If Static Discounting is Obsolete — Why Do Companies Still Use It?
October 18, 2021 |
The C2FO Team
Businesses are evolving and so should your strategy for working capital. This guide is helpful for understanding the benefits of dynamic discounting.
Static discounting — the practice of offering a fixed discount in exchange for early payment from a customer — has been around since the origin of commerce itself.
Suppliers and buyers still use static discounting today, with terms like 2/10 net 30 or 2/10 net 60 being among the most commonly used across a wide range of industries.
It’s a simple, time-tested formula. When a supplier and a customer agree to 2/10 net 30, for instance, that means the customer must pay a full invoice price within 30 days. If the customer chooses to pay within 10 days, they pay 98% of the invoice value. In theory, both parties benefit: The supplier gets paid earlier than 30 days, and the buyer saves money on the purchase.
However, both buyers and suppliers these days admit that static discounts are often superfluous. Over time, suppliers have built in the cost of the discount into the price of their products. Large companies almost always take the discount, so the net terms of the agreement are generally meaningless.
“It’s just a silly model, but it is what it is,” a company in the construction industry recently told C2FO. “So, we just build the discount into our price. You know, if I have to pay 2% on the money, it’s just going back in there. They’re paying for it.”
Suppliers find themselves in a position where they must build the price of these discounts into the overall Cost of Goods Sold (COGS). They ultimately increase the purchasing price, so the revenue generated by the discount is a direct hit to the buyer’s purchasing team.
In short, neither buyers nor suppliers truly benefit from static discounts. Yet, the process has become systemic and hard for financial leaders on the buyer side to justify giving up.
“It is obsolete,” said Kristyn Baker, vice president of procurement and sourcing strategy for C2FO. “The problem is it’s foundationally built into the numbers, and those can be some very large numbers to make up.”
This article outlines several reasons why static discounting has become almost a pointless exercise between suppliers and their customers. It also explains how, despite a more flexible and modern alternative in dynamic discounting, the ancient practice of static discounts is likely to remain a way of doing business for years to come.
A misleading game for suppliers
For most companies, the largest free source of financing is the money tied up in accounts payable. So, it’s often in a company’s best interest to hold on to the cash in AP for as long as possible.
As a result, companies in the United States are waiting longer than ever before to pay their suppliers.
For the first quarter of 2021, according to a survey of 938 businesses by Hackett Group Inc., big companies took an average of 58 days to pay suppliers, up 5.5% from 55 days in the first quarter of 2020. For the entire pandemic-plagued year of 2020, businesses took an average of 62 days to pay vendors. According to C2FO’s 2021 Working Capital Survey of more than 2,000 US suppliers, 77% of them said at least some of their customers had increased payment terms in the past year. In a recent C2FO interview, one supplier for a national auto parts chain described having to agree to terms approaching 360 days.
Waiting on payment terms of 60 days or longer could shutter many suppliers, particularly those that are small- to medium-sized businesses. However, buyers offer suppliers a lifeline: They can be paid early in exchange for a discount. The most common arrangement buyers and suppliers agree to is 2/10 net 30. Still, there are other terms that may be more beneficial to the buyer or the supplier, depending on who has more leverage in the relationship.
Static discounting seems like a simple, no-nonsense way of achieving a benefit — a straight 2% discount on invoices paid early across the board.
The reality is — many suppliers have found a way to pay for the standard 2% discount offer. They simply build that percentage into their pricing, making up for the discount. In 2021 interviews with multiple suppliers across many industries, the company owners said they felt forced to pad their prices because their margins were already razor-thin.
“Yeah, we just build it into the price of the product,” one company from the retail industry said. “We just charge them 2% more for the product … so it washes.”
Sean VanGundy, president of Pendulum Associates, a consulting firm specializing in helping companies optimize their cash conversion cycles, said he has seen “all kinds of arrangements” with static terms. Across many industries, the 2% discount for early payment is standard, which VanGundy believes is antiquated and does not take into consideration the true cost of funding.
“In today’s environment, that doesn’t make a lot of sense,” he said. “It might have made sense in 1987 when the interest rates were higher.”
As much as buyers and suppliers may like to think that a static 2% discount has an incremental value, in many cases, the discount has been built into a terms agreement for so long that it no longer has relevance. Allowances between buyers and suppliers for additional stores/warehouses in a buyer’s network or defective products from the supplier have more incremental impact than static discounts, said C2FO’s Baker, who previously served several roles in Walmart’s treasury and merchandising operations.
