Can earning prompt-payment discounts really save money?

Healthcare Financial Management, Sept, 1997 by Michael R. Lane

Prompt-payment discounts offer savings opportunities - provided appropriate cash and invoice management strategies are in place.

Healthcare financial managers should determine whether to take advantage of the discounts vendors offer for prompt payment of invoices. Prompt-payment discounts offered by vendors can result in substantial savings, but this benefit may be offset by the costs of acquiring the funds necessary for faster payment. The best results are achieved when the cost of funds is less than the discount savings that can be achieved, vendor discounts are available for a high percentage of the provider's purchase base, the provider is able to negotiate with vendors to increase discount levels, and the provider has an efficient system for processing invoices.

Across all industries, vendors offer discounts for prompt payment of invoices. Although this policy offers healthcare providers an important savings opportunity, it also poses a dilemma - whether to take advantage of prompt-payment discounts or preserve cash assets by disbursing payments over a longer time period. To determine how to take advantage of prompt-payment discounts while preserving cash flow, financial managers must perform a cost-benefit analysis that focuses on the cost of acquiring the funds needed for prompt payment, the potential savings in increased discounts, and the opportunity cost of not obtaining these discounts.

Five variables affect an organization's ability to obtain discounts and the amount of those discounts: purchase base, vendor offers and participation, cost of funds, the ability to recognize and act on opportunities, and the ability to negotiate with vendors.

Purchase base. The purchase base to which discounts may be applied includes supplies, capital equipment, and service contracts. The larger the purchase base of the organization, the greater the savings opportunity discounts may represent.

Vendor offers and participation. The percentage of the purchase base that is eligible for discounts and the level of discounts offered are set by vendors. The number of vendors that participate in discount programs also affects the amount of available discounts.

Cost of funds. The net potential benefit of discounts can be determined by identifying the cost of acquiring the funds needed to make prompt payment, which depends on the funding source (eg, current cash flow, investments, and loans).

Ability to identify and act on discount opportunities. To realize discounts, providers must have processes to identify and promptly act on opportunities for discounts.

Ability to negotiate with vendors. Vendors often are willing to increase discounts in return for higher sales volume or arrangements that reduce the cost of servicing an account. Increasing savings from discounts depends, in part, on a provider's ability to offer vendors advantages.

Funding Sources

To take advantage of discounts, providers must identify an internal source of cash to use for making prompt payment. Making payments within the discount period normally results in a greater cash outflow in a shorter time, and this cash outflow increases with increased vendor participation in discount programs. The three primary sources of cash - current cash flow, investments, and loans - have different advantages and disadvantages.

Current cashflow. To use current cash flow to make prompt payments, a provider needs to accelerate cash disbursements by at least one month, and possibly two or more months. Although this approach is the simplest way to make prompt payments, many healthcare financial managers may decide it is not feasible because the cash would be better used for capital expenditures, investments, or other operating expenses. Even a provider with a strong cash flow would face challenges with this approach. For example, to pay vendors that offer discounts for payment in 10 days, a provider that usually pays in 40 days would have to pay 40 days of cash in 10 days to obtain the discount.

Investments. Another way to make prompt payments is to use funds from current investments. This approach, however, results in the loss of interest, dividend, or capital gains opportunities.

Loans. Although borrowing to obtain discounts may seem counterproductive, loans offer unique advantages and do not affect current working capital levels or investment opportunities. This approach achieves the best results when providers can borrow at a rate lower than current investment earnings. The loan option is usually most successful for providers with significant investments and sophisticated treasury management because their rate of return on investments is usually high. On the other hand, providers with conservative investment strategies, such as investing in government securities, may earn too low a rate of return on investments to make this approach practical. Funds borrowed to pay for discounted products and services will most likely be from a taxable source (not tax-exempt funds) because they generally are used for noncapital purposes.