To a large extent, business owners think that factoring rates, factoring fees, and the factoring cost of a dollar are all the same. Although they are related, there are important differences. Actually, low factoring rates may translate to lower fees, but may not necessarily translate to lower costs per advanced dollar.
This article helps you understand how the cost per dollar is an essential tool. You can use it to determine how much each advanced dollar costs you. It is the most accurate way that we know to compare proposals.
The article assumes that you already know how factoring works and how fees are charged. If you need a refresher, consider these articles:
- What is factoring?
- How does factoring work?
- How much does factoring cost? (explains how to calculate fees)
1. Typical factoring and advance rates
The following table shows average rates and advances for the most common industries.
|Industry||Factoring rate||Advance rate|
|General Business||1.15% to 4.5%||70% to 85%|
|Staffing||1.15% to 3.5%||90% to 92%|
|Transportation||1.15% to 5%||90% to 96%|
|Medical||2.5% to 4%||60% to 80%|
|Construction||2.5% to 3.5%||70% to 80%|
The most important variable that determines your factoring rate is your financing volume. The higher your volume, the lower the rate. Like most businesses, factoring companies give better pricing to high-volume clients.
To a lesser degree, your industry also determines your rate. Industries that are easier to manage from a factor’s perspective get better rates. These industries include transportation, staffing, and general business.
Industries with complex payment structures or cash flows get higher rates. These industries include construction and third-party-paid healthcare.
In some cases, the creditworthiness of your customers may affect your rates. This is rarely the case, though. Commercial credit scores are used to determine whether a factoring company buys those invoices or not.
a) Factoring advances
Although business owners don’t focus on the advance initially, it is as important as the rate in determining your cost of factoring. The size of the advance is determined by the risk of the transaction. Industries with lower risks, such as transportation and staffing, qualify for the higher advances – usually 90% or above.
Most businesses get an average advance of between 80% to 85%. Industries with uncertain payment patterns, or which generally get underpayments, usually get advances between 70% to 75%.
2. Factoring rate, fee, and cost per dollar
Assume you get two factoring proposals with the following terms. Which proposal offers the better deal?
- A 70% advance at a rate of 3.00% per 30 days, or
- An 80% advance at a rate of 3.43% per 30 days
Let’s assume you factored a $100 invoice for 30 days using both proposals. With the first proposal, you get a $70 advance and pay $3 as a fee. With the second proposal, you get an $80 advance, but pay $3.43 as a fee. So, which proposal is cheaper?
One could argue that proposal 1 is cheaper since it has the lower rate and fee. But keep in mind that you get only $70, instead of $80.
Although both proposals apparently have different terms, they have the same cost per dollar. Therefore, each dollar that the factor advances costs you the same. So, which one is better for your business? It’s a matter of whether your company is better off with the lower advance of proposal 1, or with the higher advance of proposal 2.
Most business owners assume that the proposal with the lowest rate also has the lowest cost per dollar. This assumption is a common mistake. If you learn one thing from this article, it should be that rate, fees, and cost are not the same.
3. Calculating the cost per factored dollar
You calculate the cost per dollar by dividing the rate by the advance. This involves two steps. Convert the rates from percentages to decimals. Then, divide the rate by the advance.
Let’s calculate the cost per factored dollar for the previous example:
- 0.03 divided by 0.70 = $0.043 (4.3 cents per dollar)
- 0.0343 divided by 0.80 = $0.043 (4.3 cents per dollar)
As you see, both 1 and 2 have the same answer, and, thus, the same cost per dollar. Since the cost per dollar is the same, select the proposal that better fits your needs.
4. Common proposal options
Factoring proposals are often quoted in one of three ways. They can quote a fixed-rate proposal, a variable-rate proposal, or discount-plus-margin proposal. Let’s review these options in detail.
In a flat-rate proposal, the rate is quoted as a simple percentage, such as 4%. The finance rate is paired with an advance rate, usually in the range of 80% to 95% depending on the situation.
Fixed-rate pricing is common in the transportation industry, especially with owner-operators. However, companies with predictable payments in other industries may get this type of pricing as well. This type of pricing works well in situations where most invoices pay at about the same time.
b) Time-based / Variable-rate
Time-based rates increase as time goes on. Proposals are quoted as a percentage that is combined with a time frame and an advance rate.
