazy. Welcome to Accounting How To. I'm your host, Carolyn Grimm
0:16
That's my sidekick, Terrence, who also drives me crazy. We're here to put the fun in accounting fundamentals
0:23
So what is this gross price net price thing? This is crazy talk
0:29
So when we're dealing with inventory, we want to capture all of the costs that directly or
0:35
indirectly are involved in bringing an item into our business and getting it to the point we're
0:41
going to sell it to our customer. So what does that mean? Well, let's talk about two different
0:46
scenarios. One for a merchandising business like Amazon or Walmart, and one for a manufacturing
0:52
business like Ford Motor Company or Toyota Motor Company. In a merchandising business
0:57
we purchase goods to sell to our customers. And we buy merchandise from lots of different places
1:04
around the world. We bring it into our distribution centers, our warehouses, and then we send it out to
1:11
our stores all over the country. So to correctly capture the cost of getting that merchandise
1:16
into the hands of our customers, we need to accumulate the costs that occur at every step
1:21
of the process. Let's say our distribution center is located in the great state of Maine
1:28
where I live. If we purchase goods from California, those goods then need to be shipped across the
1:36
country, and that costs money. And then once they get to our distribution center in Maine
1:42
then we're going to ship them out to our stores, wherever our stores are, and that costs money
1:47
So the cost of that merchandise includes those shipping costs as well as the actual purchase price
1:55
Now in a manufacturing business, rather than buying finished merchandise that we're now going to sell to our customers
2:02
we're going to buy the raw materials and we're going to transform those materials into a finished product that we'll then sell to our customers
2:11
So when we determining the costs in a manufacturing business for our inventory we going to include both the costs associated with purchasing the inventory and the costs of transforming the raw materials into a finished product
2:26
Now, also part of that cost, either in a merchandising business or in a manufacturing
2:31
business, is the way that purchase discounts are handled. So a purchase discount reduces the cost of merchandise or the cost of raw materials
2:41
And when a vendor offers a purchase discount, it's stated as a percent reduction
2:49
So if it's paid within a certain time, you can take a certain percent off the price
2:54
So if we have a vendor that offers us terms of 2%, 10, net 30, it means that we can take
3:02
a 2% discount if we pay that bill within 10 days. After that, the whole of it will be due
3:09
So we cannot take a discount. and regardless it's all due within 30 days net 30 we have to pay the net amount whatever it is
3:18
in within 30 days so when we take that purchase discount it reduces the cost of our merchandise
3:25
or our raw materials so companies have a couple of different ways to account for those purchase
3:32
discounts they can use either the gross price method or they can use the net price method now
3:39
if you took my principles of accounting or financial accounting class, when we discussed
3:44
inventory, you know, the way that our textbook does this is not my favorite way. Let's see why
3:50
Under the gross price method, a company enters the full price of the purchase and then takes the
3:58
discount at the time of payment if it's paid within the discount period. So we're entering
4:04
the full amount and then applying a purchase discount to reduce the cost of the merchandise
4:09
when we pay the bill. So for example, let's say our cost of goods is $10,000. This is what our
4:16
vendor is charging us. And the terms from that vendor are 1% 10, net 30. If we pay the bill by
4:24
day 10, we can take 1% off the cost. So our journal entry would be a debit to inventory
4:31
or raw materials of and a credit to accounts payable for We going to pay this later on So at this point the cost of our inventory is If we don take the discount we don pay within 10 days then the cost remains the same
4:52
But if we pay within the 10-day discount period, now we can reduce the cost of our inventory when
5:00
we pay the bill. So our journal entry would look like this. Accounts payable, $10,000 debit. We're
5:07
going to reduce the entire amount that we put into our account's payable account. And then on the
5:13
credit side, we're only going to pay $9,900 in cash because we're going to take a 1% discount or
5:20
$100. So what we're going to do with that $100 is we're going to reduce our inventory or our raw
5:28
materials account. So once we do that, now our inventory cost is going to be $9,900. It's the
5:37
$10,000 minus the $100 purchase discount. Now using the net price method, a company assumes
5:46
and you know where that goes, it will take the discount. And so it enters the discounted price
5:53
of the purchase. So we're applying the purchase discount at the time that we are recording that
6:00
purchase. So we'll use the same example to walk through that. So cost of goods is still $10,000
6:07
That's the price of the merchandise. The terms are 1%, 10, net 30. If we pay that bill within 10 days
6:14
we can take 1% off the cost. Well, under the net price method, our journal entry would be
6:20
a debit to inventory or raw materials of $9,900, we've already captured that discount
6:28
And our accounts payable amount is going to be $9,900. It's the amount that we owe on that invoice
6:35
Now at this point, the cost of the inventory is $9,900. It's all well and good, right? The net
6:42
result is the same. $9,900, $9,900. It's the same. But what happens if we don't pay within the
6:52
discount period? Well, now we have to circle back and we have to increase the amount that we're
6:57
paying for that inventory So we going to have to do another journal entry And that journal entry will be a debit to the inventory or raw materials inventory account and a credit to accounts payable
7:09
So before we pay the bill, now we are increasing the cost of our inventory to recapture the full price
7:17
And we're also saying that we owe our vendor another $100 because we didn't pay within those discount terms
7:23
Well, it's still the same amount in the end, right? but what is the impact on the practical accounting level? So on the practical day-to-day
7:32
accounting and bookkeeping level, when we get an invoice from our vendor, we're going to take that
7:38
invoice. We're going to enter it into our accounting software. We're going to enter it as $10,000
7:45
That's what the invoice says it is. It's going to tie out to the invoice number so that when we are
7:50
paying our bills, we can say, yes, we've got this invoice number and it's for $10,000. Everything
7:56
matches up. It's great. And the accounting software is set up so that at the vendor level
8:01
we're going to be able to enter the discount terms that this vendor offers us. So within that
8:08
vendor's account on our software, we're going to enter that the terms are 1% 10 net 30. And this
8:16
is going to tell our accounting software that this is something that will be eligible for a discount
8:21
It will tell us these are the bills that are eligible for a discount if you pay by this time
8:26
And then when we pay the bill, we're going to apply the discount in the payment window, the pay
8:32
bills section of our software. And then inventory costs will be automatically reduced. And all is
8:39
good because our accounting software is set up with a gross price method. Now, if we start messing
8:46
around in our accounting software using the net price method, entering invoices at less than the
8:52
full amount, it creates confusion. It creates headaches. It creates opportunities for errors
9:00
galore. And who has time for that? So for some very specific specialized businesses
9:06
it may make sense to use a net price method if your software is set up to do that. But for most
9:14
of us, for most businesses, using the gross price method makes a whole lot more sense
9:21
Until next time, stay balanced, my friends
