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Dynamic Discounting: Backdrop, Definitions, and Enablers

08/30/2019 By

Editor’s note: This is a refresh of our 2014 series on dynamic discounting, which originally ran on Spend Matters PRO.

This Spend Matters Plus brief provides a primer on one of the timeliest topics in receivables and payables finance: dynamic discounting. Note that by receivables financing we mean the selling or other leveraging of “receivables” as an asset on a supplying organization’s balance sheet to receive early payment. By payables financing, we mean the financing of early payment by a third-party (or the buying organizations’ balance sheet).

Even this subset of trade financing is a big and complicated topic, but in this analysis, we’ll discuss how dynamic discounting can reduce risk and create greater liquidity in the supply chain. If you’re in procurement or accounts payable and are new to the topic, this brief will be a useful first step in understanding what dynamic discounting is, how it can help, and which technologies and vendors can enable it.

Dynamic Discounting Background

Dynamic discounting is discounting with a twist. The basic practice of early payment terms has evolved into what is sometimes described as dynamic discount management (DDM). Dynamic discounting is different than the static practice of one-size-fits-all (e.g., 1%, 10 day) discounts in several ways:

  • With dynamic discounting, discounts can be offered on all invoices approved by the buying organization. This can “open up” broader procurement spend rather than just invoices that have pre-approved static discounts that are ready within the allotted 10-day (or other) time period. Because of this, successful discounting is dependent on fast invoice processing — ideally less than 14 days from creation/receipt. Since only approved invoices can be used for dynamic discounting to work, the volume and number of invoices awaiting payment is the critical ingredient in unlocking the opportunity in dynamic discounting.
  • Dynamic discounts differ from traditional discounts, as the discount is calculated as a function of the time of payment. Put another way, it is based on a sliding scale of sorts (with varying numbers of offers made along that scale). This allows the buyer to set terms based on internal hurdle rates, supplier groupings, and other factors.
  • One of the advantages of new technology in the area (Taulia is a good example) is to be able to enforce electronically very detailed interactions and workflow processes between buyers and sellers and within a company’s own procurement processes based on existing contracts, previous buyer/seller relationships, geographies, tax, etc.

Dynamic discounting tools can solve a number of challenges for buying organizations – and can be as strategic as other procurement technologies. For example, suppliers must often wait 60 days (or longer) for payment from customers, often not knowing for sure when they will be paid. In addition, discounting capability introduces liquidity into the payment stream by providing a means of delivering payment earlier to suppliers (i.e., “early payment discounts”).

Without the right discounting capabilities in place, buying organizations may face increased supply risk based on their suppliers’ ability to produce cash to fund operations – especially in tight credit markets where small and medium sized business have difficulty obtaining alternative financing options. In these environments, suppliers are often forced to resort to terms for early payment through traditional “factors” that purchase receivables which are significantly more onerous than had they taken payment via a card (if that were an option) in the first place. (A factor is a third party that purchases receivables, either with or without recourse, from suppliers in exchange for early cash payment, often 80% at the time of invoice.) These factors usually present an “all or nothing” approach to suppliers, requiring participation across most or all invoices to reduce their lending risk. For further definition, a “factor” is a third party that offers a supplier early cash payment on receivables. This process is known as receivables factoring.

Challenges and Trends

The successful implementation of dynamic discounting approaches is easier said than done. The practice of offering discounts for early payment (e.g., 2%, net 10) goes back decades. But for most large companies, there is no such thing as “standard” payment terms across suppliers. Their payment terms proliferate across divisions and regions. It’s not uncommon for a large company to have at least 40 to 50 different terms, and many firms have even had hundreds of them. Moreover, changing standard terms can prove challenging even in the case of static terms, as the vast majority of AP departments do not have the correct, up-to-date vendor file information on hand to contact the majority of their suppliers in a 30- to 45-day window, as Spend Matters research suggests. This is even more challenging with dynamic offers/terms.

Beyond these basic challenges, one of the more complicated hurdles historically holding back discounting approaches is that most have failed to address invoicing and connectivity into buyer systems. In this environment of limited visibility, participants (e.g., suppliers, banks, third-party lenders, even a company’s own treasury group) lack assurance of payment in a specific amount on a specific date early in the invoice lifecycle. This forces participants to hedge accordingly based on limited information transparency (resulting in higher costs, delays, etc.). In traditional receivables financing, there are numerous risks that lenders face, including fraud risk and the need to constantly monitor the credit worthiness of the supplier, which in turn raises the costs that lenders must pass on to suppliers in the form of larger discounts needed to offset the early payment.

