The Hidden Economics of Early Payment Discounts

Early payment discounts are a common tactic in B2B transactions, but their design has not really changed for decades. It's difficult to trace exactly when these trade terms became widespread, but a 1964 study published by the National Bureau of Economic Research (U.S.) makes it clear that by the mid-20th century, they were already standard practice.​

Companies often perceive the payment terms accepted in their market segment as a given. For example, if it's customary to pay for certain types of goods within 30 days, suppliers view early payment discounts as an amount they lose when they need to receive money sooner for some reason. In other words, they see it as the cost of financing from the buyer.

However, if you think about how payment terms evolved (and trade credit terms in particular) it becomes clear that the logic of discounts is actually the reverse. Here's how the aforementioned 1964 paper describes it: "Terms of sale imply an interest charge to buyers not taking the discount and an interest return to sellers on their receivables".​ In other words, when extending deferred payment terms to a buyer, the price should include the implicit cost of such credit. If the buyer doesn't require an extended credit period, they can reduce their costs by using the early payment discount.

So the correct logic is this: the cash price is your baseline. When you offer extended payment terms (e.g., net 30), the effective price should be higher to compensate for the cost of financing and credit risk. Early payment discounts simply allow buyers to "opt out" of paying that financing cost. From this perspective, it follows that any supplier company should always offer early payment discounts. In practice, however, not all suppliers do this. Why this is the case, and what limitations traditional early payment discounts have - read about it in our next post.