Volume discounts are a common form of variable consideration found in purchase contracts today. These volume discounts are commonly provided through hierarchical pricing (incrementally lower purchase prices at predefined thresholds for additional purchases), retrospective refunds (partial refunds for earlier purchases once a threshold is reached), and percentage discount vouchers. Volume discounts are designed to promote larger purchases and continued relationships with customers. Many entities will have to consider this topic to determine the appropriate approach to recognizing revenue under the new standard.
Volume discounts are one type of variable consideration referenced in Accounting Standards Codification 606-10-32-7. Please refer to Variable Consideration and Constraint for additional information on accounting for contracts containing variable consideration components. In certain circumstances volume discounts may be considered a customer option, per ASC 606-10-45-41. Please refer to Customer Options for Additional Goods or Services for additional insights on customer options. This article will summarize relevant guidance, and then examine several examples of volume discounts and the appropriate treatment.
Variable Consideration and the Constraint
In estimating the transaction price for a volume discount, an entity should first estimate the total units expected to be sold. After unit volume has been estimated, an entity will then calculate the estimated average selling price per unit based on the schedule of discounts in the contract. Revenue is recognized at the average estimated selling price, and the remainder of any payment beyond this price is recorded as a contract liability. Subsequent sales below the estimated selling price (or retrospective refunds) reduce this liability. Similar to other transactions, revenue in a contract with volume discounts should only be recognized to the extent it is probable (a high likelihood, or ≈75-80%) that a significant reversal will not occur. At all times revenue should be recognized for at least the minimum price. If the estimated transaction price changes (due to changes in volume) during the contract period, this change should be allocated across all performance obligations–satisfied or otherwise–with a corresponding increase or decrease to revenue in the period of the change.
Customer Options for Additional Goods or Services
In accordance with ASC 606-10-55-42, a volume discount contains a material right if the customer receives a significant discount that would not be available without entering into the contract. If volume discounts contain a material right, then a separate performance obligation exists and the entity would be required to allocate a portion of the transaction price to the customer option performance obligation. The portion of the transaction price allocated to this additional performance obligation will be deferred and recognized as the future goods are provided or as the option expires.
Example 1 – Hierarchical Pricing with change in estimated purchases
Background. Widget Co. sells widgets to a variety of customers, including individual consumers, big-box stores, and boutique knick-knack shops. Widget Co. uses hierarchical pricing, in which the first 500 widgets purchased in a calendar year cost $10 each, the next 500 widgets cost $8 each, and any additional widgets beyond the first 1,000 cost $7.50 each. All customers pay in cash.
One of Widget Co.’s customers, Big Bad Big-Box (or BBBB), purchases large quantities of widgets to get the best prices. Over the past 3 years, they have purchased between 4,000 and 6,000 widgets per year. Based on economic factors and experience with similar customers, Widget Co. estimates that for the current year there is a 20% likelihood that BBBB purchases 4000 widgets, a 50% likelihood for 5000 widgets, and a 30% likelihood for 6000 widgets.
Issue 1A. In January, BBBB purchases 500 widgets for $5,000 and Widget delivers the product. How should Widget Co. account for this transaction?
Analysis of 1A. To calculate the rate at which Widget Co. should recognize revenue from sales to BBBB, Widget Co. must estimate the transaction price. An expected value approach is appropriate, because Widget Co. has many similar contracts. The average sales price is calculated as follows:
Probability*(total price)/number of widgets=Probability-weighted amount
4000 Widgets: 20%*((500*$10)+(500*$8)+(3,000*7.50))/4,000=$1.58
5000 Widgets: 50%*((500*$10)+(500*$8)+(4,000*7.50))/5,000=$3.90
6000 Widgets: 30%*((500*$10)+(500*$8)+(5,000*7.50))/6,000=$2.32
Effectively, by calculating the transaction price, management is acknowledging that a portion of revenue for the first 1,000 units is constrained, because the price paid exceeds the overall transaction price. Management should also consider whether any additional portion of revenue is constrained. Because the incremental purchase price for units after the first thousand is $7.50/unit, management determines that a significant reversal is improbable, and no additional constraint is needed. Widget Co. should recognize revenue at the full rate of $7.80 per widget, with an entry for the excess received to a contract liability. The January entry for 500 widgets at $10/unit is as follows:
….Contract Liability:………….. $1,100
Issue 1B. Suppose Widget Co.’s estimate is correct and BBBB purchases a total of 4,500 widgets from January through November, with an additional 500 units to be delivered in December (or 5,000 total widgets). What approach should Widget take to account for the delivery of widgets in December?
