When Giving Discounts is Okay

Earlier this year, I wrote a post about the dangers in giving discounts to your customers. This post has recently been getting lots of traffic - both via search engines and a freelancer forum - that I thought I should discuss some situations where giving discounts is okay.

In my experience, you should generally avoid giving discounts unless you are getting something of value in exchange.

But what merits giving a discount? That depends on your business, your industry, and your personal preferences. One of the best reasons for giving a discount is in exchange for a quicker payment. This is what 2/10 n30 invoices are based off of: Your invoice is due in 30 days, but should you pay us in ten days, we will give you a 2% discount. In this example, having the cash available to you within 10 days is worth the same or more as the 2% cost you are essentially paying.

Another example? If you are in a Software as a Service business for example (or any other business that offers a service on a monthly basis), you want to balance monthly recurring revenue (MRR) with your pre-payments. So you offer a x% discount to your customers who prepay the year upfront. You get cash upfront, and they get a discount (incentive) for doing so.

By offering discounts in exchange for something of value, you are not devaluing your own products and services because you are asking for something in exchange. This is different from the type of discount many small business owners offer where they give the customer a discount just because he/she asked.

How to determine what a good percentage discount should be

This will vary by every factor imaginable. But one way is by determining how much money is worth to you.

The basic premise in finance is that receiving $1 today is worth more than receiving $1 a year from today - because you could take that $1 today, invest it, and in a year's time have $1 + interest. In other words, you can invest the money you receive today into growing your business which would allow you to (potentially) have more money in the future. There is a value to having cash now - even if the literal dollar amount is less than what it would be in the future.

So let's assume your widget-selling business operates in a vaccuum, in which there is infinite demand, and you can buy a blue widget for $10 and sell it for $12. In this simple example, there are no other costs. This means you earn a (12 - 10)/10 = 20% return for each widget you sell.

Now let's say a friend owes you money - and when he repays you - you are going to invest that money into your business. Your friend says to you, "I have $900 in my hand right now. I know I owe you $1,000 in 12 months. Would you rather I give you $1,000 in 12 months or give you $900 today and settle the debt?"

If you take is $900 and invest it into your business, you are going to have $900 to buy 90 widgets and sell them at $12 a piece for a total value of $1,080. That's more than the $1,000 your friend owes you. In a situation like this, you would be willing to take less money today because you know you can invest it in your widget business and have more money at the originally-scheduled time of repayment.

You can also work backwards, and take $1,000 back one year: $1000/1.2 = $833.33. This means you would be indifferent to accepting $833.33 from your friend today or $1,000 from your friend in one year. If he offers you anything more than $833.33, than you are actually going to be that much better off.

So when  you are calculating discounts for your customers, you may decide to work backwards and determine the minimum you are willing to accept today to be indifferent. Here is the basic formula for working backwards (called discounting cash flows):

$/(1 + r)^t

$ = the dollar amount you could receive in the future
r = the value money has to you as a percentage (20% is what we used above)
t = time in years.

So if a customer owes you $2,500 in 12 months, and you decide to use a rate of 30%:

$2,500/(1+0.3)^1 = $1923.08

At that amount you would be indifferent as long as the customer paid you today as opposed to in one year. If you offer this customer a discount of $300 for paying today, you are receiving $2500 - $300 = $2,200 which in one year will be worth $2,200 x 1.3 = $2,860. It is worth more in one year because your business (remember, we're in a vaccuum) produces 30% returns. In this situation, you would have been able to leverage the situation to earn an additional $2,860 - $2,500 = $360 just by having the money in your pocket twelve months earlier.

I just need something simple

For many freelancers or small business owners, this may seem like overkill. But it is good to have an idea of what an advanced payment is worth to you. The math used here isn't as important as the concept - offering a prepayment discount can be smart business. If you are in an extremely high-growth business, where you could utilize additional capital to grow, you may choose to use a rate of 35-45%. If you're in a business where you have some growth, but the additional capital is only moderately beneficial in producing more sales, you may use something more conservative like 10-15%.