Getting customers to fulfill their payment liabilities can be like pulling teeth. Many customers wait until the due date to pay. With others, you need to send multiple payment requests after the deadline has passed. If your business needs cash, consider offering an early payment discount.
So, what is an early payment discount? Will offering it help or hurt your business? Find out below.
What is an early payment discount?
An early payment discount is a price cut customers can receive on their purchases if they pay before the due date. This type of discount is also referred to as a cash discount, prompt payment discount, or sales discount.
If you offer credit to your customers, you likely send an invoice that shows when payments are due, how to pay them, and more. Because invoices give customers time to pay their bills (e.g., 30-60 days), many businesses offer an early payment discount to speed up payments.
Offering an early payment discount encourages customers to pay their bills early, which can prevent late payments, or even nonexistent payments when a customer won’t pay.
You can include your early payment discount terms directly on the invoice. You might also tell customers about the offer at the point of sale. That way, they can start budgeting for the payment before they receive their invoice.
How to write an early payment discount on the invoice
When you create your invoice, you must write the early payment discount in a certain way. Before getting to that, you need to know the parts of an invoice.
Your invoice should include the invoice date, customer information, seller information, purchased goods or services, total amount due, payment terms (when payment is due, early payment discount, how to pay, etc.), and invoice number.
To write the terms of your early payment discount, you will write the percentage discount the customer will receive, followed by the number of days they must pay by to receive this discount. Then, you must write the normal due date. For example, 2/10, Net 30 would mean the customer will receive a 2% discount if they pay their invoice within 10 days as opposed to 30.
How much should your discount be?
You don’t want to offer too big of a discount, or your profit margins will be razor thin. At the same time, you want the discount to be enough of an incentive that customers want to pay early. How much should you offer?
Find your product’s profit margin. To do that, use the formula [(Product Price – Cost of Goods Sold) / Product Price] X 100.
You can find the cost of goods sold by adding up all your expenses for creating the product or offering the service. Then, subtract those costs from the price of your product to get the difference. Finally, divide that total (the product price minus cost of goods sold) by the product price and multiply by 100. This shows you what percentage of your profits you retain. You can find your profit margin without the early payment discount. Then, you can try out different discount options and determine if you will still earn a high enough profit margin.
Let’s say you set a product price at $300. It costs you $210 to make. First, find your profit margin:
$300 – $210 = $90
$90 / $300 = 30%
You want to give a 4% early payment discount to your customer, which would be a savings of $12. Determine your profit margin for the early payment discount:
$288 – $210 = $78
$78 / $300 = 26%
With an early payment discount of 4%, you would still earn a profit margin of 26%.
When deciding your cash discount, be sure to consider your industry standards and competitors. Find out how much other businesses charge for similar services or products. You may choose to offer a low enough early payment discount to stay competitive.
Here are some examples of sales discount options:
- 1/10, Net 30 (1% discount for payments made within 10 days; 30-day due date)
- 2/15, Net 45 (2% discount for payments made within 15 days; 45-day due date)
- 4/10, Net 60 (4% discount for payments made within 10 days; 60-day due date)
Make sure to leave yourself enough room to cover costs and give yourself a healthy profit. Be sure your business can handle offering the discount.
Accounting for prompt payment discounts
Like any transaction, you need to create journal entries for early payment discounts.
Using double-entry accounting, you must create an initial journal entry when the customer makes the purchase before they pay. Then, you must create a second journal entry when the customer pays.
In your first journal entry recording the transaction, debit your Accounts Receivable account and credit your Inventory account. Because the customer owes you, you will increase the Accounts Receivable while also decreasing your Inventory accounts.
|XX/XX/XXXX||Accounts Receivable||Sale to customer||X|
When the customer pays, it’s time to reverse the entry by creating a second journal entry. Debit your Cash account to increase it and credit your Accounts Receivable account to decrease it.
This is how a normal journal entry would look without the sales discount:
|XX/XX/XXXX||Cash||Sale to customer||X|
However, early payment discount accounting requires you to add another account to record the money your business is “losing” for the sale discount. You must use the Sales Discounts account.
Sales Discounts account is a contra revenue account. That means that its purpose is to help you match your unequal accounts (Cash and Accounts Receivable, in this case). As a result, you will debit your Sales Discount account. Together, your Cash and Sales Discounts accounts will equal your Accounts Receivable account.
|XX/XX/XXXX||Cash||Sale to customer||X|
Because the Sales Discounts account is actually decreasing the amount of revenue your business earns, you need to deduct the total from your business’s gross revenue at the end of the period.
Early payment discount example
Let’s say you make a $5,000 sale to a customer. You must first record the sale you made to the customer by debiting Accounts Receivable and crediting Inventory.
|XX/XX/XXXX||Accounts Receivable||Sale to customer||5,000|
You offer an early payment discount of 4% if the customer can pay within 15 days (4/15, Net 30). The customer pays within 15 days, and you must record the transaction in your books.
To record the customer’s payment, you will debit your Cash account and credit your Accounts Receivable account. Because the customer receives a discount, you must also debit your contra revenue account, which is Sales Discounts.
|XX/XX/XXXX||Cash||Sale to customer||4,800|
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This is not intended as legal advice; for more information, please click here.