Lockbox solution - lecture notes PDF

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Chapter 9: Cash Collection Systems Practice Questions 1. Explain the role that each of the following play in the cash collection process. a. Mail float b. Processing float c. Availability float 2. What are the advantages and disadvantages of the following cash collection systems? a. Decentralized collection b. Centralized collection c. Lockbox collection 3. How does a lockbox collection system reduce mail delay? How does it reduce processing delay? How does it reduce availability delay? 4. A company has five remittances for the typical month as listed below. Assume the typical month has 30 days. The days of mail, processing, and availability float for each remittance is also shown. Under the firm’s currently system, remittances of $1 million or more receive expedited processing while all other remittances receive standard processing. Remittance Mail Float Processing Float Availability Float $500,000 5 1 2 $100,000 2 2 1 $50,000 5 1 2 $1,000,000 3 0.5 0 $25,000 1 2 2 a. Calculate the total dollar-day float for the month. b. Calculate the average dollar-day float. c. Calculate the average collection float in days. d. If the annual opportunity rate is 5%, calculate the annual cost of float. 5. As cash manager for a sporting goods manufacturer, you are responsible for the firm’s cash management activities. One of these activities is the management of the firm’s cash collection system. Your firm receives an average of 5,000 remittances per month with an average face value of $10,000. Your current collaction system consists of your customers remitting to your company headquarters. You estimate the average mail delay is 3 days. The typical remittance remains at headquarters for 2 days. You are informed that the average deposit receives good funds in 2 days. a. Based on the information above, compute the monthly total cost for your cash collection system if your firm’s opportunity investment rate is 5% and your bank charges$.35 per item and a monthly fixed cost of $150. b. Your bank, interested in selling you a lockbox system, indicates that a lockbox system would reduce mail float by 2 days, processing float by 2 day, and availability float by 1 day. If the system charges a variable cost of $.80 per item and monthly fixed cost of $500, should you change to the lockbox system? You may assume your opportunity investment rate remains at 5%.

ANSWERS 1. Explain the role that each of the following play in the cash collection process. a.) Mail float: the time delay from the time a check is mailed to the time it reaches its destination. b.) Processing float: the time delay from receipt of the check until the check is entered into the clearing process. c.) Availability float: the time delay from when the check is entered into the clearing process until good funds are credited to the deposit account. 2. What are the advantages and disadvantages of the following cash collection systems? a.) Decentralized collection systems: Advantage - mail and availability delay is minimal. Disadvantages - 1.) the field office may not be very efficient at depositing the checks, 2.) the deposits may remain at the field office's bank account earning minimal rates of return if any. b.) Centralized collection systems: Advantage - A centralized collection system would generally have highspeed processing equipment to ensure quick depositing of checks. Also the cash manage has more control since there are far fewer deposit accounts compared to the decentralized alternative. Disadvantages - mail and availability time would generally be greater than for a decentralized system. c.) Lockbox collection system: The lockbox system is similar to the decentralized collection system in that there are dispersed collection sites to reduce the mail and availability delays. It is similar to the centralized collection system in that there is enhanced corporate control by having the funds deposited in the collection banks transferred on a frequent basis to a few concentration accounts at the firm's credit or disbursing banks. 3. How does a lockbox collection system reduce mail delay? How does it reduce processing delay? How does it reduce availability delay? A lockbox collection system reduces mail delay by placing collection sites relatively close to the customer mailing site. It reduces processing delay by making several pickups daily from the local post office, by using unique zip codes which speeds up sorting, and by using trained staff and state of the art processing equipment and finally by working 24 hours daily. Availability delay is reduced because the collection site is relatively close to the mail site and the bank selection process considers mail float as well as availability float.

4. Calculating float and the cost of float. ASSUMPTIONS: Remittances Mail Processing Availability per month Float Float Float $500,000 5 1 2 $100,000 2 2 1 $50,000 5 1 2 $1,000,000 3 0.5 0 $25,000 1 2 2 $1,675,000 Days in month

30

Dollar-Day Float $4,000,000 $500,000 $400,000 $3,500,000 $125,000 $8,525,000

a.)

Calculating the total dollar-day float for the month Total dollar day float = S [remittances*(mail + availability float)] = $8,525,000

b.)

Calculating the average dollar-day float Average Dollar-Day Float = Total Dollar-Day Float / Days in month = $8,525,000 / 30 = $284,167

c.)

Calculating the average collection float (in days) Average Collection Float = Total Dollar-Day Float / Total Remittance = $8,525,000 / $1,675,000 = 5.09 days

d.)

Calculating the annual cost of float Annual Cost of Float = Average Dollar-Day Float * Discount Rate = $284,167 * 0.05 = $14,208 5. Comparing costs of cash collection systems. ASSUMPTIONS: Average number of remittances per month, N Average face value Mail float Processing float Availability float Total days of float, D Annual opportunity rate, k Fixed cost, FC Variable cost, VC

a.)

5,000 $10,000 3 2 2 7 5% $150 $0.35

Calculating the monthly total cost for a cash collection system TC per month = N * ((F*D*i) + VC) + FC = 5000*((10,000*7*0.05 / 365) + 0.35) + $150 TC per month = $49,845.21 b.) Changing to a lockbox system ASSUMPTIONS Average number of remittances per month, N 5,000 Average face value, F $10,000 Mail float 1 Processing float 0 Availability float 1 Total days of float, D 2 Annual opportunity rate, k 5% Fixed cost, FC $500 Variable cost, VC $0.80 TC per month = N * ((F*D*i) + VC) + FC TC per month = $18,198.63 Yes, change to the lockbox system. The monthly cost drops substantially (over half !)....