September 2, 2014

The Straight Skinny on When to Offer Early Payment Discounts

Some businesses try to encourage early payments from customers by offering what are known as trade terms.  Typical trade terms might be 1/10/30.  Those terms mean that the buyer gets a 1% discount if paying within 10 days, and the balance is due in 30 days from the date of the invoice.

Sounds simple enough, right?

Discounts for early payment - trade terms

But I wanted to know if trade terms work in the real world, especially from the point of view of the company extending the trade terms.  So I asked John Mariotti, President and CEO of the Enterprise Group and formerly the CEO of Huffy Bicycles.  He’s had a lot of commerce experience, both as buyer and vendor.  Here’s what he had to say:

Question:  Why do vendors offer early payment discounts?

Mariotti: There are five reasons the vendor would be willing to offer a discount to encourage early payment:

  • Companies want their money.  It sounds simplistic — but isn’t.  Getting paid early is important in business.
  • They want their money ahead of other people.  The buyer may not have enough money to go around.
  • The longer it takes, the greater the risk that something happens and you don’t ever get your money.  The earlier you get paid, the less risk.
  • It helps you from the perspective of working capital.  The more money you have in hand, the less need to find working capital from other sources.
  • It lowers your costs of borrowing and can even substitute for loans.  The more money you get in hand, the less you have to borrow. This is important in times when it’s hard to borrow money or interest rates are high.

Question:  Is there ever a downside to offering discounts for early payment?

Mariotti: Yes.  Consider:

(1) Discounts cost you money.  Again, it sounds obvious — but discounts add up. A 1% discount for monthly invoices amounts to 12% interest a year.  A 2% discount, as some companies offer, would amount to 24% interest.

(2) Look out for the “double whammy.”  If you are having trouble getting a buyer to agree to a price increase, you might attempt to negotiate by offsetting the increase with an early payment discount. But the customer may squeeze you over price AND expect the discount — and still pay you later.

Question:  Are there any other advantages to offering early payment discounts?

Mariotti: Sometimes those who plan to sell their companies will offer early payment discounts to help reduce their DSO (days sales outstanding) number.  This could make the company appear more attractive to acquirors.

Question:  Now for the big question:  do early payment discounts actually work?

Mariotti: In my experience, many customers take the discount and still pay later.

If that happens, you may not be able to do much about it.  You can call them and try to jog the payment.  Penalties usually don’t work. You can try to charge the customer back to recover the discount, but then it becomes a confrontational negotiation and usually the penalty gets negotiated away in the end.

I’ve had the best response by going back to the buyer and saying “That wasn’t the deal we made. We’d like you to honor the deal you made.”  Sometimes that has an impact.

If you must go back to enforce the terms, the way to do it is to call and talk to a human being.  The second best approach is an email to someone you’ve previously spoken with, requesting them to intercede on your behalf.

Question:  What would you advise a small business?  Should they ask for early payment trade terms?

Mariotti: First I’d assess the situation. What is the prevailing practice in your industry?  Are competitors offering discounts?  Do customers expect a discount or not?

If you discover that a discount is expected, then a modest discount of 1% makes sense in most industries.

Some customers normally pay late — so by offering an early payment discount you also are raising the issue of the time value of money up front.   And that’s a valid issue.

If the prevailing terms in your industry are to pay in 30 to 45 days, be sure to build that into your plans. Sometimes you build it into a price negotiation. You say, “Instead of charging an 8% increase, I’ll knock that down to a 6% increase and also offer you a 1% discount if you pay early.”

And always document the terms, even if just in an email exchange. If there’s a change in personnel at the other company, that documentation will be needed.

Question:  Is a discount of 10 days realistic?

Mariotti: 10-day discounts are usually not going to happen, unless the buyer has electronic funds transfer capabilities. The practical aspects of cutting checks and mailing them makes a payment in 10 days unrealistic.  Consider 15 days instead.

Question:  What about the situation where a small business is selling to a large corporation? Would you offer a discount?

Mariotti: No.  If I were selling to WalMart, my pitch would be, “WalMart, you can borrow money cheaper than my company — why don’t we just agree on 15-day terms and I’ll reflect that in my pricing?  Otherwise, I have to borrow at a higher rate than you – and also reflect that in my pricing.”

