Last editedApr 20233 min read
Collecting on-time invoice payments is key to a healthy cash flow. Do your customers wait until the last minute to pay their invoices? Offering an early payment discount might give them incentive to make them pay sooner. So, what is an early payment discount, and is it right for you? Here’s how this invoicing strategy works.
What is an early payment discount?
Sometimes called a cash or prompt payment discount, an early payment discount is a price cut negotiated between buyer and seller. The buyer receives a discount on the total invoice amount, provided they pay the bill before it’s due.
When your business sends an invoice to a customer, it will include payment terms including a fixed deadline. Payment terms typically range between 15 and 60 days. Offering an early payment discount is one way to speed up this payment process.
How to calculate early payment discount
The discount and its accompanying terms should be clearly marked on the invoice. For example, imagine you want to offer a 2% discount if the customer pays their invoice within 15 days rather than the usual 45. This will be listed on the invoice as 2/15, Net 45.
As you can see from this example, an early payment discount represents a percentage of total cost. The early payment discount formula can be written out as:
Early Payment Discount Amount = (Invoice Total) x (1 – Discount Percentage)
For example, imagine that you’ve sent a customer an invoice worth a total of $1500 and payment terms of 2/10, Net 30. This means the customer receives a 2% discount if they pay the invoice within 10 days rather than 30. Here’s how to calculate the new amount due using the early payment discount formula:
$1500 x (1-0.02) = $1470
The customer receives a discount of $30 for paying the bill early.
This is an example of a fixed early payment discount, but there’s additional flexibility with pricing models. A dynamic discounting model offers a sliding discount rate, with customers receiving a higher discount for earlier payments. Tiered discounting models also leave room for adjustments in fixed price tiers. For example, the vendor offers a 2% discount for invoices paid within 10 days, and a 1% discount for invoices paid within 20 days.
Advantages of early payment discount
Both business and customer can benefit from early payment discounts. As a business owner, you’ll be able to boost your cash flow, strengthen customer relationships, and improve buyer satisfaction. At the same time, you’ll help prevent late payments and speed up the cash conversion cycle.
There are benefits for the buyer as well. In most cases, they’re already planning to pay the invoice. By simply paying a few days earlier, they receive a cash discount – making this a win-win situation for both sides.
Disadvantages of early payment discount
Of course, there are also potential pitfalls. Disadvantages of early payment discounts crop up if payment terms aren’t crystal clear. Make sure both parties agree on the submission and due date of each invoice to avoid any misunderstandings. This will protect customer relationships.
The other issue to consider are your profit margins. If a business is operating just slightly above cost, there’s little room for any discounts.
When to use early payment discount
So, is an early payment discount right for you? Here are a few points to consider:
Industry standard: Is it common to apply an early payment discount in your industry?
Competitors: Do your competitors also offer early payment discounts or will this set you apart?
Profit margins: Can you afford to offer a discount on goods and services provided?
The key to success is to offer an appropriate discount to encourage early payment, while still earning a profit. Give your business enough wiggle room to cover appropriate costs, looking at industry standards as your guide.
Be specific with payment terms on invoices to avoid confusion, automating the invoicing process where possible to cut time and cost. GoCardless offers a way to automate payment collection, letting businesses pull funds on the day they’re due. Rather than accepting card payments, we use open banking and Direct Debit. This puts your business in full control over invoice payment collection, with affordable fees and built-in anti-fraud intelligence. Get paid on time, with or without an early payment discount.
We can help
GoCardless is a global payments solution that helps you automate payment collection, cutting down on the amount of financial admin your team needs to deal with. Find out how GoCardless can help you with one-off or recurring payments.