Early Payment Discounts: are they working for you or against you?

Early Payment Discounts (EPDs, or Early Settlement Discounts) are an enticement used by many businesses around the world for customers to pay invoices promptly. In theory, EPDs should eliminate the need for onerous collections activities, and ensure prompt payment – at a small loss of margin. 

EPDs can be a lot more complicated than that, however, and are normally not well understood commercially or financially.  Does the business understand whether the terms are being honoured?  Or are EPDs being taken despite late payment?  Is the level of EPD correctly set according to strategic pricing strategy, or otherwise commensurate of the cost of capital and cost of collections?  Are erroneous discounts tracked?  Are there repercussions for late payers?  If so, what and how? 

A worked example

This invoice for €10,000 has net payment terms of 30 days, but offers an Early Payment Discount of 2% for payment within 10 days. This is probably the most common discount term we see around the world.  The supplier is hoping to entice prompt payment within just 10 days, thereby improving cash and working capital, and not needing to allocate any resource to chase up cash collection, thereby saving cost. 

Let’s break down what the discount is worth as an annual cost of capital. 

Instead of paying after 30 days, the customer must pay within 10 days, so 20 days earlier. In return, they can pay 98% of the original invoice, a 2% discount. 

So, 2% / 20 days / 365 days = 36.5% cost of capital 

That is an irresistible rate of return, and one every customer should take advantage of, as any business could borrow money at a much lower cost to fund the earlier payment, even if they were short of cash. 

But if that’s the case, is it a reasonable discount to offer for the supplier? 

Erroneous discounts

A few years ago, we were working with a German packaging business, which had just been acquired by a new private equity owner, looking to improve cash to offset debt from the deal. In Germany, it’s fairly common to use Early Payment Discounts, all part of their standard practices.

As we dug deeper into understanding the process, analysing every invoice from the previous 18 months, it became clear that there was a significant percentage of invoices being paid late, while the customer was still taking the early payment discount. 

How could this be?  Why didn’t the business straighten out these non-compliant customers? 

The simple answer is that our packaging business had no idea that this was happening. 

Between contractual payment terms not always being accurately reflected in the system, often complex terms with multiple discounts available, and limited metrics that focused on month-end collections, the general expectation was that payments were being received on time, and there were no data available to paint the true picture. One challenge in particular is that an invoice can have several due dates for complex early payment terms, and so not be flagged as late in the system or on any debtor ledgers, and then it gets paid, so it can be easy for erroneous discounts to fly beneath the radar. 

By analysing every invoice for due date, payment date, EPD date, invoice value, and discount value, by invoice, by customer, and by collector, we were able to build a comprehensive understanding of the volume and value of the problem. 

So let’s go into some example invoices: 

For all three invoices: 

The payment terms are complex, with multiple potential due dates; 

The customer made payment before the system due date, which is, by default set as the net term (whereby no discount should be applied), so no invoices were ever flagged as being past due, nor as being settled late; 

Because of the complex payment terms, with the description being a free text field with multiple possible outcomes, there is no correct ageing past due date that considers those discount terms; and 

Crucially, none of these invoices are past due vs the net due date at the end of the month, so remain undetected as late payments. 

For invoice 1, the system due date is calculated based on the net payment terms of 30 days, but, as the 2% discount has been taken by the customer, the due date should actually be ten days after invoice date. Payment of the invoice was made after 27 days; before the system due date, so not flagged as late, but 17 days after the qualifying date for the discount. This makes the discount taken invalid, or otherwise we must say that the invoice has been paid late. 

In financial terms, the invoice ought to have been paid 17 days earlier, which would have an annualised cash benefit of 17 /365 * €9,800 paid = €456.44. Alternatively, the discount could be clawed back, improving margin (and also cash) by €200. 

For invoice 2, there are three potential due dates and terms available to the customer: no discount to pay in 60 days, a 1% discount for payment within 30 days, and a 3% discount for payment within 10 days. The customer has paid the invoice in 30 days, thereby qualifying for a 1% discount, but has taken a 3% discount of $150 on an invoice value of €5,000. This is thus an erroneous discount of €100 that could be clawed back from the customer. 

Otherwise, ensuring the customer pays on time versus the correct due date, an improvement of 20 days, would mean an annualised cash improvement of 20 days/ 365 * €4,850 payment value = €265.75.  That is to say that payment after 10 days instead of 30 would give the supplier an increased average cash balance for the year by €266. 

For invoice 3, the customer has a 3% early settlement discount available for paying within 20 days, or otherwise has 60-day net payment terms with no discount on offer. 

In this case, the customer has paid their invoice after 42 days, 22 days after the discount due date, and 18 days before the net due date.  

And, guess what, they took their EPD, so paid 3% less than the invoice value. As they did not pay within 20 days, the discount is therefore erroneous and could be reclaimed, improving margin by €600. Again, the alternative here would be to have made the customer pay within 20 days, an annualised cash improvement of €1,169.32. 

The ERP has no reporting to capture these erroneous discounts, and the issue was never previously raised to management, so no manual reporting was ever conceived. The issue is therefore not on the radar and these erroneous discounts are continued to be taken, year after year. 

Let us for a moment assume that these invoices are exemplar, and imagine that €20,000,000 worth of invoices included erroneous discounts through the year. Using the weighted averages to correctly extrapolate the same delays, the financial impact would be: 

  1. To claw back erroneous discounts: €514,286 margin and cash improvement 

2. To ensure discounts are only taken for payment within the discount terms: €1,080.861 annualised cash improvement 

So once we understood the scale of the problem, the business had a number of options. Was it commercially acceptable to give out discounts for late payments? Did pricing need to be adjusted? Should they claw back these erroneous discounts? Or should this be something to monitor and improve in the future only? 

The answer was a combination of all of the above. 

But this was no exceptional example, it is fairly typical whenever Early Payment Discounts are in use. Until the business really understands what is going on at an invoice level, beyond month-end measurements and with complex payment terms, the right commercial and financial decisions cannot be made. 

POP Collect includes full daily reporting for collections performance by invoice, picking apart complex payment terms and capturing erroneous discounts on the fly, so you and your business will always be on top of any potential issues affecting your competitors.


Christian Terry