Analysis of 1B. Because Widget Co.’s estimate of sales volume was correct, no adjustment to the transaction price is necessary, and over the course of the year the entire contract liability will be eliminated. In December, Widget will recognize revenue at the same rate of $7.80 per widget, receive cash of $7.50 per widget (the price for any sales above 1,000 widgets), and relieve the contract liability for the $.30/unit (or $150 total) as follows:
Contract Liability: ….$150
Issue 1C. Suppose in May, one of Widget Co.’s main competitors introduces a new high-end widget, disrupting the Widget Co.’s primary market. Through the first quarter BBBB has purchased 1,500 widgets, and Widget Co. now predicts a 10% chance that BBBB will purchase a total of 2,000 widgets during the year, a 75% chance it will purchase 3,000 widgets, and a 15% chance they will purchase 4,000 widgets. For the quarter ended June 30, Widget Co. sold 500 widgets (of the 1500 sold so far) to BBBB. How much revenue should Widget Co. recognize for the second quarter?
Analysis of 1C. For the first 2,000 widgets, Widget Co. received cash of $16,500 and recognized $15,600 of revenue, with a contract liability for the difference of $900. This change of facts requires Widget to recalculate the per-unit price and allocate the change to performance obligations that have been fulfilled. The new transaction price is calculated as follows:
$4,000 of revenue is recognized from the sale of 500 widgets (500 Units*$8/Unit). In addition, $300 is recognized for the widgets sold in the first quarter due to the increase in estimated transaction price from $7.80 to $8 (1,500 units* $.20 price increase). Consequently, the entity recognizes revenue of $4,300 for the quarter. The contract liability is relieved for the difference between the price received and the transaction price. Because the incremental price is $7.50, and the transaction price is $8, the 500 incremental purchases cause the contract liability to be relieved $250 ($.50*500). The transaction price also increased by $.20 per unit for the first 1500 widgets, decreasing the contract liability by $300, causing a total decrease in the contract liability of $550. The change in contract liability will also be the difference between cash received and revenue recognized.
….Contract Liability: …………..$550
Example 2 – Fixed price with discount for high-volume purchases
Background. Gizmo Biz, Inc. allows customers to order gizmos in quantities of 500, 1,000, or 5,000 units. Each customer order is independent of any prior order from that customer. Gizmo provides a discount based on the volume ordered, with orders of 500, 1,000, and 5,000 priced at $15, $14, and $12 per gizmo, respectively. BBBB regularly purchases 22,000 gizmos in a year from Gizmo Biz (typically 4 orders of 5,000 and 2 orders of 1,000).
Issue 2A. What transaction price should Gizmo Biz use to recognize revenue for BBBB’s purchases?
Analysis of 2A. There is no variable or contingent element in these contracts. Although there is a reduced selling price for high-volume purchases, the price is fixed. As such, this is not a “volume discount” in the sense used in this article. The 5-step approach should be used as with any other transaction, with a transaction price of $12/unit for any 5,000 unit order and $14/unit for the 1,000 unit orders.
Example 3 – Retrospective refund with constraint
Background. Lee’s T-Rex shop sells full-size plaster T-Rex molds to various museums and dinosaur collectors. To encourage sales, they provide volume discounts with retrospective refunds. To receive volume discounts, all sales must take place within a two-year period. The pricing schedule is provided below. Customers must pay a higher price for lower volume purchases until the next threshold is met. When a customer reaches the next level of sales they will receive a refund for all cumulative purchases equal to the difference between what they initially paid and the new price threshold.
Despite this policy, most sales are still for one to five plaster molds. A prospective customer that owns many dinosaur museums, The American Institute of Tyrannosaurus Plaster Accumulators (or AITPA), has approached Lee’s T-Rex shop to make a very large purchase of plaster molds. Lee’s T-Rex shop rarely has transactions of this scale. The retrospective discount schedule for the shop is shown below, along with its estimates of the likely amount of AITPA purchases.
Issue 3A. Which approach to estimating variable consideration (expected value or most likely amount) is preferable? Which approach would be appropriate supposing that Lee’s T-Rex shop has many similar transactions?
Analysis of 3A. The proper approach depends on which method the entity believes will better predict the amount of consideration to which it will be entitled. ASC 606-10-32-8 states that the expected value approach is likely appropriate when there are many similar contracts, whereas the most-likely approach is preferable if there are only two possible outcomes. Although there are more than two possible outcomes, three outcomes still represents a relatively small number of discrete possible outcomes. Because there are few similar contracts, the most-likely approach is appropriate. However, if there were thousands of similar transactions then the expected value approach would be applied. Regardless of the method, the entity would also need to consider the constraint.
Issue 3B. Is there a constraint on the recognition of revenue? Does this vary depending on which approach is used to estimate variable consideration?
