There are several things to be considered when deciding whether to take vendor discounts for paying early as opposed to paying the full amount on time. One of the major drivers of whether or not to take early payment discounts is the set of alternatives that your organization has for using the cash and whether those alternatives would provide a better rate of return than you would get by taking the discount.
As we teach in our online course, Finance For Strategic Procurement, Part II, the rate against which cash usage and investing is evaluated usually is the organization’s weighted average cost of capital. It’s a pretty complex topic too extensive to discuss on this blog. But it takes into account various uses of the organization’s money, from paying down debt, to reinvesting in a growing part of the business, to investing the cash in bank accounts or securities.
Let’s focus on “investing the cash” for a moment.
If an organization’s only benefit to holding the cash longer was the fact that it could earn interest during that time, accepting most suppliers’ early payment discounts will beat that alternative in today’s environment. Handly.
Interest rates for bank investments are ridiculously low at the moment. I’ve seen one bank’s savings rate for a million dollar balance be less than a half-a-percent! And their certificate of deposit rates were not much better, requiring a commitment of at least 48 months just to hit 1%!
Hopefully, your organization has other areas in the business that it can invest in for a greater return. But, if earning interest was the main reason your organization liked to forgo those early payment discounts in the past, the 1 or 2% your suppliers are offering to shave off your price in exchange for paying 20 or so days early looks mighty good right now, doesn’t it?