Early Payment Discount: What Is It & Should You Use It?

Published on February 20, 2024
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Early payment discounts are strategies companies can employ to try and reduce the number of late payments they receive. After all, late payments prove a hassle to even the most successful company; they tie up your cash flow — leaving you with fewer business options, and they unnecessarily increase the amount of time and energy that you need to devote to your accounts receivable (A/R) processes.

Of course, businesses can always impose late fees and other penalties to discourage payment delays. As an alternative, though, companies can offer a financial “carrot” alongside this fee “stick:” an early payment discount. 

This article covers the basics of early payment discounts, including types, benefits, drawbacks, early payment discount alternatives, and more. 

What is an early payment discount and how does it work?

An early payment discount sometimes referred to as a prompt payment discount, refers to a reward or price reduction that a business can offer to its customers if they pay their invoice before the due date — typically within a set period. 

This type of discount is often expressed as X/Y Net Z, where:

  • X = the percentage discount
  • Y = the maximum timeframe that a payment can take to achieve the discount
  • Z = the general credit terms, when the full payment is due if an early payment doesn’t occur

So, for example, a 1/10 Net 30 credit term indicates that a 1% discount would be applied to the purchase if the payment is made within ten days of the invoice being issued. However, if the buyer fails to meet that initial target date, they will need to send over the full payment within 30 days or face potential penalties.

Some businesses choose to offer early payment discounts as an ongoing incentive to shorten the cash conversion cycle. These incentives are often limited to a particular timeframe, such as if the business is trying to bolster its cash reserves before a quarterly report or to offset some loss.  

Types of early payment discounts 

Static early payment discounts

The most common option, a static discount, establishes a set price reduction — typically 1% to 2% — that is tied to payments made within a specific number of days. Since the figures in this format are rigid, calculating the appropriate discount is straightforward.

Sliding scale early payment discounts

Conversely, a sliding scale discount adjusts the percentage savings based on when the payment is made before the due date. So, the longer the buyer takes to close out their invoice, the less of a discount they will receive. Typically, these offers will stretch from the initial invoice date until the due date, offering the maximum savings on the invoice date and no discount on the due date.

For example, a business might set up a maximum 2% reduction that goes down .4% every six days. So, ten days after invoicing, the discount would have lowered to 1.33%. At 15 days, it would reach 1%, and at 20 days, it would only offer a .67% savings.

Dynamic early payment discounts

While the other two options focus on standardized discounts that apply across customers and transactions, a dynamic discount is instead determined on a per-invoice basis. Admittedly, this method requires the most work to put in place. Still, it also allows your business to prioritize when and how it offers discounts to optimize cash flow without eating into revenue.

These discounts can either be offered by the seller or requested by the buyer — with some manner of negotiation typically occurring before both parties agree. As such, the final discount itself will commonly operate the same as a static or dynamic type.

Early payment discount formula 

Before being able to calculate your discount prices, you need to be able to determine an appropriate discount percentage, particularly for discounts, using the sliding scale discount method.

Fortunately, that calculation is also fairly straightforward and will follow the format of:

Current Discount %

=

Max Discount

+

Change in Discount

x

Days Passed

Change in Days

Bear in mind that the Change in Discount should be expressed as a negative value since the savings rate will decrease over time.

Once you have your discount percentage, you can determine the discount price. No matter which type of discount is being offered, the corresponding formula and calculations remain the same. However, the actual formula to determine an early payment discount is commonly listed in one of two derivative expressions:

Discounted Price = Original Invoice Amount x (1 – Discount %)

or

Discounted Price = Original Invoice Amount – (Original Invoice Amount x Discount %)

Early payment discount example 

Chocolobster Ltd. is a leading manufacturer of frozen, pre-made chocolate-covered seafood dishes, which are sold in specialty grocers across the Eastern Seaboard. In early 2024, it was time for Good Eats — a small grocery chain and one of Chocolobster’s most long-standing customers — to replenish its reserves of Chocolobster and ClamCrunch dishes. Altogether, the chain ordered 1,000 Chocolobsters and 260 ClamCrunches, resulting in an invoice total of $23,120.

Unfortunately, the last few months of 2023 had been rough on Chocolobster due to unexpected supply chain issues. The business is facing a small cash crisis as its reserves are beginning to dwindle. Wanting to encourage faster payment for its current shipments, Chocolobster reached out to Good Eats, offering a dynamic type early payment discount.

