Chapter 9 Cash Collection Systems

THIS IS A PRELIMINARY DRAFT OF THE 3rd EDITION IM AND IS SUBJECT TO CORRECTION AND REVISION. IF YOU FIND ERRORS IN THE TEXT OR CALCULATIONS, OR HAVE OBSERVATIONS REGARDING THE CONCEPTS PRESENTED, PLEASE E-MAIL THE IM AUTHOR AT: bordenk@unk.edu . --Karl Borden
Professor of Financial Economics University of Nebraska Kearney, NE

Contents Cash Flow Timeline and Cash Collection The Cost of Float Types of Collection Systems The Lockbox Location Study The Lockbox Model Lockbox Bank Selection A Lockbox Study Case Example Appendix 9A: A Linear Programming Formulation of the Lockbox Model

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Answers to Questions:
1. 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.

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 manager 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. 4. A lockbox collection system helps the cash cycle by reducing collection float thus speeding up the cash cycle. A retail lockbox is characterized by processing a large volume of relatively low face value items with standardized remittance information. A wholesale lockbox is characterized by processing a relatively low volume of high face value items with non-standardized remittance information. The variables include: number of items, average face value, days of collection float, variable processing cost per item, and fixed cost. Customer groups versus individual customers. Remittance sample. Mail and availability times

5. 6.

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7.

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. It will definitely increase the efficiency of collection systems by reducing the number of banks that a company will need to deal with. Increasing efficiency will reduce the costs associated with collections and it will also tend to speed up the receipt of cash.

8.

Answers to Questions:
1. 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. 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. 4. A lockbox collection system helps the cash cycle by reducing collection float thus speeding up the cash cycle. A retail lockbox is characterized by processing a large volume of relatively low face value items with standardized remittance information. A wholesale lockbox

2.

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is characterized by processing a relatively low volume of high face value items with non-standardized remittance information. 5. 6. 7. The variables include: number of items, average face value, days of collection float, variable processing cost per item, and fixed cost. Customer groups versus individual customers. Remittance sample. Mail and availability times They both use the same data variables and they both start out with the one-site collection point with similar calculations. However, then the complete enumeration model begins to assess ALL possible combinations of collection sites while the greedy algorithm evaluates combinations of ever increasing collections sites that only include previous optimal combinations of sites. 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. It will definitely increase the efficiency of collection systems by reducing the number of banks that a company will need to deal with. Increasing efficiency will reduce the costs associated with collections and it will also tend to speed up the receipt of cash.

8.

9.

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Solutions to Problems: Chapter 9

1. Calculating float and the cost of float. ASSUMPTIONS: Remittance Mail per month Float $100,000 2 $5,000 7 $300,000 1 $10,000 5 $150,000 4 Total $565,000 Annual opportunity rate Days in month a.)

Availability Float 1 2 1 1 2

Dollar-Day Float $300,000 $45,000 $600,000 $60,000 $900,000 $1,905,000=Total

4% 30

Calculating the total dollar-day float for the month Total dollar day float = S [remittances*(mail + availability float)] = $1,905,000= b.) Calculating the average dollar-day float Average Dollar-Day Float = Total Dollar-Day Float / Days in month = $1.905 mil / 30 = $63,500 Calculating the average collection float (in days) Average Collection Float = Total Dollar-Day Float / Total Remittance = $1.905 mil / $565K = 3.37 days Calculating the annual cost of float Annual Cost of Float = Average Dollar-Day Float * Discount Rate = $63,500 *.04 = $2,540 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 Annual opportunity rate Days in month a.) 5% 30

c.)

d.)

2.

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

Calculating the total dollar-day float for the month

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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 mil / 30 = $284,167 Calculating the average collection float (in days) Average Collection Float = Total Dollar-Day Float / Total Remittance = $8.525 mil / $1,675K = 5.09 days Calculating the annual cost of float Annual Cost of Float = Average Dollar-Day Float * Discount Rate = $284,167 * 0.05 = $14,208 3. Comparing costs of cash collection systems. ASSUMPTIONS: Average number of remittances per month, N Average face value, F Mail float Processing float Availability float Total days of float, D Annual opportunity rate, k Fixed cost, FC Variable cost, VC

c.)

d.)

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

a.)

