Lock Box Example: Transamerica Occidental Life Co.
The lockbox decision can be illustrated with the following example. Suppose that the Transamerica Occidental Life Insurance Company (a subsidiary of Transamerica Corporation), located in Los Angeles, currently receives 'and processes all customer payments at its corporate headquarters (that is, a centralized system). The firm is considering establishing a bank lockbox collection system for seven southeastern states - Florida, North Carolina, South Carolina, Tennessee. Alabama, Georgia, and Mississippi - that would be located in Atlanta. The lockbox would reduce average mailing time for customer payments from 3 days to 1 ½ days, check processing time from 2 days to 1 day, and clearing time from 3 days to 1 ½ days.
Annual collections from the southeastern region are $91.25 million, and the average number of payments received total 550 per day (assume 365 days per year). A bank in Atlanta has agreed to process the payments for an annual fee of $15,000 plus $0.10 per payment received. This bank would not require a compensating balance. Assuming an 8 percent opportunity cost for released funds, should Transamerica use the lockbox collection system?
Table 1 shows an analysis of this decision. in Step A, the amount of funds released ($1 million) is found by multiplying average daily collections ($250,000) by the reduction in collection time (4 days). The annual (pretax) earnings on the released funds ($80,000) are found in Step B - by multiplying the amount of funds released ($1 million) by the opportunity cost of funds (0.08). The annual bank processing fee ($35,075) is computed in Step C as the sum Of fixed costs ($15,000) and variable costs ($20,075). Finally, in Step D, the net (pretax) benefits of establishing a lockbox s) system ($44,925) are computed by deducting the annual bank processing fee ($35,075) from the earnings on the released funds ($80,000). Because the net (pretax) benefits are positive ($44,925), Transamerica should employ the lockbox collection system.
Table 1
Step A:Reduction in collection time = Reduction in mailing time + Reduction in processing time + Reduction in check-clearing time.
= (3 - 1.5) + (2 – 1) + (3 – 1.5)
= 4 days
Average daily collections= Annual collections / 365
= $91,250,000 / 365
= $250,000
Amount of funds released = Average daily collections x Reduction in collection time
= $250,000 x 4 days
= $1,000,000
Step B: Annual (pretax) earnings on released funds = Amount of funds released x
Interest rate
= $1,000,000 x 0.08
= $ 80,000
Step C: Annual bank processing fee = Fixed cost + Number of payments per year x
Variable cost per payment
= $ 15,000 + (550 x 365) x $ 0.10
= $ 15,000 + $ 20,075
= $ 35,075
Step D: Net benefit (net cost) = Annual (pretax) earnings on released funds
-Annual bank processing fee
= $ 80,000 - $35,075 = $ 44,925
Decision: Transamerica should adopt the lock box because it will receive an additional $44,925 in pretax earnings.