Our company is considering offering discount terms to our customers in hopes of encouraging them to pay sooner. How do I go about performing an analysis to determine the effect on cash flow as well as the cost of offering this discount? Any guidance would be greatly appreciated.
Cash Flow and Discount Payment Terms
Answers
There's a formula to determine the cost of not taking the discount. If terms are 2%,10 N,30 formula is:
2'%/100%-2% X 365/30-10=37.2%
1
This formula is correct (for 2% 10, Net 30) when based on receipt of the cash in 10 days. Typcially, many customers will take the discount after making the payment in 15 to 20 days. Factor that into the equation and the cost of money offered the customer skyrockets proportionately. You, the seller, will find it uneconomical to pursue the discount taken outside of the 10 day terms.
I've seen GE pay in 120 days, take their mandatory 4% payment terms and still call it a "prompt payment discount".
Joseph has given you the formula. You might also consider your collection efficiency ratio in weighing the decision to offer discounts. If you are experiencing a high level of delinquency, the change may be worth it.
If you're using some spreadsheet to forecast cash flows on say a weekly basis, you would shift the collections into an earlier week and reduce the sales value collected by the amount of the discount.
To assess the cost, it may be more helpful to think in present value terms comparing the present value of a discounted price offered at time t to a full price offered at a later time T because this provides a dollar cost rather than ROI type approach noted by Joseph above.
That would be, P(1-d)/(1+r)^t vs. P/(1+r)^T where r is the annual percentage discount rate and time is measure in fractions of a year. Using the 2/10 N30 example and a 100 price with a 5% discount rate, you have:
100(1-.02)/(1+.05)^10/365 vs. 100/(1+.05)^30/365
97.869 vs. 99.6
So, the "discount" price is 1.74% less than the net 30 price in present value terms and you will receive that much less pretax profit. However, since offering a discount is like offering a price reduction, now you can also ask your
I very much dislike discounts. You will either reduce profits or raise price and then apply the discount, essentially placing you with the same profit as today. But if used incorrectly, discounts can negatively affect your economics.
-Discounts for early payments could be used to reward good behavior. In this case I would use one-time specials. Once a discount starts, it continues in perpetuity.
-At times companies try to implement discounts to entice late payers to pay earlier. That could be a very large mistake. What you are actually saying to your customer, "If you do not pay me I will give you a discount." The end result will be a customer that does not pay, waiting for your discount.
Good luck, but tread carefully.
2
I disagree a bit here. I think you have to look at discounts in connection with your pricing strategy, and realize what you are looking for is the net achieved cash in the door which can be arrived at several ways. One advantage to having a higher discount policy is that it really will incentivize your customers to pay within terms; your customers' AP supervisors will be loath to pass on a 4 % discount. It is true that you will have to set you base price higher by day 2%, in this example , if you normally offered a 2% discount, however, your sales team can explain that pretty fast. What happens in practice, is those customers that you have with cash flow problems are more likely to pay YOU than someone else in order to not give up that 4% discount. It is a quite effective strategy. One other benefit, though it is usually one time shot, is that you have the opportunity to put in place a price increase without changing your published price lists if you ever decide to back off down to the 2% again. I have seen a company successfully use this strategy over the course of many years and walk a base level 10 % discount down to 3%.
Barry
I think Regis makes some great points here. Do you know why your customers pay late, which ones are the worst?
How do you manage processes for:
-sales terms; prices tied to payment terms; advise your sales team that ability to pay is a key criterion of accepting new business
-new accounts: train them to pay on your terms
-collection: prevention is better than cure-don't let overdue accounts become habitually overdue.
If you can improve/refine your sales/order entry/billing/collection processes maybe you can avoid discounting.
And, when money market accounts pay below 1% p.a., discounts are really a margin loss. Jake provides that clearly in his response above.
Best of luck!
Thank you all for the advice and information. It has been very helpful in our decision process.
I think it can be very beneficial to give discounts, if approached correctly. I would basically raise the price to Net 30 pricing. One problem I have seen with discounting for payment in 10 days, is that it may be hard for some companies to process payment in 10 days. Maybe 15 days would work better? Even though a 1% discount mathematically can be a real savings, if your invoices are very small, the customer may not see that as not worth while. You would also have to look at how the customer would look at you raising your prices to cover this, many do not consider the discounted price. I do not mean you would actually tell them this, but if you are already charging as much as they want to pay, it might make a difference?
The effect on cash flow can be estimated by modeling the change in your DSO based on the proposed terms. In terms of the cost, you would model the amount of discount to be taken against the reduction in your financing cost from the improvement in cash flow.
While getting customers to pay early can be a good idea (i.e. increases cash flow, reduces need to borrow) consider whether this customer is a profitable one on an "all in" basis (sales - cost of goods sold + or - cost of funds using formulas already included in other answers to this question + some cost allocation to monitor terms compliance).
Another suggestion - move to standard electronic billing / payment methods. A customer that requires one off processing should not be given discounts unless profit margins warrant it
After all, a low / no margin customer that pays early may still remain an unattractive one
Bottom line - be selective about who gets any "early bird" special discounts. Atest program makes sense too.
Another observation gained from experience with using customer prompt payment discounts is that the additional management and enforcement efforts plus a lot of
Those who sincerely take advantage of the discount will barely have the time to comply and will usually miss it. Your A/R personnel will often apply the discount regardless of when the payment is received because it is difficult and very time consuming to deal with all remaining balances on invoices that were not paid in full due to the discounts taken. This is similar to a finance charge policy that rarely works and has been abandoned by so many companies.
In terms of cash flow and cost of discount, even without a detailed analysis you can easily see that a 2% discount for having the money for 20 days earlier (assuming customer compliance) can be very expensive and resembles cost of factoring which can be a viable solution to increasing cash flow, albeit at a great expense. As mentioned here in an earlier post, you are rewarding slow paying customers and sending the wrong message to them. I prefer establishing additional trade discounts with the good customers to offering prompt payment discounts to everyone.
Sorry Alan, got to chime in here. On point I agree with you, but the great expense of factoring is relative to a companies ability to use outside capital to increase their bottom line. If being able to turn your asset increases over an annual period then you are ahead of the game. If you have a 20% profit margin but little reserves to bid on substantially larger contracts, giving up a few percentage points to increase your ability to perform is a positive trade off.
Regarding early discounts, turn it around - reward a customer on their next order with a surprise discount noted as a fast payment appreciation credit. Don't rely on human nature to comply, compensate for good behavior.
Thanks everyone for the very insightful advice. Part of the issue that I'm facing is that our industry tends to be slower at paying in general. The construction industry from my experience tends to be "pay when paid" regardless of our standard terms (which is Net 30). Many of the customers that pay the slowest are contractors that don't have the ability to pay us until they receive payment on the project.
Offering a discount for paying within 10 days would definitely not be an option for us, but I'm considering offering a discount if paid within 20 or 30 days. I believe that some of our customers will take advantage of the discount, but I still think that some of them will not pay any sooner simply due to cash flow.
That said, I definitely appreciate everyone taking the time to provide comments and suggestions.
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