In the “carrot and stick” approach to promoting good behavior, a “carrot” is a reward for doing things the right way, and a “stick” is a punishment for doing things the wrong way. When it comes to collecting payments, it sometimes seems like businesses solely wield the stick—mainly by levying late fees when a customer pays past a contractually obligated due date.
As a business owner, you have another way to ward off unpaid invoices: You can reward your customers for paying early. Just like some businesses offer a cash discount or special discount prices when customers use a store-issued credit card, many—especially in business-to-business (B2B) transactions—offer early payment discounts, which lower a customer’s bill when they pay an invoice early.
Here’s why you should offer early payment discounts and how they fit into the broader category of discounting solutions.
An early payment discount is a financial incentive that a seller offers to buyers so they pay invoices before a prescribed due date. Also known as a prompt payment discount, it rewards members of a seller’s customer base who choose to pay early.
An early payment discount can apply anytime a buyer pays bills early. Here are some scenarios in which payment terms might include early payment discounts:
Of course, there’s no guarantee customers will take advantage of financial incentives by paying their invoices early. But these examples demonstrate how a seller might utilize early payment discounts as part of its strategy to, for example, speed up cash flow to cover operating expenses, reduce its reliance on business loans, or strive to maintain consistent working capital funding.
In many cases, early payment discounts create a win-win situation for both sellers and buyers, helping finance teams achieve more flexibility while mitigating supply chain risk. Here are some specific benefits for buyers and sellers alike.
Benefits for sellers include:
Benefits for buyers include:
Whether you’re a vendor looking to receive early payment or a purchaser hoping to capture early payment discounts, it helps to understand the different ways that businesses extend special rates to customers who pay their bills early:
Imagine a Shopify merchant who runs a custom wooden furniture store. They have a B2B relationship with a materials supplier who provides all their lumber. The supplier sends an invoice for a large shipment of wood totaling $10,000, with the payment terms set to 2/10, net 30.
The furniture maker has two options. The first is paying within 10 days of receiving the invoice. In this case, the early payment discount formula is:
Cost of shipment – (Cost of shipment x discount) = Payment due
This results in the following calculation:
$10,000 – ($10,000 x 0.02) = $9,800
In exchange for paying early, the merchant saves $200 on the invoice, which is a direct reduction in their cost of materials.
The other option is paying the full $10,000 much closer to the due date. A buyer might choose this route if they’re experiencing cash flow problems and would have to borrow money in order to pay early. But even if the furniture maker doesn’t take advantage of the discount, making a full payment by the invoice’s due date is still wise. Nearly all vendors levy penalties for late payments, even if they also offer early payment discounts.
Early payment discounts benefit a wide range of buyers and sellers—but not all buyers and sellers. Specifically, sellers with very slim profit margins and buyers with very little working capital may not have the financial flexibility to participate in early payment discount programs. Fortunately, there are early payment discount alternatives that may be equally compelling:
Instead of a single, fixed discount (e.g., 2% for 10 days), a dynamic discounting program allows for a sliding scale of discounts. This means the buyer can take a smaller discount for a payment that is slightly early, or a larger discount for a payment that is very early. The buyer and seller negotiate the discount amount, basing it on the specific number of days the buyer will pay the invoice before its due date.
If dynamic discounting solutions don’t make financial sense to a buyer, there’s also the option of supply chain finance, which people sometimes call reverse financing. In this model, a third-party financial institution pays the supplier immediately on behalf of the buyer, and the buyer repays the institution at a later date, with interest due.
There’s also invoice factoring, where vendors sell their approved invoices to a factoring company at a discount. This provides immediate cash without requiring buyers to pay early. However, the factoring company’s fees can sometimes be higher than discounts, making this a less alluring option for many sellers.
Perhaps the most common early payment discount is called 2/10, net 30. It means the buyer receives a 2% discount if they pay the invoice within 10 days. Otherwise, the full amount is due within 30 days of the invoice date.
An early payment discount program is an invoicing arrangement where a buyer receives a discounted rate if they pay their invoice before the official due date.
Many sellers consider early payment discounts to be worth the slightly diminished revenue because they encourage quicker inflows of cash. They also help prevent the need for invoice factoring or loans, the latter of which puts a business at the mercy of fluctuating interest rates. Many buyers appreciate the savings that come with early payment discounts, and they may purchase larger quantities to take advantage of the reduced prices.
If you’re a seller, you record an early payment discount in a ledger by reducing accounts receivable by the full invoice amount, recording the cash received, and posting the discounted amount to a sales discounts account. If you’re a buyer, you’ll reduce accounts payable by the full invoice amount, record the cash paid, and post the discounted amount to a purchase discounts account. Both accounting maneuvers will ensure the discount is properly reflected on an income statement while maintaining accuracy on a balance sheet.