After negotiations, the two parties agreed on a sliding scale discount that offered a maximum 2% savings, with the discount gradually eroding at a rate of .4% every five days. 

Good Eats paid out the invoice through Chocolobster’s payment portal on the fifth day after invoicing, meaning the grocery chain netted a 1.6% savings rather than the full 2%.

With the appropriate discount percentage identified, Good Eats determined its updated invoice total.

Discounted Price = Original Invoice Amount x (1 – Discount %)

Discounted Price = $23,120 x (1 – .016) = 22,750.08

Benefits of using early payment discounts 

Early payment discounts typically offer a win-win scenario for both buyers and sellers. Sellers can encourage payment practices that better align with their cash flow objectives. Meanwhile, buyers can potentially rein in spending and make each dollar stretch a little further. Since these agreements aren’t mandatory for every purchase, buyers and sellers can choose to participate only when the discount makes sense for both parties. 

The benefits of early payment discounts for both vendors and customers include:

For vendors

For customers 

  • Lower costs
  • Greater payment flexibility
  • More attractive credit history

Drawbacks of early payment discounts 

As with everything, there are tradeoffs for early payment discounts, and a poorly executed or mismanaged strategy can deliver more disadvantages than value. Further, offering any discount level may not be feasible or reasonable, depending on your business structure. For example, if you already sell your products or services with razor-thin margins, any discount might mean closing deals at a loss.

Some common drawbacks that you should bear in mind when considering an early payment discount program include:

  • Lower revenue: Any discount you offer means that you’ll be drawing in less total revenue, so make sure that you have the available flexibility in your budget.
  • Wasted incentives: If a healthy percentage of your customer base is closing out invoices well before their due dates, is a discount even necessary?
  • More resources: An early payment discount will make your A/R processes more complicated as you’ll need to verify that the correct savings were applied and the proper amount paid.
  • Unnecessary losses: In some cases, it might make more financial sense for a cash-strapped business to take out a loan rather than sell its goods or services at a discounted cost.

Alternatives to early payment discounts 

Of course, there are plenty of other methods that your business can employ to increase its cash flow beyond offering a discount. You can boost your sales or increase prices, you can cut operating costs by improving negotiations with suppliers, or you can implement new efficiencies throughout your production processes.

Or you might employ other strategies that leverage your invoices, such as:

  • Invoice factoring: Focusing instead on late and unpaid invoices, you might sell these assets to a third-party financer — known as a factoring company — for a percentage of their face value. Commonly, these businesses will offer a portion of the value as an initial payment, handing over the remainder of the pro-rated price when the debt is collected.
  • Invoice financing: Rather than selling your unpaid invoices, use these legally obligated debts as collateral to borrow the additional funds required by your business.
  • Loans: You can also borrow money from a financial institution without this new debt being backed by your invoices as collateral. Depending on how favorable interest rates are at the moment, a loan might prove to be a much cheaper cash-generating strategy than a discount.
  • Supply chain financing: Often initiated by the buyer, this method involves the seller agreeing to extend the due date for the invoice — commonly offering an additional 30 – 60 days. At the same time, the buyer also obtains backing from an outside financer who agrees to pay the full amount (minus some handling fee) immediately to the supplier. The buyer can then use the additional time to gather together the revenue to pay back the financer.

Should your business offer early payment discounts?

Whether or not your business should offer an early payment discount depends on the nature and health of your business. Ask yourself these questions:

  • Are you quickly burning through your cash reserves? 
  • Do you need to bolster your cash flow to support a growth plan or improve your standing for a loan? 
  • Are your customers frequently missing payment deadlines?

If the answer to any or all of these is “yes,” then offering an early payment discount could make sense for your business. Long story short, by incentivizing early action, you’ll be more likely to get paid at all, let alone on time.

The strategic use of early payment discounts can be made even easier if businesses use an automated platform to help create discounts and follow up with customers. 

Invoiced: Automate early payment discounts 

Invoiced is an accounts receivable invoicing and billing platform that offers sophisticated discount logic, letting the platform take care of the heavy lifting, freeing up your A/R team for more important tasks. Our automated accounting tools can help you manage your incoming and outgoing payments more efficiently while encouraging more accurate and consistent financial processes and reporting.

To learn how Invoiced can handle all manner of invoicing complexities — from early payment discounts to dispute resolution to rebates and credits — schedule a demo today.

Published on February 20, 2024
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