Are Prompt-Payers Costing You?
An exercise in one of our seminars puts credit staff in the position of debtors, and forces them to make decisions about which creditors they will pay and which they will not pay. One of these scenarios is for a debtor whose debts are due tomorrow. These debtors will pay everyone over the next few weeks but can't pay everyone just at the moment. Among the possible people they could pay are a close friend who's helped them start the business, someone who depends on the money to augment his pension, and their mother who desperately needs the money.
One of the things we find is that whichever of the friends and relatives they pay or don't pay, they almost always pay the creditors who give 2% discount for prompt-payment, and the ones who threaten to charge interest. They will often pay the friends and relatives ahead of the creditors who offer 1% discount, but not ahead of the 2%. In our exercise, the 2% discount is worth $20. Draw what conclusions you will about the relative values placed on motherhood and friendship.
From a psychological perspective, prompt-payment discounts and late-payment interest are useful 'reverse psychology' techniques. The old line "you always want what you can't have" does have a ring of truth to it. It's why teenagers are consistently more attracted to those people their parents disapprove of. They are asserting their freedom and independence.
The power and freedom we manage to achieve in life comes from the ability to make our own decisions. Most people want power and freedom, so most people want the opportunity to make decisions. Offer anyone the chance to make a decision about anything, and you can be about 99% sure they'll take it.
When a creditor offers customers a prompt-pay discount, or a chance to avoid paying interest, they are actually offering them a chance to retain their sense of freedom, by making a decision about when they will pay. The catch is that the choice must be made before the deadline. After the deadline there is no choice, and consequently, no power to be gained. What creditors tell the customer is essentially: "choose a discount (or no interest) now, because after the deadline you won't be able to choose."
Reverse psychology, or to give it the technical name, psychological reactance, is frequently used in sales. Those television advertisements that bombard us with "limited offer" and "while stocks last" are obvious examples. They indicate to potential customers that by making haste, they have the option of buying a fabulous product, but if they don't buy soon, they may lose their chance of buying at all.
If you have ever looked at buying a car privately you might have come across the " well, take your time by all means, but you should know I've got a really keen chap coming to look at it this afternoon" line. Even though they might suspect the motives behind the warning, many people still feel they need to make the decision to buy now just in case that "potential buyer" really does exist and might deprive them of their chance to own such a vehicle.
As credit consultants, we can certainly attest to the fact that prompt-payment discounts work. They work on two levels. First, the discount gets customers paying by the due date and that saves interest. Second, the fact that the customer pays your bills ahead of others may save you in terms of reduced bad debt. Your accounts get paid promptly while others are allowed to drag out to 60 or 90 days. When the customer goes into receivership your debt is only what was not yet billed or not yet due for payment.
The second aspect is hard to assess in a cost benefit analysis. The benefit of the prompt payment discount must be weighed against the fact that many customers, particularly consumers, pay early even without an incentive. Would the benefit of a discount exceed the cost, bearing in mind that the business would give it to customers many of who would have paid on time anyway?
This is perhaps better seen with an illustration. Suppose that you had 100,000 debtors each with a monthly account of $100. Seventy percent of your debtors pay their account on time, while 30% pay anywhere between 0 and 60 days late. If you offered a 2% discount for payment on time then the total cost of the discount to you would be somewhere between $140,000 and $200,000 depending upon the number of late payers that choose to pay on time. Interest savings would depend on when the late debtors currently pay, but for the sake of argument suppose on average that they pay 15 days after the due date. At most, the interest savings would be $15,000 if your cost of money is 12% p.a.
The other consideration is that buyers on price tend to get confused by what are known as "below the line" discounts. This is especially so when there are a number of elements, say volume discount, free shipping and prompt payment discount. From a sales perspective it seems to be better to reduce the unit price, rather than offer a prompt payment discount, because that's what most buyers who are basing their decision on price pay most attention to.
There will also be some customers who will take the discount even though they haven't paid on time. There will be disputes and queries. Of course, a creditor who can get away with simply putting prices up then giving a discount of the amount of the increase, has no problem.
A good solution may be to combine the prompt payment discount with a volume discount. A Sydney manufacturer, for example, introduced a new scheme for its customers that offered volume rebates at the end of the year. The more they bought, the more they got back but only if the bills were paid by the due date every month. The incentive to buy more means that increased sales compensate for the cost of the discount.
In a competitive market imposing penalty interest can achieve the same result. It gives debtors the choice of whether to pay on time or pay late and have interest added to the account. Of course if you are going to add interest it must be in your contract with the debtor.
Chartered Accountants Journal of New Zealand