A Beginner's Guide to Dynamic Discounting

March 24, 2014 Matthew Stammers

 

beginners-guide-dynamic-discounting

As with any industry or specialist area, the language around how a large organisation manages its buying process and its suppliers is full of jargon. In fact it’s almost impossible not to slip into using it accidentally!

Common terms include P2P, supply chain management, supply chain finance, vendor management, etc. but unless you understand the industry, many of these won’t make much sense.

In this blog post I’m going to take a look at one of the newer terms on the scene – dynamic discounting  – and explain what it is, and why it could make a significant difference to how you choose to partner with your suppliers. 

Dynamic Discounting Explained

So what is dynamic discounting? Quite simply, it gives suppliers the opportunity to get paid early on approved invoices in return for a discount. The reason that the word ‘dynamic’ is in there is because the size of this discount varies according to how early the supplier wants to get paid. 

For example, if the buying organisation sets the APR at 18%, and the supplier wants to be paid 30 days earlier than the original net due date, the incremental discount would be 1.5% (18% APR / 360 days = 0.05% * 30 days acceleration = 1.5% discount). The point here is that the discount percentage changes on a sliding scale according to the APR set by the buying organisation and how early the supplier wants to get paid. And the best part about dynamic discount payments is that they don’t just have to be on specific days (as in the example given above), they can be on any day when the buying organisation is doing a payment run. 

This is very different from traditional discount programmes which normally only offer a discount if the invoice is paid by a set day. An example of this is the common discount term 2% 10 net 30 (which simply reeks of jargon!) which actually means that a supplier has agreed to accept a 2% discount if they are paid by day 10 on a 30 day payment term. The problem with this is that if the invoice is not approved before day 10, there is no discount opportunity between day 11 and 30.

What’s in it for buyers?

So why might buyers and suppliers be interested in dynamic discounting? Let’s start with buyers. The argument for buyers adopting dynamic discounting is compelling. 

A large buying organisation is always seeking to maximise its working capital, and one of the ways it currently does this is to hold on to its cash for as long as possible by paying invoices as late as possible. 

However, the time where this made sense has passed. Holding onto cash doesn’t make sense in this near-zero interest rate environment. 

Twenty years ago, when rates were over 15% it made sense, but not anymore. At rates currently around 1%, this cash is in fact losing value as it’s not even keeping up with the cost of inflation (currently circa 2.5% in the UK). 

So, what’s the alternative? 

If a buying organisation chooses to pay its approved invoices early in return for a discount, it can earn far more on this cash than if invested elsewhere. Buying organisations can segment their suppliers by size, geography, cashflow needs, cost of capital, and many other factors to determine interest rates that make most sense to each supplier. The rates can range anywhere from 3% APR to upwards of 24% and can be set to maximize the effectiveness of the program.

If you’re not used to this topic, the percentage amounts may not instantly grab you as being a project worthwhile investing in. But, imagine that you are a very large buying organisation with purchase costs of £1bn. A 1% reduction in this cost equates to £10m and this sum gets added straight onto the bottom line! 

For a real life example, have a look at what PG&E, the largest US Utility, achieved in the space after just two years by adopting dynamic discounting.

Suppliers need easy access to cheap cash

Now let’s look at suppliers. Why would they be interested in taking a discount on their payment when they’ve put all the hard work in to provide the goods or services? 

Quite simply, cash funds every business, and access to cash in a timely manner is critical to support business continuity, growth and investment. If a business can get timely access to cash, at better rates, from one source than another, they’re going to take it. 

This is where dynamic discounting is attractive for suppliers. It provides early access to cash at much cheaper rates than if they went to the market and looked for alternative sources of finance. 

To take an example, they may be accepting an APR of 15% through a dynamic discounting programme, but this would compare very favourably to accepting a 25%+ cost (and this is the low end!) by going through a factoring programme

Another benefit of dynamic discounting is the ease of use - suppliers simply press a button in the portal they’re already using for eInvoicing - no more complex, expensive or time consuming processes.

So suppliers will be keen to engage with this type of programme. Again, have a look at a real life example of how suppliers have adopted and are using dynamic discounting to help release more cash into their business.

It’s nothing without the technology!

The concept of dynamic discounting has been around for a number of years, but it’s only now starting to be a reality in business. And the reason for this is quite simple: We have now reached the point where enabling technologies such as eInvoicing and self-services platforms are sophisticated enough to make it not just possible, but actually easy to implement and carry out on a day to day basis. These are normally very intense and complex finance and accounts payable or receivable functions.

Moving from understanding to assessing

So in summary, the question should really change from ‘what is dynamic discounting?’ into ‘is this relevant for me to adopt in my business?’

To learn more, check out this deep dive into the various types of dynamic discounting and this PayStream Advisors whitepaper on The State of Dynamic Discounting Management.

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