What is Trade Discount?
Trade discount is an amount or a percentage by which the list price or the maximum retail price of goods (generally mentioned in the catalogue of the manufacturer) is reduced when goods are sold by manufacturers or wholesalers to wholesalers or retailers who have good business relations with each other in bulk quantities and is different from cash discount which is availed by end customers in form of various payment plans.
Explanation of Trade Discount
It is a common business practice among manufacturers to offer trade discounts to retailers and wholesalers. Trade discount is generally offered in the form of a percentage on the list price/maximum retail price of goods. It is reduced from the list price of goods when goods are purchased by wholesalers and retailers in large quantities.
Trade discount and cash discount differ from each other. Trade discount is offered when goods are purchased in bulk by retailers and wholesalers from manufacturers. However, cash discount is offered by retailers to the ultimate consumer of goods in the form of various payment plans.
Example of Trade Discount
Example of trade discount are given below:
Example #1
A wholesaler purchases 100 laptops from a manufacturer. The list price of each laptop is $8,000. Trade discount offered by the manufacturer to the wholesaler is 15%.
Compute the gross amount, discount amount, and net amount.
Solution:
The gross amount is calculated by multiplying the list price with the number of laptops purchased:
$8,000 × 100 = $800,000
The trade discount amount for each unit will be computed by multiplying the list price of each laptop with the percentage of discount:
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8,000 × 15% = $1,200
The net price to be paid for each laptop will be computed by subtracting the discount amount from the list price of each laptop:
$6,800 ($8,000 – $1,200).
Total amount to be paid by the wholesaler to the manufacturer will be computed by multiplying the net price to be paid for each laptop with the number of laptops purchased by the wholesaler:
$680,000 (100 × $6,800).
Accounting for Trade Discount
It is pertinent to note that trade discount is not posted anywhere in the books of account by creating an account named “trade discount account”. It is neither recorded in the books of accounts of the manufacturer nor wholesaler/retailer. The gross amount is reduced by the amount of trade discount and such reduced amount is recorded to book the sale/purchase of goods in the books of the manufacturer/wholesaler. In the example quoted above, the manufacturer, as well as the wholesaler, will record the sale/purchase in their books of accounts by $680,000 (discounted amount) instead of $800,000 (gross amount). There will be no entry for the amount of trade discount granted by the manufacturer to a wholesaler in the books of accounts of both parties.
However, cash discounts provided to the ultimate customers are recorded in the books of accounts of retailers as an expense. In the case of cash discounts, sales are recorded at the gross amount and cash discounts are recorded as an expense.
Journal Entry for Trade Discount
As explained above, the amount of trade discount is not recorded anywhere in the books of accounts. The transaction of sale/purchase is recorded in the accounts of both parties by the discounted amount. The gross amount is used solely for computing the discount amount by applying the discount percentage to arrive at the net sales/purchase amount.
In the books of the manufacturer, the retailer’s/wholesaler’s account is debited and the sales account is credited by the discounted amount. In the example above, the discounted amount is $680,000. In the books of retailer/wholesaler, the purchase account is debited and the manufacturer’s account is credited by the discounted amount. In the example above, the discounted amount is $680,000.
Therefore, the entries in the books of the manufacturer and the wholesaler mentioned in the example will be as follows:
Books of Manufacturer
| Particulars | Debit (in $) | Credit (in $) |
| Wholesaler/Retailer Account | 680,000 | |
| To Sales Account | 680,000 |
Books of Retailer/Wholesaler
| Particulars | Debit (in $) | Credit (in $) |
| Purchase Account | 680,000 | |
| To Manufacturer Account | 680,000 |
Advantages
Advantages of trade discount are listed below:
- Offering trade discounts helps in promotion of business of the seller.
- It increases the sales quantities thereby increasing sales revenue.
- Increased sales revenue helps cover costs related to manufacture.
- It promotes goodwill of the manufacturer.
- Prevents piling of excess stock in the warehouse of the manufacturer as goods are sold in bulk quantities.
Disadvantages
Disadvantages of trade discount are listed below:
- It may result in reduction of profits of the seller in long term.
- Small discounts may add up to form huge amounts which would result in a decrease in profitability.
Conclusion
Trade discount offered by manufacturers proves to benefit manufacturers as well as retailers/wholesalers.
From the point of view of a manufacturer,it boosts the sales volume resulting in increased profitability in case of manufacturers. Also, stacking up of inventory in the warehouses of manufacturers is avoided by selling goods in bulk quantities. Additionally, it helps improve business relations with retailers/wholesalers. On the other hand, the retailers/wholesalers enjoy a good margin on goods purchased in large quantities. They can further pass on the discounts to ultimate customers in the form of cash discounts which helps improve their goodwill among the clients.
An interesting fact about trade discount is that it is not recorded anywhere in the books of accounts of both the parties i.e. the party who offers the discount who is the manufacturer and the other party who avails the discount who is the retailer/wholesaler. Therefore, the amount of discount a manufacturer offers a retailer/wholesaler largely depends on their mutual understanding and business relations. Also, the discount percentage may be driven by the market forces of a competitive environment in the industry.
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