Dynamic discounting is a term used to describe the negotiation between a vendor and a business for discounts. The word “dynamic” means the process is collaborative. It requires a business that’s at the top of its game with a robust procurement to payment process, one that usually involves P2P automation.
Discounting gives a supplier the advantage of getting paid earlier in exchange for discounting the invoice. This mutually beneficial arrangement lends flexibility and customization in the payment of business invoices.
Until procure to pay automation software, early payment terms were difficult for accounts payable to meet. The chances vendor payments were made early were slim—let alone on time. There was just too much paper in the P2P process. While discounting isn’t new, putting new systems into practice is something many organizations didn’t find practical.
Calculating the value of an early payment discount offer requires the cost of working capital. This is done a few different ways. Sometimes working capital is valued as the cost of a company borrowing money. Other times, working capital is determined as the cost of not investing money (i.e. potential interest earnings).
What formula do I use?
`"Discount" - ("cost of working capital"/365)xx"difference in payment"`
For a supplier offering 2 percent discount for 10 day terms rather than the standard 45 days where the buyer cost of working capital is 5 percent, the calculation would look like this:
`2% - ("5%"/365)xx35 = 1.52%`
For invoices worth $1,000,000, the value of the discount is $15,200. This discount is generated by paying 35 days early. That’s a return of 1.52 percent in 35 days. To get a treasury manager really excited, turn that into an annual figure. The annualized value then is 15.85% for paying their suppliers early. What a significant benefit!
By leveraging the power of a dynamic discounting program, suppliers working closely with buying organizations build proactive business relationships that earn discounts, reduce purchase price, and save on AP costs.