“The advantage (for buyers) is the static discount is a lever to get a lower cost on an item,” she said. “The disadvantage is it’s been there for so long, at some point, you get the law of diminishing returns. It’s no longer necessarily anything incremental to you. It’s part of your base at that point.”
For some suppliers, playing the “game” of offering a 2% discount for early payment doesn’t make good business sense, given that they’re already operating on tight margins.
Hard habit to break for buyers
Many buyers understand the gamesmanship that goes on behind static discounts.
Some of them have experienced only mixed success using a static discounting model. A survey of more than 200 organizations by C2FO and PayStream Advisors found that 50% of buyers that used static terms like 2/10 net 30 with their suppliers were only able to capture discounts “sometimes.” Often, manual processes rife with bottlenecks were to blame for the missed opportunities.
So why do buyers persist in building static discounts into payment terms with suppliers?
The answer, more than anything else, is tradition. Static discounting has been around a long time. It’s still taught as a viable model in business schools. Walking away from static discounts could mean hundreds of millions lost from their profit and loss statement for the largest companies. What remains unknown is how much of those perceived profits are built into the COGS by the suppliers.
“From a buyer perspective, you’re taking away a done deal from a profitability standpoint,” Baker said. “And when you’re a big buyer, that could be a substantial amount of money, and you’ll have to make up for it in a different way.”
VanGundy said both buyers and suppliers could “get addicted” to static discounting — buyers love the discount, and suppliers like getting paid early. For financial executives on the buyer side, walking away from those kinds of agreements carries significant risk.
“In theory, it makes total sense, but if you’re responsible for that valuable nugget of revenue at your company, how do you plug that hole?” VanGundy said.
However, some buyers have found a way to “kick the habit” and break free from the static discounting cycle.
“The technology industry has largely moved away from static discounting in recent years,” said Jordan Novak, senior vice president of market innovation for C2FO. “They realized they could no longer justify giving that kind of discount because it masks the underlying price of the commodities and components for personal computing, servers and storage,” he explained.
Instead, the technology industry and other buyers have found another way — a more flexible, viable alternative for both buyers and suppliers.
A better form of discounting
A more recent evolution on the concept of early payment provides an attractive, empowering alternative to static discounts and traditional funding sources.
The difference is flexibility. Static discounting provides the buyer and supplier with only two payment options: pay early in exchange for a fixed discount or pay 100% of an invoice at full term.
The early payment window doesn’t close at 10 days with dynamic discounting, and the discount isn’t fixed at 2%. The buyer and supplier have the flexibility to agree on a discount for early payment at any time during payment terms. Dynamic discounting empowers the supplier to choose which invoices to accelerate payment on at discounts that work for both the supplier and buyer. Because no buyer can have a complete view of their suppliers’ credit costs or cash flow needs, this solution gives the supplier a better incentive to negotiate the correct price from the onset of the payment terms.
With C2FO’s secure Early Payment platform, a supplier has visibility of all of its invoices from a customer, can select specific invoices for early payment and can offer customized discounts on those invoices. When the buyer agrees to that offer, payment takes place in as little as 24 to 48 hours, giving the supplier more flexibility and control over its cash flow.
For buyers, the flexibility of C2FO ensures that suppliers are offering a true discount on their receivables, not an artificial one that’s been built into their pricing for years and years. For suppliers, dynamic discounting no longer tethers them to a static discount, regardless of market conditions or seasonal demands. In many cases, they can access early payment at a much lower cost than the traditional 1% or 2% discount.
“For the supplier, they wouldn’t ever be stuck,” Baker said. “They could fluctuate in different periods and when the market changes.”
Just because something has been around for eons doesn’t mean it’s the best way to do business.
Such is the case with static discounting, which often devolves into a shell game in which suppliers build the fixed discount into their pricing, and buyers pretend they’re gaining a premium for paying invoices early.
Dynamic discounting with C2FO is a more flexible and appealing early payment alternative for both buyers and suppliers. That is why 73 of the Fortune 100 companies are part of the C2FO network of over 1 million customers. It enables suppliers to select invoices for early payment at discounts that work for them, and it ensures that buyers receive a true discount for choosing to pay their suppliers early.