When to offer early payment discounts

What are Early Payment Discounts?

An early payment discount is an offer to a seller’s customers to pay their bills early, in exchange for a discount from the full amount of the invoice. A seller usually makes this offer when it has minimal cash reserves, and so needs to collect cash from its customers sooner than would normally be the case.

Example of an Early Payment Discount

Arkansas Barrel Company (ABC) sells $10,000 worth of barrels to a customer on April 1st, with standard payment terms of Net 30 (meaning full payment is due by April 30th). However, to encourage faster cash flow, ABC offers an early payment discount of 2/10, Net 30. This means the customer can take a 2% discount if they pay within 10 days (by April 11th).

If the customer pays by April 11th, they are eligible to deduct 2% from the invoice amount, which is $200. Therefore, the customer would only need to pay $9,800 if they pay early. If the customer misses the April 11th deadline, the full $10,000 would be due by April 30th without any discount. When ABC records the transaction, it initially recognizes a $10,000 accounts receivable. If the customer pays early and uses the discount, the company will record $9,800 in cash received and $200 as a sales discount expense or reduction of revenue, depending on its accounting policy.

When to Offer an Early Payment Discount

Early payment discounts are quite expensive, and so should only be offered to customers when the seller is having severe cash flow problems. The problem is that the effective interest rate the company is offering to its customers through a discount deal is extremely high. For example, allowing customers to take a two percent discount if they pay in 10 days, versus the usual 30, means that the company is offering a two percent discount in order to obtain cash 20 days earlier than normal. An interest rate of two percent for twenty days equates to an annualized rate of about 36 percent. The seller should be able to obtain less-expensive debt from some other source than paying this amount through its early payment discount deals.

Furthermore, many customers will not pay within the 10-day discount period, but will still take the discount. This can lead to a great deal of difficulty in obtaining payment of the withheld discount. Consequently, early payment discounts - especially for substantial amounts - should only be offered when a business is in dire financial straits and has no other sources of cash.

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