The carrot vs the stick

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There has long been a debate in business regarding the carrot and the stick, as in what works better – an incentive to behave properly, or a disincentive to misbehave. When it comes to credit management there are definitely two distinct schools of thought.

OPTION 1: The Carrot – the prompt payment discount

This approach is used by many power companies, amongst others. When a client pays at or before the due date, they get up to a 15 percent discount, which is a strong incentive indeed and works for a large corporation that has large administrative overheads.

The client question “what’s in it for me” is asked and answered swiftly. And because it is a common industry practice, very little market education is needed and the amount of clients paying late compared to similar providers that do not offer the prompt payment discount would be markedly different in my view.

The issue with applying this to the small and medium enterprise market is that typically a client will pay the lowest amount communicated. Therefore the need to have very strong yet easily understood contractual terms is essential. Added to this, it will require a large amount of client education as it is shift in standard practice, which may make it cumbersome.

The other issue with the above is one of margin. To shift the engrained behaviour of a typical SME client, the discount will need to be considerable. In my experience anything less than 10 percent has little or no effect, which leads to an interesting situation.

The average client these days of any product or service is more educated and has access to more instant information than ever before, including wholesale prices for goods, industry average charge rates for time, IRD vehicle running cost recommendations and the like. If a provider wants to adopt the prompt payment discount option they have two options – swallow a 10 percent reduction on gross margin or try and build in a 10 percent buffer to all priced jobs, while still trying to remain viable and competitive.

OPTION 2: The stick – the finance company approach

As everyone knows well, if you have a loan with a finance provider and you miss a scheduled payment there is a financial penalty. Almost every business person or individual has accessed a loan or funding of some kind, or knows a person who has experienced the consequences of not adhering to the terms that have been agreed.

Using this approach in an SME business is relatively elementary. If the agreed payment is due in seven days or by the 20th of the month following and is not made, then there is a late payment fee or interest is applied to the account and this reoccurs at agreed intervals until the principal amount plus any late payment fees and interest is paid in full.

Of course this is only legal if agreed terms are in place and have been legally disclosed; large fines can potentially be levied against businesses that do this incorrectly. The benefit of this “carrot” approach is that it stops invoices devaluing each month and preserves cash flow level once paid.

However, businesses often neglect to charge the late payment fees and interest even when they have agreed terms with the legal right to do so. This leads to not only a devaluation of the invoice, but also does not encourage improved client payment behaviour. Tools only work when you use them properly.

The advantage of the second option is that is very easy to administer through any common accounts management system such as Xero, MYOB or Quickbooks and allows the provider to retain pricing integrity, which allows them to be more competitive. The second advantage is that late payment fees are an accepted and well known device that most if not all clients have been exposed to. It is generally seen as a natural and automatically applied consequence of the client’s own decision and not a selective punishment.

I have implemented the second option into thousands of businesses and on average we have seen a reduction in payment times of around 11 days in habitual late paying clients and in some extreme cases improvements of 30 days or more.

Just a thought.

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Nick Kerr
Nick Kerr
Nick Kerr is the director of IPI Group Limited. He can be reached on 021 876 527 and nick@nzipi.com.

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