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Why Offering Early Payment Discounts is More Valuable Than You Think

As an incentive for payment, business owners may want to consider offering an early payment discount to their customers. Find out the advantages and disadvantages of offering early payment discounts.

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.

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 which serve as an informal agreement between you and them. My advice is to always have a signed contract on hand for fixed price, T&M or specific performance to avoid ambiguity about what is owed to you.

For example, say you regularly sell to a shop called Toms Donuts. Although he's a good customer, Tom is always playing hockey and never on time with his payments waiting always until the very last minute to pay his bill.

Tom is frequently late with payment. While there’s technically nothing wrong with that as long as he'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 Tom with an incentive to pay a bit earlier in the month, you decide to offer him 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 Tom's Donuts’ next invoice, you decide to offer a 2% discount. The discount would be reflected as “2/10 net 30,” meaning that if he pays the bill within 10 days, he’s entitled to a 2% discount on the amount.

The invoice was dated Oct. 20, and the bill was for $180. If Tom decides to take advantage of the early payment discount offered, he would calculate what he owes using the early payment discount formula:

$180 x 2% = $3.60 Discount

$180 - $3.60 = $176.40 Total Due

If Tom were to pay the invoice within 10 days of the invoice date, he could pay the discounted amount of $176.40, but if he doesn’t, the entire $180 will be due within 30 days.

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. with an influx of cash you are able to put that cash to use by purchasing goods and assets that are turned into revenue and profits.

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 want to increase cash flow

The quickest 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.

There are a lot of 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. Manage the downside risks to ensure that you get the benefit of offering payment discount and not end up costing you more than you receive in return.

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