Most large corporations are good for payment.  Don’t waste your cash discounts on the highly solvent companies, but rather on the companies you’re nervous about.

Question:  You’ve given a lot of advice.  What points would you like to close with?

Mariotti: I’d like to emphasize 3 points above all:

  • It is always good to get your money sooner.
  • In case of noncompliance, fall back on the ethics:  “That’s the deal we made.”
  • Beware of the double whammy, which is where the customer takes the discount and you still don’t get paid any sooner.

Thank you, John Mariotti.

Editor’s note:  this article was originally published at the OPEN Forum.

19 Comments ▼
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Anita Campbell - CEO


Anita Campbell Anita Campbell is the Founder and Publisher of Small Business Trends and has been following trends in small businesses since 2003. She is the owner of BizSugar, a social media site for small businesses, and also serves as CEO of TweakYourBiz.com.

19 Reactions

  1. “A 1% discount for monthly invoices amounts to 12% interest a year. A 2% discount, as some companies offer, would amount to 24% interest.”

    The correct formula for the APR is

    Amount of discount/Discounted Price x Number of days in the (accounting) year/number of days paid early

    “2% 10, net 30″ works out as follows:

    2 divided by 98 = .020408

    360 divided by 20 = 18

    18 times .020408 = 36.7%

  2. I’ve worked in an industry (B2B) where most vendors offer trade terms (2% 15 days). Unfortunately many buyers do not pay within terms and still take the discount. It’s almost as if they don’t see/hear the terms anymore (i.e. that a discount is given for prompt payment). The vendors typically get into a squabble about the unearned discount and everyone ends up frustrated.

  3. “To stop suffering, stop greediness. Greediness is a source of suffering.” ~ The Buddha

  4. From the perspective of a retail consultant, I advise ALL of my clients that they need to be managing their cash flow with the objective that they capture EVERY early payment discount; and that they need to be aggressive in insisting on these discounts. These discounts are pure profit that flows to the bottom line. If a retailer isn’t capturing ALL of this money then they have work to do on their cash flow management.

  5. Ted Hurlbut, what do you advise your clients about taking discounts they don’t deserve?

  6. Thanks for the pointers, John. Good reminders and advice. I do appreciate the ideas.

    For the most part, as a small service company, I have great relationships with my clients and they generally know that this is how I pay my bills and feed my family, so they mostly pay on time. Every now and then, I deal with a larger company that has its pay cycle and no amount of cajoling, or discount, or incentive, can get them to move faster. They pay when they pay. 30, 45, 75, whatever. If I was in another line of business, I might view this more aggressively.

    I have to wonder though if all our attention on cash flow management isn’t simply lack of savings or forethought. Now before everyone gets upset, I know that lots of small business owners face tough situations, but couldn’t an owner build up some reserves and thus ease the stress and worry of a late payment? That doesn’t mean that you don’t have an energetic A/R focus, but that you don’t suffer each month when a group of customers doesn’t pay on time.

    • From a purely financial standpoint, as a customer paying your vendor….it is foolish to NOT take a prompt pay discount. Most people aren’t savvy enough to realize that a measly 2% 10 day discount really equates to an APR of 36%….not 24% as suggested above. In today’s day and age…if it only costs you 4-6% to borrow and someone is giving you a 36% discount rate you don’t take…you are throwing money away.

      Conversely, if you are the vendor and you have a low cost of borrowing….and your DSO is within 45-50 days…it is foolish to offer your customers 36% on your money that only costs you 4% annually to float their balance.

      As far as building reserves….If you have good cash flow, idle money is usally not a great idea as there is usually an alternative use of that money that will pay you back more than todays cost of borrowing.

      The article is right, it’s all about cash flow, but I do not believe most companies that offer a discount to “get the sale” realize how much money they lose by offering it.

