Question

​(Cash receipts acceleration system​) Peggy Pierce Designs Inc. is a vertically​ integrated, national manufacturer and retailer of​ women's clothing.​ Currently, the firm has no coordinated cash management system. A​ proposal, however, from the First Pennsylvania Bank aimed at speeding up cash collections is being examined by several of​ Pierce's corporate executives. The firm currently uses a centralized billing​ procedure, which requires that all checks be mailed to the Philadelphia head office for processing and eventual deposit. Under this​ arrangement, all the​ customers' remittance checks take an average of 4 business days to reach the head office. Once in​ Philadelphia, another 1 days are required to process the checks for ultimate deposit at the First Pennsylvania Bank. The​ firm's daily remittances average ​$2.0 million. The average check size is ​$2,500. Pierce Designs currently earns 11 percent annually on its​ marketable-securities portfolio. Under the proposed​ plan, First Pennsylvania said that they could reduce funds tied up by mail float to 2 ​days, and processing float will be eliminated. Funds would then be transferred twice each business day by means of automated depository transfer checks from local banks to the First Pennsylvania Bank. Each DTC costs ​$18. These transfers will occur all 270 business days of the year. Each check processed through the proposed cash collection system will cost ​$0.17.

a. What amount of cash balances will be freed up if Peggy Pierce Designs Inc. adopts the system suggested by First​ Pennsylvania?

b. What is the opportunity cost of maintaining the current banking​ setup?

c. What is the projected annual cost of operating the proposed​ system?

d. Should Pierce adopt the new​ system? Compute the net annual gain or loss associated with adopting the system.

Answer 1

Answer (a)

Cash to be freed up on adoption of proposed system

=Daily cash remittances * Number of days reduced(2 days saved in mail float & 1 day saved in processing float)

=$2 Milion daily

=$6 Million Total in 3 days

Answer (b)

If Peggy pierce designs decide to continue the current banking setup, then it will loose the opportunity of $2 Million cash available to be invested for 3 days to be saved under proposed system.

$2 Million * 11%* 3/365=$1808.22

$2 Million * 11%* 2/365=$1205.48

$2 Million * 11%* 1/365=$602.74

Total Opportunity Cost =$3616.44

Answer (c)

Projected annual cost of proposed system

1. Cost of DTC= 2 times a day*270 Days*$18

Cost of DTC=$9720

2. Cost of check processing =$0.17* (2,000,000*270/2500)

=$36720

Total annual cost =$46440

Answer (d)

Pierce should not adopt the new system. Cost of maintaining proposed system will be higher than cost of opportunity.

Following will be amount of loss on adopting new system

Total Annual Cost of proposed system =$46440

Less: Cost of Opportunity =$3616.44

Net Loss =$42823.56