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Dynamic Discounting & Supply Chain Finance: A Deeper Dive Part 1

Posted by James Wilson on Mar 11, 2019, 10:17:39 AM
James Wilson
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Companies striving to maximize cash flows can find themselves in the middle of a constant and difficult balancing act: How to maintain profitability given the downward pressure on costs while being more efficient with working capital. The immediate reaction from buyers is to press for payment dynamic blog4terms extensions or negotiate payment discounts while somehow maintaining cordial relationships with their strategic supply base. Suppliers are torn between the need to be paid sooner and reducing trade credit exposure while still providing quality goods and services to their valuable customers. Underlying these dynamics is the need for both the buyer and seller to remain competitive versus peers while maintaining individual profitability.

There was a time when changes to contractual payment terms were achieved with the benefit accruing to one party but to the detriment of the other. Think about this balancing act: If the buyer cannot extract terms extensions or discounts from their suppliers over time, they may find themselves in a weaker financial position versus their peer group. This is because buyers may be paying suppliers sooner than they are collecting receivables from customers which constrains working capital and may hinder their ability to take advantage of negotiated discounts. Holding onto cash longer from terms extensions could be utilized by the buyer to take advantage of trade discounts, implement process improvements, or fund other ways to grow the business. Discounts can be utilized by the buyer to reduce product or service costs while increasing margins. Conversely, the seller may find their financial position weakening as they leverage working capital to build inventory in response to terms extension creep increasing their cost to carry receivables. Additionally, buyers taking advantage of early pay discounts from suppliers can reduce the seller’s margins.

Given that the buyer and seller need each other to fulfill their operating missions, their relationship should be viewed as a partnership instead of adversarial. But how can the buyer and seller do away with the give and take of changes to terms and create a win-win situation given the competitive pressures of reducing costs and/or the need to extend payments?

There are two solutions that come to mind that can truly benefit the buyer and seller’s needs: dynamic discounting and supply chain financing. This Blog will take a deep dive into dynamic discounting with a follow-on blog on supply chain finance in the coming weeks.

So, what is dynamic discounting?

The dynamic discount concept is simple: Dynamic discounting is a solution that offers the buyer flexibility on when to pay suppliers while giving suppliers a choice to accept a discount for earlier payment on a transaction-by-transaction basis. Dynamic discounting can be integrated with your ERP and use a series of automated supplier communications, responses, and ERP integrations to execute. Supporting this concept is software that the buyer and supplier have access to in order to facilitate this transaction.

Dynamic discounts come in two main varieties:

Buyer-initiated discounts: For suppliers not wishing to accelerate every payment, this allows the buyer to automatically offer early payment upon the approved to pay invoice. The supplier can then choose whether or not to capture the early payment in return for offering a discount.

Supplier-initiated discounts: Similar to the buyer-initiated option, this allows the supplier to request early payment at terms they suggest without the buyer having to make an initial offer. Together with the buyer-initiated program, these options allow suppliers to make counter offers if they are interested in offering a discount but found the initial discount offer from the buyer undesirable.

So how does dynamic discounting work?

Well, to better illustrate how dynamic discounting works, let’s compare the difference between a basic invoice settlement versus one settled through dynamic discounting:

Without dynamic discounting, the basic settling of an invoice with Net 30 days terms (for example) would have the seller issue an invoice to the buyer immediately after a goods order has been fulfilled or services have been rendered. Once the buyer performs the 3-way match between the PO, Invoice, and goods or services receipt, the buyer would issue the seller a payment on the due date which would be 30 days from the invoice date.

There are some inefficiencies in this scenario worth noting:

From the buyer’s perspective:

  1. If the buyer is not utilizing a system to receive invoices electronically, there may be manual processing steps to receive the invoice, perform the 3-way match, confirm payment terms, confirm payment instructions, get payment approval, release the payment, clear the AP aging and subledger, and post to the general ledger.
  2. The buyer may also be subject to a cyclical business model. In periods where the buyer has excess cash and no revolving debt, there is no incentive from paying an invoice early that does not offer a discount.
  3. Without a streamlined option of capturing a discount, the buyer does not have another way of lowering their product or service costs without renegotiating pricing or requesting terms concessions with the supplier.

From the seller’s perspective:

  1. If the seller is not utilizing a system to issue invoices electronically, there may be manual processing steps to settling the invoice, capture the payment receipt, clear the AR aging and subledger, and post to the general ledger.
  2. The seller may also be constrained by a cyclical business model. In periods where the seller needs capital to build inventory, their options of raising funds would be to draw on credit lines which could lever up the company at a time when operating income may be at its lowest. or enter into a costly factoring program with a third party.
  3. Without a streamlined option to offer a discount to the buyer, the seller does not have an immediate and efficient way of raising capital during a cash crunch. 

With dynamic discounting, the settling of the same Net 30-day invoice from the example above would have the seller issue an electronic invoice to the buyer immediately after a goods order has been fulfilled or services have been rendered. Once the buyer performs the 3-way match between the PO, Invoice, and goods or services receipt within the system, the buyer would then approve payment based on payment terms. The buyer also has the option to initiate the sliding scale discount to be settled up until the payment due date. There are some efficiencies in this scenario worth noting:

From the buyer’s perspective:

  1. If the buyer is utilizing a system to receive invoices electronically, they may avoid all the manual processing steps to settle the invoice including: Performing the 3-way match, confirming payment terms, confirming payment instructions, getting payment approval, releasing the payment, clearing the AP aging and subledger, and posting to the general ledger. The work effort that would normally be tied to manually processing the invoice could be repurposed to other work endeavors inside or outside of Procurement, Shared Services, and Accounting yielding additional savings and efficiencies.
  2. If the buyer has a cyclical business model, in periods where the buyer has excess cash and no revolving debt, they can leverage cash on their balance sheet by initiating an offer to settle this invoice at a discount which would typically yield a higher return than an overnight investment. In periods where the buyer does not have excess cash, they can revoke the option to settle the invoice at a discount and instead pay upon the maturity date.
  3. In summary, processing efficiencies and savings accrue to the buyer through managing the workflow electronically while yielding additional costs savings from the capture of the discount.

From the seller’s perspective:

  1. If the seller is utilizing a system to issue invoices electronically, they may avoid all manual processing steps to settling the invoice including: Capturing the payment receipt, clearing the AR aging and subledger, and posting to the general ledger. The work effort that would normally be tied to manually processing the invoice and clearing the receivable could be repurposed to other work endeavors inside or outside of Accounts Receivable, Treasury, and Accounting yielding additional savings and efficiencies.
  2. The seller may also have a cyclical business model. In periods where the seller needs capital to build inventory, they could offer a supplier-initiated discount allowing them to settle invoices early at a discount to capture immediate cash and avoid costly factoring programs.
  3. In summary, processing efficiencies and savings accrue to the seller through managing the workflow electronically while avoiding costs related to revolving credit lines or expensive factoring programs.

Final Thoughts:

Dynamic discounting is a proven product that allows both the buyer and seller to capture savings and efficiencies generating win-win opportunities for both parties. It offers the buyer the opportunity to deploy idle working capital to capture discounts while providing the seller opportunities to raise capital from trade balances at their discretion. Both parties enjoy savings and efficiencies from electronic processing components that can be redeployed throughout the organization.

In part 2, of this blog, we will look at the win-win opportunities that Supply Chain Financing (SCF) offers for both buyer and sellers.

Topics: treasury and working capital, dynamic discounting

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