Calculating the monthly total cost for a cash collection system TC = Total cost N= # of remittances F= Average face value of remittances D= Total days of float i= Daily opportunity cost VC= Variable cost FC= Fixed cost TC per month = N * ((F*D*i) + VC) + FC = 5000*((10,000*7*0.05 / 365) + 0.35) + $150 TC per month = $49,845

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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 = $18,199 Yes, change to the lockbox system. The monthly cost drops substantially (over half !). Comparing costs of cash collection systems. ASSUMPTIONS Average number of remittances per month, N Average face value, F Mail float Processing float Availability float Total days of float, D Annual opportunity rate, k Fixed cost, FC Variable cost, VC Total Cost for cash collection system TC = Total cost N= # of remittances F= Average face value of remittances D= Total days of float i= Daily opportunity cost VC= Variable cost FC= Fixed cost

4.

130,000 $285 3 1 1.5 5.5 4% $125 $0.25

a.)

Calculating the monthly total cost for a cash collection system TC per month = N * ((F*D*i) + VC) + FC TC per month = $54,957 Changing to a lockbox system ASSUMPTIONS

b.)

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Average number of remittances per month, N Average face value, F Mail float Processing float Availability float Total days of float, D Annual opportunity cost, k Fixed cost, FC Variable cost, VC TC per month = N * ((F*D*i) + VC) + FC TC per month = $106,046

130,000 $285 1 0 1 2 4% $425 $0.75

No, do not switch to the lockbox system since monthly costs increase.

5.

Determining the optimal number of lockboxes and customer allocation.

ASSUMPTIONS: Annual opportunity rate = Average Customer Monthly Group Remittances Remittances Number Face Value 1 2,000 $50,000 2 4,000 30,000 3 1,000 18,000 4 200 20,000 Variable Processing Costs Fixed Costs

8.00% Days of Float Bank A Bank B 5 3 1 6 3 7 7 1 $0.30 $300 $0.60 $400

Bank C 1 4 5 3 $0.80 $150

1-Bank Solution: Variable Costs = N*(F*d*i + VC) Example: for Bank A in Group 1, Variable Costs = 2000 * [(50000 * 5 * 0.08 / 365) + 0.30]

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1-Bank Solution: Group 1 2 3 4 Bank A Bank B Bank C

Fixed Cost Total Cost

$110,18 9 $66,953 $23,518 $160,20 $108,40 $27,501 8 5 $12,136 $28,216 $20,526 $6,197 $997 $2,790 $300 $156,32 3 $400 $256,77 5 $150 $155,3 89 minimum cost for a 1-bank system

2-Bank Solution: 2-Bank Solution: Group 1 2 3 4 Total VC Fixed Cost Total Cost Combinatio Combination n1 2 Bank A Bank B Bank A Bank C $27,50 1 $12,13 6 $66,953 $27,501 $12,136 $997 $39,637 $300 $2,790 $26,308 $150 $997 $997 $400 $23,518

Combination 3 Bank B Bank C $23,518 $108,40 5 $20,526 $152,44 9 $150

$39,63 7 $67,950 $300 $400 $108,28 7

$66,39 $153,99 5 6 minimum cost for a 2-bank system

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3-Bank Solution: 3-Bank Solution: Group 1 2 3 4 Total VC Fixed Cost Bank A $27,50 1 $12,13 6 $39,63 7 $300 $997 $997 $400 $23,518 $150 $65,00 2 Select the 3-bank system since it minimizes total costs. As for customer allocation, customer group 1 remits to Bank C. Customer group 2 remits to Bank A. Customer group 3 remits to Bank A. Customer group 4 remits to Bank B. Combination 1 Bank B Bank C $23,518

6.

