## Effective Cost of Factoring to the Firm

When a firm sells its receivables to a factor, the factor charges a commission and deducts interest on the advance it gives against those receivables. To decide whether factoring is worthwhile, compute the effective (annual) cost of factoring and compare it with the firm's existing cost of borrowing.

### Core formulas

```

Rate of Effective Cost of Factoring

= (Net Annual Cost of Factoring / Amount available for advance) x 100

= (Net Annual Cost of Factoring / Advances to be paid) x 100

```

where

```

Advances to be paid = Amount available for advance - Interest deducted by factor

```

> Convention: In these problems, 1 year is taken as 360 days.

### Decision rule

Situation	Advice
Effective cost of factoring < existing cost of borrowing, or factoring gives a positive net annual benefit	Avail factoring services
Effective cost of factoring > existing cost of borrowing	Do NOT avail factoring services

### Steps to build the answer

1. Compute savings from factoring (saved administration/collection cost, saved bad debts, interest saved on receivables released).

2. Deduct factoring charges (commission + interest charged by factor) to get the Net Annual Cost (or Benefit).

3. Divide by the relevant base (amount available for advance, or advance actually received) and express as a percentage per annum.

4. Compare with the firm's borrowing rate and advise.

Worked example

### Example 1

Illustration of the rate computation

Assume for a year: amount available for advance = Rs. 10,00,000; interest deducted by factor = Rs. 80,000; and the net annual cost of factoring = Rs. 1,20,000.

Advances to be paid = 10,00,000 - 80,000 = Rs. 9,20,000
Effective cost (on amount available) = (1,20,000 / 10,00,000) x 100 = 12%
Effective cost (on advance actually received) = (1,20,000 / 9,20,000) x 100 = 13.04%

If the firm's existing borrowing cost is, say, 15%, factoring is cheaper, so the firm should avail it.

⚠️ Common exam mistakes

Using 365 days instead of the 360-day convention specified for these problems.
Dividing by the gross receivables instead of the correct base (amount available for advance, or the advance actually received net of interest).
Forgetting to subtract the interest deducted by the factor when computing 'Advances to be paid'.
Comparing the effective cost with the wrong benchmark — it must be compared with the firm's existing cost of borrowing.
Confusing 'net annual cost' with 'net annual benefit' and getting the decision direction reversed.

Reference:

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