- 1% per 10 days
- 3% per 30 days, 1% per 10 days thereafter
In the first case, the rate is 1% if the invoice pays in 1 to 10 days, 2% if it pays in 11 to 20, 3% if it pays in 21 to 30 days, and so on. In the second example, the rate is 3% if the invoice pays in 30 days or less, 4% if it pays in 31 to 40 days, 5% if it pays in 41 to 50 days, and so on.
Variable-rate proposals have advances that range from 80% to 90%.
These plans are common in larger and more complex transactions. They combine a discount on the invoice with a yearly margin rate on the advance. The yearly rate is based off the prime rate and is prorated.
The table shows two examples:
|Invoice discount||Yearly margin rate|
|2%||Prime + 3%|
|1% per 30 days||Prime + 4%|
5. Cost per dollar for each fee structure
In this section, we show how to calculate the cost per factoring dollar for the three most common pricing structures. Note that most factors base their fees for fixed-fee and time-based plans on the gross value of the invoice. Fees for discount plus margin plans combine fees on the gross value of the invoice and fees on the advance.
Calculating the cost per dollar on a fixed-fee proposal is very simple. Divide the rate by the advance. That calculation gives you the cost in cents per dollar.
For example, assume a 4% flat rate with an 85% advance. The first step is to convert the percentages to decimals – 0.04 and 0.85. Then, divide 0.04 by 0.85, which equals $0.047 (4.7 cents). In other words, the cost of this proposal is 4.7 cents for every advanced dollar.
To calculate the cost per dollar, determine the factoring rate for the invoice based on how long it takes to pay. Then, convert the percentages to decimals and divide the rate by the advance.
Let’s assume that your company has a proposal for 1% per 10 days with an 85% advance. Let’s also assume that invoices pay in 30 days.
At 1% per 10 days, a 30-day invoice has a rate of 3%. As decimals, the rate is 0.03 and the advance is 0.85. Dividing 0.03 by 0.85 shows a cost per advanced dollar of $0.035 (3.5 cents).
To calculate the cost per dollar for a discount-plus-margin proposal, first estimate how long your invoices take to pay. Then, calculate the cost per dollar of the discount. Lastly, determine the cost per dollar for the margin and add all costs.
Let’s assume a proposal quotes a 2% discount, a prime + 2% margin, and an 85% advance. Assume that the prime rate is 4% and that the invoice pays in 30 days. Keep in mind that prime rate varies.
Step 1: Calculate the cost of the discount
The cost of the discount is simple. In this case, it’s a flat fee of 2% – or $0.02 (2 cents) per dollar.
Step 2: Calculate the cost of the margin
To calculate the cost of the margin, first you must calculate the margin rate for the period that the invoice is open. Then, multiply this number by the advance.
Calculating the margin rate for the period that the invoice is open requires a couple of steps. Start by converting the yearly margin rate to a decimal and dividing it by 360. This calculation gives you the daily margin rate. Multiply the daily margin rate you just calculated by 30 days, which is the length of time the invoice is open. This calculation gives you the margin rate for 30 days. Lastly, multiply the 30-day margin rate by the advance rate to calculate the dollar cost of the margin.
Here is how the calculation looks for the example:
- Yearly margin is 6% (Prime + 2%)
- Divide 0.06 by 360 = 0.00017 (or 0.017% daily rate)
- Multiply 0.00017 times 30 days = 0.005 (or 0.05% 30-day rate)
- Multiply 0.005 times 0.85 = $0.0043 per dollar
Note: We use 360 days in a year in step 2, since this is the common “commercial year” that finance companies use.
From step 4, we conclude that the cost per dollar of the margin is $0.0043 (a little less than half a cent).
Step 3: Add the discount and the margin costs
Add the discount cost of $0.02 to the margin of $0.0043, which gives a factoring cost per dollar of $0.0243 (a little less than 2 and a half cents). Each dollar you got for the invoice has a cost of around 2.43 cents.
6. Additional costs to keep in mind
The simplest proposals are all-inclusive and have no additional fees, except a funds transfer fee. The funds transfer fee defrays the factor’s ongoing costs of sending ACH deposits to your company.
However, some factoring companies add other costs to their proposals. In general, most large and complex factoring proposals may have some (or all) of these costs:
- Due diligence
- Funds transfer fees (ACH vs. Wire)
- Account maintenance
- Lockbox setup and maintenance
- Minimum invoice size
- Minimum factored volume
- Credit checks
Keep these costs in mind when comparing factoring companies. These costs can add up and become expensive, especially if they are recurring or if your contract has minimums.
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