Dynamic discounting is an excellent tool for vendors and business customers to get paid early, save money, and build solid supplier relationships. Dynamic discounting can shorten the supplier’s cash conversion cycle by collecting accounts receivable quicker.
What is Dynamic Discounting?
Dynamic discounting is a method used by vendors in which business customers take a variable early payment discount to reduce their cost of purchasing goods and services. The earlier the invoice is paid, the higher the discount earned by the customer. Suppliers offer invoice payment date(s) and a calculated discount amount for the actual invoice paid date.
How Does Dynamic Discounting Work?
Vendors select specific customer invoices and make or accept offers of ad hoc invoice payment term discounts the customer can take to reduce their costs of purchases.
Suppliers use automated procurement software systems. A dynamic discounting provider’s software includes an invoice basis submission process, discount offers and acceptance, and calculations of early payment discounts prorated to the day an invoice is paid.
In dynamic discounting, buyers can also initiate the dynamic discounting process, asking their vendors for discounts if they’re currently receiving or being offered standard net 30, net 45, or net 60 payment terms. In this case, seeking dynamic discounts is a customer negotiation to get better credit terms.
When paying an invoice selected for dynamic discounting, the customer pays its vendor invoice (included in their accounts payable balance) early; the early payment discount is calculated based on the day paid. To pay its invoice, the customer can choose its preferred payment method using the AP automation software integrated with its ERP system. Preferred electronic payment methods may include ACH payment processing, global ACH, credit card, or PayPal.
In a dynamic discounting program, the customer has payment options. If the customer chooses not to take an early payment discount, it pays the full invoice amount due on the invoice due date, in the net number of days specified. Late payments may result in a late fee at a stated interest rate or a fixed amount included in the terms.
Example of Dynamic Discounting
An example of dynamic discounting is Alphabet/Google and its suppliers using the SAP Ariba procurement automation system. SAP Ariba includes the functionality of a real-time dynamic discounting solution that automates workflows and can calculate and capture discounts.
In this Ariba SAP example for Google’s procurement, after onboarding, suppliers send and submit customer invoices from their ERP system to the Ariba Network portal that Alphabet/Google shares with its suppliers.
In the Ariba Network, the supplier selects one or more specific invoices and accepts early payment terms offer(s), including dynamic discounting payment dates within Google’s payment window. The supplier invoice is updated within SAP Ariba. The invoice is sent from the SAP Ariba Network to the supplier’s ERP with accepted invoice discounting terms.
The customer (Alphabet/Google) pays its approved invoice early on a prorated sliding scale, depending on their actual invoice payment date. The Ariba dynamic discounting platform automatically calculates the discount based on the customer’s invoice payment date.
For example, if Alphabet/Google offers 2%/15 net 45, 1%/30 net 45, or net 45 dynamic discounting terms on an invoice, it will receive a lower discount the longer it waits to pay the invoice. In Google’s example for this dynamic discounting terms scenario, it gets a 1.66% pro-rated and automatically calculated discount for paying on day 20, which is after 15 days but before 45 days from the invoice date.
When it has excess cash, a supplier may not offer/accept dynamic discounting on all of the Alphabet/Google customer invoices. Instead, the vendor will use net 45 payment terms for the invoice, expecting invoice payment in full at the invoice due date (45 days from the invoice date).
The advantages (pros) outweigh the disadvantages (cons) for suppliers and customers using dynamic discounting.
Pros of Dynamic Discounting
Pros of dynamic discounting include:
- Vendors improve their cash flow, working capital liquidity, and days sales outstanding (DSO) by receiving earlier payments for invoices after invoice approval.
- Vendors can select specific invoices to offer early payment discount terms when they need cash, rather than offering discounts on all invoices issued to customers.
- Vendors improve cash flow forecasting.
- A dynamic discounting program is confidential, without customer knowledge, in contrast to invoice factoring.
- Customers have lower cost of goods sold (COGS) from inventory purchases and lower business expenses spending, increasing their gross profit margin and net income.
- Customers can choose whether to earn lucrative early payment discounts for cost savings or retain cash for other needs.
- Customers can still earn a lower discounted amount after the deadline for standard fixed 10-day discount payment terms.
Cons of Dynamic Discounting
- Vendors receive less cash and profit on invoices when the customer takes early payment discounts.
- Customers must pay invoices sooner to earn discounts, reducing cash flow.
- A vendor with excess cash may not offer dynamic discounts for early payment on all customer invoices, creating a disadvantage for customers.
What is a Discounting Facility?
A discounting facility is a loan financing option on approved open invoices in the accounts receivable ledger not yet collected by a vendor. An invoice discounting company issues a loan on up to 95% of the invoice amount to provide cash to the seller before accounts receivable are collected from customers. The seller then repays the loan. The fee is generally 1 to 3% of the invoice amount.
Invoice Discounting vs. Factoring
Invoice discounting differs from invoice factoring because the vendor doesn’t sell accounts receivable to a factoring company and collects their receivables quickly by offering customers early payment discounts. Supply chain finance (SCF), also called reverse factoring, is a process where suppliers sell approved customer invoices to a funder for early payment, incurring a financing fee.
What is an Early Payment Discount?
An early payment discount is a percentage discount that a buyer receives for paying a vendor’s invoice early within a stated number of days. A typical standard fixed payment term discount is 2/10, net 30. Vendors may offer a buyer a dynamic discount for paying invoices early on a sliding scale from higher to lower amounts based on variable percentages.
What is Static Discounting?
Static discounting is the traditional type of fixed discount offered by vendors as an early payment discount on invoices. Typical static discounts are 2/10 net 30 or 1/10 net 30, which means the buyer gets a 2% or 1% discount by paying the invoice promptly to ensure the supplier receives payment within 10 days of the invoice date (or another specified number of days).
When vendors provide static discounting, standard payment terms, including identical early payment discounts, are offered to all credit-worthy customers billed on account.
Who Uses Dynamic Discounting?
Vendors and their invoiced customers use dynamic discounting without involving sources of third-party financing. When the customer pays vendor-selected invoices for which a dynamic discount is offered, they earn a calculated early payment discount based on the day they pay the supplier invoice. The earlier they pay, the higher the early payment discount the customer receives.
