The true cost of early payment discounts

Much has been written about the advantages and disadvantages of offering early settlement discounts. The arguments in favour usually focus on the ease of implementation, the benefits of accessing working capital and of reducing customer insolvency risk by obtaining early payment. But the math underlying these arguments often doesn’t add up, and usually assumes businesses operate in a perfect world.

In the real world, early settlement discounts can prove a hit and miss strategy at best.

The main problems are as follows:

• There are often cheaper solutions for accessing working capital.
• It's common practice for clients to stretch out settlement dates beyond the payment terms by a few days – sometimes weeks and still pay the discounted rate. Policing this is expensive and risks alienating the client.
• Customers often short-pay invoices. It is standard practice for customers to take the discount on the total amount of the invoice (which includes tax and shipping), leaving suppliers to pick up the tab.
• The discount may need to be significant in order to receive satisfactory take up, cutting deep into a business’ margins.
• Some customers use the early settlement discount to trade for more favourable terms on other fronts such as price, claiming the time value and interest cost to them in paying up front. This means suppliers pay twice.

A whole industry has developed around providing advice on taking advantage of early settlement discounts.  “Don’t forgo early payment discounts: the returns are astounding”.  This online article notes that that taking advantage of early settlement discounts is particularly a good strategy for low-margin companies.

This being the case, the logic flows that, on the flipside, discounts are a particularly poor strategy for low-margin suppliers. Discounts cost money so when costs blow out, low-margin businesses are hit hardest.

Having to endure all of the above complexities might be acceptable if supplier discounts were the only option available to business to improve cash flow, or even if it were the cheapest option available, but it’s not. One such alternative is debtor finance.

Invoice Discounting facilities don't preclude the use of settlement discounts. A business can easily use debtor finance to fund a percentage of invoices while focusing on one or two big, easy to process debtors that may lend themselves to an early settlement discount (typically companies that aren’t enjoying solid credit).

The table below compares three scenarios - the cashflow benefits of an Invoice Discount facility clearly outweigh those of early settlement discounts.    

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