Many firms offer early payment discounts as part of their terms of sale. Whether you should or not depends on the competitive conditions facing your firm as well as the benefits and costs your firm will realize from offering discount terms. The benefits acrue from the volume of accelerated payments you can realize and the costs that result given your capital structure.
An early pay discount provides your customers with the option of paying invoices by the discount date or by the due date. Discounts typically range from half a percent to 2 percent. Discount dates are usually set for 10 to 15 days after the invoice date, though sometimes longer when the due date is beyond 30 days. Due dates typically range from 30 to 90 days.
Discounted terms are typically expressed in the format of 1% 10 Net 30. This translates to a one percent discount if paid within 10 days of the invoice date. If not paid by the discount date, the full amount is due in 30 days.
Similarly, in a wholesale situation where all invoices billed in one month are due on a single date the following month, terms in the format of 2% 10 Days EOM (or PROX) are often used. In this case the discount of two percent is used to encourage payment by the 10th day of the next month, which is also the due date. After the 10th, the invoice is technically past due, but with most accounting systems it won’t show up in the 1-30 past due aging bucket until the first day of the subsequent month - e.g., an item billed in April is due the 10th of May at a two percent discount and will be reflected as past due the first of June.
The cost to the buyer of skipping a discount, given the discount percentage and the time difference between the discount date and the due date is very high. The annualized savings from taking the discount on 1% 10 Net 30 terms is about 22%, which remains extremely attractive even in our rising interest rate environment. Except for the very cash poor, this savings provides a strong incentive for buyers to pay early.
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Impact of Offering Discounts
From the seller’s perspective, the effect on revenue from offering an early pay discount needs to be weighed against the potential reduction in Accounts Receivable (AR) carrying costs, bad debt and collection expenses. Seller’s also need to consider the cost to administer discounts.
Lower AR Carrying Costs: These are simply the cost of financing your AR. Assuming the supplier has a line of credit, the longer a customer delays payment the more interest the supplier has to pay the financial institution. Even if the supplier had no need for a loan, their is an opportunity cost for having the funds tied up in AR as opposed to being available to invest in growing the business or becoming more efficient. By instituting an early payment discount, you are motivating customers to pay more quickly, thereby accelerating AR turnover and reducing the size of your firm’s investment in AR, and resulting in lower AR carrying costs.
Bad Debt Reduction: Accelerating customer payments with a early payment discount reduces your exposure to bad debts. While customers taking advantage of the discount are unlikely to default, your exposure to them will still be less than if they were paying slower — good paying companies do occassionally end up bankrupt. More importantly, offering an early pay discount helps you better identify those customers with adequate cash reserves (the discount takers) as well as those customers who are likely to have cash flow challenges (those who don’t take the discount). A buyer’s response to a discount is a powerful signal of its financial condition, because the high annual cost of not taking the discount is a penalty buyers will avoid if they can. By more carefully monitoring the customers that don’t take the discount, you can reduce your exposure to bad debts.
Less Collection Expenses: Lacking a prompt payment discount incentive, all your customers will pay near the due date or some number of days past due. A significant amount of collection effort is directed at customers that, though past due, tend to self cure within 15-30 days. With a discount in place, a large segment of customers are paying early, so there are fewer accounts that need to be monitored for going past due, thereby reducing the number of initial collection contacts you need to make. Along with the reduction in exposure to accounts that might default, the reduction in collection activities is an offset to the small percentage of sales consumed by the discounted terms.
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Administering Discounts
While the reduction in AR carrying costs, bad debt and collection expenses serve to offset the discounts taken, there may also be administrative costs associated with administering a discount. These costs are usually small, but not always trivial.
The primary issues are any extra time required for posting cash as well as handling unearned discounts. Strict enforcement of your discount terms prevents abuse, which usually comes in the form of companies sending payments beyond the discount date.
Sometimes missed discount dates are due to the customer taking the discount from the receipt of goods rather than date of invoice, which should be the date of shipment or the next day. Hopefully that is fixed with a friendly conversation.
Problems may also occur if the customer only processes payments one or two days per month. As a result, whether discounts are taken in time can be hit or miss. Again, a short conversation with the customer about their accounts payable (AP) process should be sufficient to resolve the matter.
A more serious problem are the customers who tell their AP departments to take every discount offered no matter when payment is sent. Chances are you are not going to get customers like this to change their policy (or their character for that matter). The best solution is to only offer these abusive accounts net terms with no discount for early payment.
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If the lapsed time from shipment to delivery is more than a few days, you should take this issues into account when setting the discount date in order to reduce unearned discounts and disputes. Ten days may not provide your customer with enough time to receive the invoice, the goods, and to process payment. If you are mailing invoices, you can eliminate delays by instead sending invoices by email or through an invoice portal. In addition, you should be generating and transmitting invoices within 24 hours of fulfilling the order. This doesn’t affect the discount cycle, but it does have a significant impact on the overall payment cycle.
Another issue that arises is if customers are paying by credit card. When possible, AP departments like to pay with a Purchasing Card (P-Card) or a Virtual Card because they get cash back from their card issuer. However, not only does the seller end up offering a discount, but also gets charged a merchant fee to their card processor, typically around 2.5 percent. One solution to this is to include a surcharge, roughly equal to the merchant fee, for all payments via credit card.
All the above mechanics need to be weighed against your gross margin percentage. If you enjoy high margins, administrative costs are less of an issue. if your margins are tight, however, you will probably be offering a lower discount percentage than if margins were higher, and so you don’t want administrative costs working against the benefits.
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Competitive Considerations
In many cases, the biggest advantage of offering an early pay discount is that it provides an advantage over competitors that don’t offer a discount. Not only are you competing in the marketplace for sales, but very often also for who gets paid first. By offering discount terms, you may be able to differentiate your company from your competitors with your payment terms as well as from all your customer’s other suppliers that do not offer discounted terms.
Your decision to offer an early pay discount will hinge on a number of factors. Your position in the marketplace is certainly key. Lower AR Carrying Costs along with Reductions in Bad Debt and Collection Expenses are reliable benefits. The nature and habits of your customers will determine any administrative burden related to discount handling, and that needs to be considered in regard to the impact on your gross margins.
Lastly, all the above are affected by the discount percentage and discount time frame you offer. Change those parameters, and you will need to re-calibrate all these other consequential factors. If you do your homework, implementing an early payment discount is very likely to be a success.