      • Ron,

        I just ran across this thread and I notice that it is old, but I also see that you posted years after the original. My point being that I don’t know if you will see this, but I would like to ask you a question regarding your 36% comment. If I spend $1,000 per month with a vendor (no matter how it is broken up) and make each payment in 10 days to earn the 2% discount, will I not simply receive a 2% discount on each dollar? Therefore the total discount for the year is simply $20 or 2%. I understand annualizing interest rates due to compounding, but in this case it seems to me there is no compounding effect. In this case you the 2% seems more like a coupon than a compoundable interest rate. I would love to hear your thoughts on this as you seem to be a savvy finance guy and most people annualize the discount to be 24%. I agree with you that if we are going to annualize the rate it should be 36%. However, I’m not sure it should be annualized at all. Again, I hope you get this, and I look forward to your response.

        Regards,

        Mike

  7. Here is an update copy of one of my comments on the post on Open Forum:

    Anita,

    Very interesting post. I could see many examples from my time as a purchaser and a cost analyst (sitting near a credit analyst who had “tabs” on the payment from customers).

    It is great if you could get paid early and you have longer terms of payment on the other side to your suppliers. I think that the purchasing department and sales department should have discussion with the financial / economics department about the cash flow and compare ingoing and outgoing invoices.

    I wonder when America will get on the train of today’s technology and start to use wire transfer in a higher degree. I remember that customers could say: “the check is in the mail” as an excuse for not paying on time. Compare that with the general custom in Sweden to pay on time, calculating with how long time the bank would take to do the electronic transfer.

    “Mariotti: 10-day discounts are usually not going to happen, unless the buyer has electronic funds transfer capabilities. The practical aspects of cutting checks and mailing them makes a payment in 10 days unrealistic. Consider 15 days instead.”

    I had German suppliers who gave me a certain percentage discount if we paid within 10 days instead of 30 days. The hard thing was to get the invoice through the system in time so the administration could pay it within 10 days. I should check the invoice with the delivery, write in the account numbers for the bookkeeping department and then give it to my boss so he could sign it.

    As a side note: I think one of my former bosses is now working at Huffy Bicycles! I have a hybrid bike (not Huffy brand) stored at a place in Troy, OH.

  8. It is indeed very important for Businesses to get paid early. Great Strategy!

  9. I have one client – only one, alas! – who pays me via PayPal. He uses its “batch processing” function which costs him only $1 to pay up to several dozen bills at once. No fees are deducted on the recipients’ end.

    One day I emailed an invoice; went to the bathroom; and when I returned I had cash.

    I drop whatever I’m doing when he needs something.

  10. Hi Barking Unicorn,

    Thanks for pointing that out.

    Actually I’m quite sure John was doing a much simpler calculation equivalent to uncompounded monthly interest to annual interest, as here:

    http://www.stoozing.com/mon2yr.htm

    No matter how you look at it, the point still is valid — discounts cost money. Under your calculation they cost even more money. :)

    – Anita

  11. Great interview, worthwhile to read.

  12. Early-payment discounts offer buyers an advantage only if they comply with the plan, and large vendors are able to offer them because the vast majority of buyers will not take advantage of the offer, but it wouldn’t make much sense for most Small Businesses. If your clients take advantage of the plan, then you’re paying out those huge annual rates on money you are now “borrowing” from your clients.

  13. Great interview, and some thoughtful ideas for all-sized businesses.

    Perhaps the early payment discount strategy could be customized a bit:

    > Early payment discounts for returning clients
    > Early payment discounts by using PayPal (as noted earlier) or other electronic transaction means (as long as they cover the transaction fees!)
    > Others?

    I think the real idea is to have a solid relationship with your customers. If they aren’t able to pay on time or to take advantage of discounts, maybe ask them how you can work with them to make the process easier on both ends.

  14. My new payment terms:

    Pay me what you can, when you can, until you no longer feel indebted to me.

    http://barkingunicorn.wordpress.com/about

    I’m worth twice what I thought I was, so far. Makes sense. Economic theory says nobody buys unless he thinks he’s getting more than he’s paying. Guilt and debt-aversion help me pick up money I would leave on the table if I set the price.

    Of course, this doesn’t work with corporations. They have no minds or consciences so cannot decide what to pay. You have to tell them and then beat it out of them. But I’m migrating out of that market.

  15. barkingunicorn is so smart on his mouth. quite amazing for a guy who only fishes

  16. As a buyer how do I know when it is better to accept an early pay discount vs longer pay terms?

    example: is 2%10 net 30 better than net 60 pay terms ?

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