The invoicing process is a crucial accounting task vital to your business’s operations and cash flow. Some businesses offer early payment discounts as a way to reward their customers for paying their bills before they are due. You might have heard of this strategy—and you might have taken advantage of it yourself as a customer—but you might still be confused about whether this is a good strategy for your business.
Early payment discounts can be a good way to speed up collections in your business and improve your cash flow. But they have to be used correctly, and they aren’t right for every business. If you aren’t careful, early payment discounts can cost you not only money but also relationships with your customers.
In this article, we’ll take a close look at early payment discounts, including how to determine if offering them is a good strategy for your business.
Early Payment Discount Advantages
Typically, small business owners are advised against discounting their offerings on a regular basis. Doing so can negatively impact your bottom line and encourage undesirable customer purchasing behavior.
The exception to this rule can be early payment discounts on invoices. When you use early payment discounts as a strategy, several positive things can happen:
- You could receive payments from customers faster. Speeding up collections is the primary reason most businesses offer early payment discounts to their customers. Customers with good cash flow often take advantage of early payment discounts to save some money—improving their bottom line. Although these discounts are nominal on a case-by-case basis, over the course of the year they can have a significant impact on your customers’ bottom line.
- Faster payment collection improves your business’s cash flow. If a business is looking to collect payments from customers faster, it’s usually because the business is looking to improve their cash flow. According to a survey conducted by QuickBooks, cash flow is something 61% of small business owners regularly struggle with. A nominal discount on an invoice which results in payment up to three weeks earlier than normal can have a significant impact on a business’s cash flow. Better cash flow means more money to grow your business without the hassle and expense of incurring debt.
- You could reduce the risk of customers defaulting on payments. The more time that passes without payment, the more likely it is that your customer will default on the amount owed. Offering an early payment discount encourages your customers to pay early, thus decreasing the chance of default.
- You might increase customer goodwill. In addition to the potential positive benefits to your business’s cash flow, offering early payment discounts can promote goodwill with your customers. Your customers like to save money, and by offering early payment discounts, you are helping them do just that. If your business is in a highly competitive industry, customers might even use early payment discounts as a determining factor regarding whether to do business with you or another vendor.
- You can choose which customers are offered an early payment discount. Unlike sales and special offers that usually must be offered to all customers, you can choose which customers you offer an early payment discount to. In other words, you can reward your best customers for doing business with you by giving them a chance to save money on every purchase they make from you.
By now, you might be wondering why you wouldn’t offer early payment discounts. Although the advantages are compelling, there are some risks and downsides to offering discounts to your customers for paying early.
Early Payment Discount Disadvantages
Business opportunities are usually accompanied by risk, and the same holds true for offering your customers early payment discounts. Some of those risks and downsides include:
- A reduction in your profitability. The primary and most obvious downside to offering vendor discounts for early payments is a reduction in your profitability. Although not all of your customers will take advantage of early payment discounts, some will, and those discounts will impact your bottom line. You must weigh the benefit of getting paid sooner and improving your cash flow against the loss of profit you will experience by offering the discount.
- Friction with your customers. Offering early payment discounts can increase customer goodwill, but it can also cause friction if customers take discounts they haven’t earned. This most commonly happens when the customer pays slightly outside the time frame to earn the early payment discount, but they reduce their payment by the discounted amount anyway. If you choose to offer this perk, you must provide very clear early payment terms and conditions upfront about what is required for the customer to claim the discount, and you must be ready to address misuse cases.
- Administrative burden. The actual calculation and application of early payment discounts can be handled quickly by most accounting software packages, but there is still an administrative burden to these discounts. Also, keep in mind that many businesses don’t offer early payment discounts if the payment is made by credit card (since credit card processing fees will further eat into the total your business receives), meaning there is an added burden of processing payment by check.
Now that you know some of the early payment discount advantages and disadvantages, let’s look at the most common early payment discounts.
Types of Early Payment Discounts
Early payment discounts are typically nominal—1% to 2% per invoice. On a large invoice, though, even a small percentage can lead to sizable savings for the customer. And collecting a large invoice in a fraction of the time can help you keep your business running smoothly.
Most companies that offer early payment discounts have standard payment terms of net 30. This means the entire amount of the invoice is due within 30 days of the invoice date. When a company offers an early payment discount, they reduce the amount the customer pays in exchange for the customer paying in less than 30 days. The most common early payment discounts are “2/10 net 30” and “2/15 net 30.”
If that looks like some strange sort of math, hang with us for a second. The first number in the early payment discount—the two—is the percentage amount of the discount. So, the customer would get a 2% discount on the invoice.
But the customer must give you something in return for this discount. That’s where the second number comes in.
The number behind the forward slash is the time period within which the invoice must be paid in order to get the discount. Payment discount terms of 2/10 indicates a 2% discount if the invoice is paid within 10 days, and 2/15 indicates a 2% discount if the invoice is paid within 15 days.
The “net 30” indicates the normal payment terms of the invoice. If the customer chooses not to take advantage of the early payment discount—or if they pay after the discount timeframe—the entire amount of the invoice is due within 30 days.
To put this in plain English, in exchange for a 2% discount, the customer is giving you the money owed to you 15 to 20 days sooner than is typically required. If the customer chooses not to take advantage of the discount, the full amount of the invoice is due 30 days from the date of the invoice.
Some businesses offer variations on the 2/10 net 30 and 2/15 net 30 early payment discounts. You might see 1/10 net 30 or even 2/10 net 60. There’s no “wrong” way to offer an early payment discount, but remember the goal here is to encourage your customer to pay you earlier than you would normally expect to be paid.
Should You Offer Early Payment Discounts on Invoices?
We’ve looked at the benefits and risks of offering early payment discounts as well as the most common types of early payment discounts. You might still be wondering if early payment discounts are a good strategy for your business. Take some time to consider the following four questions to determine if you should offer early payment discounts to your customers:
- What is your positioning? Does your business provide critical products or services customers cannot easily obtain elsewhere? If your business is critical to a supply chain, and if you don’t have much competition, you can likely require more favorable payment terms—like net 10 or net 15—from your customers. Net 10 or net 15 terms indicate your customers are expected to pay their full invoices within 10 to 15 days of the invoice date… the typical window for an early payment discount. The advantage is you don’t have to discount the invoice in order to compel them to pay their invoices this quickly.
- Does your competition offer early payment discounts? We’re not fans of doing (or not doing) something just because everyone else in your industry is doing it. But before you offer early payment discounts to your customers, do some research to see if this is an industry standard. If no one else is offering early payment discounts, consider whether or not doing so will give you a competitive advantage.
- How will early payment discounts impact your profitability? As we mentioned in the disadvantages section, early payment discounts will impact your profitability. Analyze your profit margin, cash flow, and historic customer payment habits to determine if you can afford to offer early payment discounts.
- Will your customers even take advantage of it? If most of your customers pay by credit card, or if they habitually pay right at the due date (or even after the due date), they might not be interested in or able to take advantage of early payment discounts. You can also poll some of your best customers to see if they would be interested in an early payment discount benefit.
The Final Word
Offering early payment discounts on your invoices can be a good way to speed up the collections cycle in your business, improve your cash flow while increasing customer goodwill, and, of course, avoid late payments. It can also lead to some challenges, including a loss of profitability and administrative burdens.
Before deciding whether or not to offer early payment discounts to your customers, work with your accountant or bookkeeper to analyze the impacts—both positive and negative—these discounts could have on your business. Your accountant or bookkeeper can also help you set up your accounting software to streamline the administration of early payment discounts should you decide to offer this benefit to your customers.