If you’re looking for ways to help cash flow while rewarding your customers, consider offering an early payment discount. Used as an incentive to get your customers to open their wallets a little sooner, an early payment discount may be a good option for your small business.
Overview: What is an early payment discount?
An early payment discount or cash discount is offered as a means to get your customers to pay their bills a bit earlier. If you don’t have a lot of late-paying customers, offering a cash discount may not be necessary, but if you do, offering a cash discount may be a good solution.
Unlike quick discounts, which are offered at the time of sale and usually involve a cash purchase, an early payment discount is part of the terms that have been agreed upon by you and your customer. Any customer that you sell to on credit should have credit terms assigned to them in your accounting software application, which serve as an informal agreement between you and them.
For example, say you regularly sell to a shop called Donna’s Donuts. Although she’s a good customer, Donna always waits until the very last minute to pay her bill.
Sometimes she’s even a day or two late. While there’s technically nothing wrong with that as long as she’s paying within the agreed-upon terms, waiting upwards of 30 days to receive payment can negatively impact your cash flow, particularly if you’re a small business with limited cash available.
To provide Donna with an incentive to pay a bit earlier in the month, you decide to offer her an early payment discount. In most cases, an early payment discount ranges between 1% and 5%, but businesses are free to offer any type of discount.
On Donna’s Donuts’ next invoice, you decide to offer a 2% discount. The discount would be reflected as “2/10 net 30,” meaning that if she pays the bill within 10 days, she’s entitled to a 2% discount on the amount.
The invoice was dated Oct. 20, and the bill was for $180. If Donna decides to take advantage of the early payment discount offered, she would calculate what she owes using the early payment discount formula:
$180 x 2% = $3.60 Discount
$180 - $3.60 = $176.40 Total Due
If Donna were to pay the invoice within 10 days of the invoice date, she could pay the discounted amount of $176.40, but if she doesn’t, the entire $180 will be due within 30 days.
How to calculate an early payment discount
Calculating an early payment discount is easy. For example, the invoice below has terms of 2/10 net 30. The date of the invoice is March 27, 2015. If Stone Arbor Landscape were to take the early payment discount terms, they first need to calculate the discount amount.
$2,848.50 x 2% = $56.97
Next, they need to subtract the discount amount from the total amount due.
$2,848.50 - $56.97 = $2,791.53
To take advantage of the discount, Stone Arbor Landscaping will need to pay $2,791.53 within 10 days of the invoice date of March 27, 2015, making their payment due by April 6. If they don’t pay by that date, they will need to pay the entire amount of the invoice, which is $2,848.50.
What are the benefits of offering an early payment discount?
There are some benefits that small businesses can take advantage of if they decide to take an early payment discount. These benefits may include:
1. Increases influx of cash
If your business is experiencing cash flow problems, offering a cash discount to your customers can help increase incoming cash and allow you to pay your bills on time.
2. Increases customer loyalty
Even a small discount can help customers feel appreciated. While a 2% discount may not seem like much on a small order, the discount can quickly add up. In addition, customers receiving a discount may want to take advantage of it by upping their orders.
3. Motivates customers to pay their bill
A lot of people receive a bill, glance at it, and toss it aside until it’s time to pay. But by offering even a small discount, the odds are suddenly much better that you’ll receive your payment sooner.
What are the disadvantages of an early payment discount?
While offering an early payment discount can be beneficial in certain circumstances, there are some disadvantages as well.
1. Tight margins
If you have little markup on your products and services, offering even a small discount can quickly cut into your operating margin, leaving you with little to nothing in profit. When initially setting pricing for products and/or services, make sure to take any future early payment discounts into consideration.
2. Customers take the discount but don’t pay early
This is one of the most frustrating scenarios for business owners. They offer an early payment discount and their customer takes the discount, but they don’t pay until the net 30 due date. If this happens a lot in your business, it might be best to consider other ways to reward good customers and just eliminate the early payment discount.
3. Creates extra work
If you’re using a manual accounting system to record business transactions, properly tracking and accounting for early payment discounts can create a lot of extra work. As a business owner, it’s up to you to decide whether it’s worth it.
When to take advantage of early payment discounts
It may not always be beneficial to take advantage of early payment discounts, but there are times when they’re worth considering.
When you’re using accounting software
As mentioned above, tracking early payment discounts can be a nightmare if you’re still using a manual accounting system. Using accounting software allows you to create specific terms for each customer, and when payment is received early, you can easily post the payment along with the discount total with no additional journal entry needed.
If payment is not received by the early due date, you can just post the total amount due in your software application.
When you want to increase cash flow
The only way to increase your customer base is to offer credit terms. Sure, you can continue to just accept cash payments, but that eliminates many potential customers who are interested in purchasing on credit.
It can be a nail-biting experience to wait for payment from your customers, particularly for new businesses operating on very limited cash flow. Offering your customers an incentive for paying early can help regulate cash flow throughout the month, giving you a bit of breathing room and offering your customers a sweet deal if they pay early.
Offering an early payment discount may help your business
There are a lot of really good reasons to give your customers an early payment discount, particularly if you’re looking to expand your business or need to increase your cash flow. But look out for the downsides, which may end up costing you more than you receive in return.