Exploring Dynamic Discounting Adoption

There are a number of factors contributing to the growth of dynamic discounting adoption.

The first factor is that dynamic discounting has dual value to treasury and procurement. It is both a treasury tool to manage surplus cash and a procurement payment option that enables suppliers to have an alternative liquidity option for their respective invoices with that buying organization. There is no pressure – they either want the money at the discount rate offered or not. For procurement, it helps lessen supplier risk (and can give the buyer insight on supplier behavior relative to their apparent hunger for quick cash), and can even generate purchase price savings that they might get credit for.

It seems that suppliers increasingly want the money. Both corporate buyers and technology providers providing dynamic discounting software have indicated that suppliers have a great interest for early payment, and this is confirmed by data in some vendors’ systems showing a high percentage of suppliers requesting funds immediately upon invoice approval. Corporations running successful programs tend to use a high percentage of discounts that are in the upper slope of the sliding scale (>75% of the discount taken occurs from invoice approval, or day zero, to the normal discount date). By also having the ability to adjust discount rates to reflect different supplier groupings (e.g. Strategic supplier group, or group by spend category) these programs can have significantly higher take-up.

Still, there are ways to go with these programs. Treasury typically requires a hurdle rate, which is significantly higher than a supplier’s short-term debt rates. Most suppliers do not use weighted average cost of capital, which blends the cost of debt and equity, when analyzing options.  With exploding cash balances at many large technology, pharmaceutical, and other companies, Treasury has added cash manager to their other roles. With interest rates near zero for short-term fixed income products, treasury groups need to put balance sheets to work. Rates earned on dynamic discounts can typically (far) exceed short-term commercial paper, Bank CDs, treasuries, etc. For example, earning a 2% early pay discount on day 10 versus 0% on day 30 is clearly economically superior from a Net Present Value standpoint. Still, many treasury groups and CFOs have set Days Working Capital (DWC) targets for themselves that tend to lock them into a mindset of stretching payment days as far as possible without bankrupting suppliers. More progressive firms, however, are either offering dynamic discounting (if they are not slaves to DWC) or Supply Chain Finance programs (if they are DWC sensitive) performed in conjunctions with large lenders. We’ll dive into the details of these programs in future posts.

There are also other factors contributing to the growth of dynamic discounting adoption. One key factor is acceleration of e-invoicing implementations. E-invoicing solutions have enabled a much higher capture rate of invoices. While some companies have deployed EDI solutions with their partners for some time, the frequency of invoice capture is much higher when solutions leveraging web-based XML standards, PO-based invoices, ERS (Evaluated Receipts Settlement) and invoices originating electronically from a supplier portal or an e-invoicing network such as SAP Ariba, Basware, Tungsten, Tradeshift  or Taulia are deployed.

Tools from all of these providers (and others) can help overcome the limitations of today’s current A/P processes and technologies. Consider that most larger customers pay on net 60 terms (on average). Without more advanced e-invoicing tools, the time it takes between paper invoice creation and the beginning of the approvals process is at least 15 days. And if a company is doing A/P processing offshore, it can be even longer (before it even starts the approvals process). In essence, without automating the invoicing process electronically, 25-50% or more of the potential financing period is eliminated because of latency in the process and manual steps.

Moreover, by tying electronic invoicing into the process, it becomes possible to speed up the invoice approval process both in cases where straight through processing is allowed, as well as other situations where exceptions occur or an invoice is flagged when participants inside the buying organization must wait for goods, sign-off on quantity, quality, etc. and provide this through a manual means.  Spend Matters research shows that this can greatly expand the potential to finance early payment across 75% or more of the invoice maturity. This accelerated process then of course leads to available approved invoices to offer up via dynamic discounting or Supply Chain Finance techniques.

Fundamentally, any type of early payment approach requires integration between transactional procurement / invoicing tools (and/or network) and a company’s ERP system. Dynamic discounting capability is what “systemitizes” the process of managing discounts. Without technology, most companies have little idea how much earlier they are paying suppliers than they ought to be – whether it’s “due upon receipt” or even just 0% net 30 days. Of course, a good sourcing process should maximize payment terms to the extent possible. But, from a broader source-to-pay perspective, it’s the combination of e-invoicing-led visibility and dynamic discounting capability – coupled with tight ERP integration – that is what can enable companies to realize the benefits of an effective dynamic discounting program regardless of the effectiveness or standardization of payment discounts negotiated upstream during the sourcing process.

If you’re considering the implementation of a dynamic discounting solution or broader trade financing components, don’t hesitate to reach to us. We’d be happy to trade thoughts on the topic, as well as provide a shortlist of providers for consideration based on your program goals.