Determining the optimal number of lockboxes and customer allocation. Assumptions Opportunity rate 8.00%

Group

Customer Average monthly Remittan ces Remittances Number 500 1,000 100 50 Face Value $50,000 30,000 18,000 20,000 Bank A 5 1 3 7

Days of Float --------Bank B 2 5 4 1 Bank C 1 4 5 3

1 2 3 4

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Variable Processing Costs Fixed Costs

$0.25 $500

$0.70 $600

$0.50 $400

1-Bank Solution: Group 1 2 3 4 Fixed Cost Total Cost Bank A Bank B Bank C $5,729 $26,801 $2,023 $683 $400 $35,63 6

$27,52 2 $11,309 $6,825 $33,577 $1,209 $1,648 $1,547 $254 $500 $600 $37,60 3 $47,388

2-Bank Solution: Group 1 2 3 4 Total VC Fixed Cost Total Cost 3-Bank Solution:

Combinati Combinati Combination on 1 on 2 3 Bank A Bank B Bank A Bank C Bank B Bank C $11,30 9 $6,825 $1,209 $8,034 $500 $254 $11,56 3 $600 $20,69 7 $6,825 $1,209 $683 $8,034 $500 $6,412 $400 $15,3 46 $5,729 $1,648 $254 $1,902 $600 $5,729 $26,80 1 $32,53 1 $400 $35,43 3

Combination

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1 Group Bank A 1 2 3 4

Bank B Bank C $5,729

$6,825 $1,209 $254 $8,034 $500 $254 $600 $5,729 $400 $15,51 8

Total VC Fixed Cost

Minimum Cost $15,3 Solution= 46 Select the two-bank system, A & C 7. Determining the optimal number of lockboxes and customer allocation. Assumptions Opportunity rate 8.00%

Group

Customer Average monthly Remittan ces Remittances Bank A 6 5 1 $0.55 $350

Face Number Value 1 2,000 $500 2 10,000 900 3 4,000 1,500 Variable Processing Costs Fixed Costs

Days of Float -----Bank B 2 1 4 $0.20 $550 Bank C 1 3 6 $0.70 $250

1-Bank Solution: Group 1 2 Bank A $2,415 $15,36 3 Bank B $838 $3,973 Bank C $1,619 $12,918

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3 Fixed Cost Total Cost

$3,515 $350 $21,64 3

$6,060 $10,690 $550 $250 $11,42 1 $25,477

2-Bank Solution: Combination Combination Combination 1 2 3 Group Bank A Bank B Bank A Bank C Bank B Bank C 1 2 3 $3,515 $3,515 $350 $4,811 $550 $9,226 $838 $3,973 $3,515 $3,515 $350 $1,619 $12,91 8 $14,53 7 $250 $18,65 2 $838 $3,973 $6,060 $10,87 1 550

Total VC Fixed Cost Tot. Cost

$0 $250 $11,67 1

3-Bank Solution: Group 1 2 Total VC Fixed Cost 3 $3,51 5 $3,51 5 $350 Combination 1 Bank Bank A B Bank C $838 $3,97 3 $4,81 1 $550

$0 $250 $9,47 6

Minimum Cost Solution =

$9,22 6 Select the two-bank system, A & B

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8.

Determining the optimal number of lockboxes and customer allocation. Assumptions Opportunity rate Customer Remittan ces

10.00% Average monthly Remittances Days of Float --------Bank B 6 4 5 $0.40 $500 Bank C 1 3 4 $0.70 $250

Group

Bank Number Face Value A 1 50,000 $98 5 2 100,000 55 1 3 75,000 125 3 Variable Processing Costs $0.55 Fixed Costs $350

1-Bank Solution: Group 1 2 3 Bank A Bank B Bank C $36,342 $74,521 $62,774 $250 $173,88 7

Fixed Cost Total Cost

$34,212 $28,055 $56,507 $46,027 $48,955 $42,842 $350 $140,02 5 $500 $117,4 25

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2-Bank Solution: Combination Combination 1 2 Combination 3 Group Bank A Bank B Bank A Bank C Bank B Bank C 1 2 3 Total VC Fixed Cost Total Cost $0 $350 $28,05 5 $46,02 7 $42,84 2 $116,9 25 $500 $117,7 75 $34,21 2 $56,50 7 $48,95 5 $139,6 75 $350 $28,05 5 $46,02 7 $42,84 2 $116,9 25 500

$0 $250 $140,2 75

$0 $250 $117, 675

3-Bank Solution: Group 1 2 3 Total VC Fixed Cost $0 $350 Bank A Combination Bank B $28,055 $46,027 $42,842 $116,92 5 $500 1 Bank C

$0 $250 $118,025

Minimum Cost Solution =

$117,425

Select the one-bank system, B