Analysis of 3B. Revenue should be recognized to the extent it is probable (of a high likelihood) that a significant reversal will not occur. An entity should consider the likelihood and magnitude of a potential reversal. If Lee’s T-Rex shop decides to use the most-likely amount, then a transaction price of $6,000/unit would be used; however, there remains a 40% chance the contract will ultimately lead to a price of $5,000 per unit. This is only slightly less than the 45% likelihood of the $6,000/unit price, and would be of significant magnitude due to the relative size of the transaction. Additional factors that provide evidence that revenue recognition should be constrained include (1) the company has limited experience with similar contracts, (2) the uncertainty will not be resolved for a relatively long period of time (two years), and (3) the amount of consideration is susceptible to factors outside the influence of Lee’s T-Rex Shop.If the facts of the case warranted using the estimated value approach, then the estimated transaction price would be $5,638. Although the magnitude of a subsequent reversal would be smaller, the factors mentioned previously would still provide strong evidence that the transaction price should be constrained to the minimum purchase price. Regardless of the approach used, the amount of revenue that is not probable to be subject to a significant reversal (and therefore the constraint) should be the same. Consequently, revenue should be recognized at the minimum selling price of $5000 in either case.
Example 4 – Discount Voucher/Customer Option
(This example is from Customer Options for Additional Goods or Services)
Vendor A sells product X to customer P for $1,000 and gives the customer a 40% discount voucher to be used on a future purchase within the next thirty days. The vendor plans to offer a 15% discount on all transactions in the next thirty days as part of a promotional event. The 40% discount voucher cannot be combined with the 15% promotional offer. Vendor A estimates 80% of customers who receive the discount voucher will actually make additional purchases, and on average, each customer will purchase $1,000 of additional products. Product X has a standalone selling price of $1,000.
Issue 4A. What are the performance obligations and how should revenue be allocated between them?
Analysis of 4A. Because the 40% discount is significant and would not be available to other similar customers, the incremental discount, or 25%, is a customer option. In effect, customer P has paid for the right to make future purchases at a discounted rate. Consequently, honoring the discount voucher and delivering product X are both performance obligations. The standalone value of the discount voucher is $200 ($1,000 in additional products * 25% incremental discount * 80% probability the voucher is used), while product X has a selling price of $1,000. Consequently $167 of revenue should be allocated to the discount voucher (200/1,200)*1,000 and $833 should be allocated to the delivery of product X (1,000/1,200)*1,000.
Issue 4B. When should revenue be recognized for the discount voucher?
Analysis of 4B. Revenue should be recognized as performance obligations are fulfilled. For customer options, revenue is recognized as they are exercised or as they expire. For additional details on this example see Customer Options for Additional Goods or Services.
Comparison to 605
Accounting for volume discounts under ASC 606 remains relatively similar to ASC 605 guidance. The most significant changes are in the approach to calculating the revenue to be recognized and the consideration of a constraint on revenue. Under current guidance (ASC 605-50-25-7) an entity must “recognize the rebate or refund obligation as a reduction of revenue based on a systematic and rational allocation of the cost of honoring rebates or refunds earned.” This leads to the same result as the 606 guidance. However, the current 605 approach is different conceptually in that an entity takes the gross transaction price and reduces it for an estimate of the cost of honoring the rebate, as opposed to recognizing revenue at the estimated variable transaction price.
Additionally, ASC 606 provides two specific methods of estimating this price, rather than the general guidance of using a systematic and rational allocation. With regards to the constraint, current guidance requires that if the amount of future refunds cannot be estimated reasonably, then the maximum liability should be recognized. The new standard takes this a step further, as there will be times when an estimate can be made but a portion of the transaction price is still constrained.
Entities that provide volume discounts are required under ASC 606 to estimate total sales volume, and then calculate an average selling price per unit. Revenue is recognized at the estimated selling price, with any excess payment recorded as a contract liability. Subsequent sales below the estimated price (and retrospective refunds) will reduce this liability. If a volume discount is provided through a discount voucher that constitutes a material right, the voucher is a separate performance obligation. As with all variable consideration, entities should also consider the constraint on revenue recognition.
- ASC 605-50-25-7 to 25-8; ASC 606-10-32-5 to 32-9; ASC 606-10-55-42, 55-216 to 55-220, 55-291 to 55-294.
- Deloitte, Revenue from Contracts with Customers: “Roadmap to Applying ASU 2014-09.” February 2015. Section 6.3.2 “Customer Options for Additional Goods or Services.”
- Plastec Technologies, Ltd. SEC Comment Letter. March 27, 2013. Question 13 Written by Jeffrey M. Gallant.
- PWC, “Revenue from contracts with customers.” August 2016. Section 188.8.131.52 “Volume discounts” and Section 7.2 “Customer options that have a material right.”