Q&A: How to Calculate Earnings Allowance?

When I thought to write Q&A posts I assumed I'd run out of questions to answer but, from outside the field, very few Bankers or Treasurers understand Account Analysis so it has given me more to write about and - hopefully - this space remains informative.

What is required to calculate the Earnings Allowance?

Calculating your Earnings Allowance (EA) requires:

1. A Collected Balance (CB)
2. The Earnings Credit Rate (ECR)
3. The Reserve Requirement (RR)
4. Days in the Period (DP)
5. Days in the Year (DY)

Where, EA = CB * (1-RR) * ECR * (DP/DY)

In some instances where the month itself is unknown so you cannot accurately calculate whether there are 30 days versus 31 days in the period, some calculations use the following:

EA = CB * (1-RR) * ECR/12

Can you calculate EA without a Collected Balance?

Sure, you can but I wouldn't call it an Earnings Allowance.  If the Earnings Allowance relies on a Collected Balance to determine how much that balance has "earned" to offset qualifying bank service fees, then how can you calculate EA without it?  The answer received...

There is no standard!

Umm.  Yes, that is theoretically correct; there is no standard because no one felt they needed to standardize such a thing.   

When there is difficulty figuring out how your bank is calculating the Earning Allowance (or anything for that matter), the best thing to do is to ask the bank to provide you their calculation formula.  Not including a Collected Balance in an Earnings Allowance calculation formula might appear to be a typo at first until you get a response such as, "there is no standard!"  At that point, you may assume the attitude is, "we can do whatever we want and make up calculations because no one has told us we can't."  

Ask questions and ask them often even requiring an explanation for things that just do not compute.  

Happy Analyzing!

Fee vs Balance Compensation

There are two strategies a treasury department can pursue when determining how to pay their bank fees; Fee or Balance Compensation.

Fee-Based Method

With a fee-based method, Treasurers maintain low account balances fully aware that they will not earn much by way of an earnings allowance.  Why this strategy?  The intent with this method is to forgo any potential earnings allowance and instead pay the service fees incurred. Since the ECR of most corporate accounts have been ridiculously low, most can find investments with higher returns than the bank-offered ECR elsewhere.  When considering the earnings potential of excess funds, the fee-based method may be the best strategy.  Outside of investing, paying down high interest debt is also a great alternative for excess funds.

Balance-Based Method

With a balance-based method, Treasurers maintain certain balances in their accounts to earn enough earnings allowance which then offsets qualifying bank service fees.  Why this strategy?  The ECR is not too low compared to other investment options, the balance compensation method covers the service fees incurred, and the company may stand to gain some benefit from the bank by maintaining high account balances.

Company's vs Bank's Perspective

Neither strategy has consistent pros or cons since both depend greatly on the needs of the company at a given time.  Also, there are other issues to consider such as taxes and the liability of accounting for those high bank balances. Above are some reasons why the Fee-Based or Balance-Based Compensation method is used from a Treasurer's perspective; there are also various reasons to consider from a bank's perspective as well. However, since my day job consists of helping companies save on their bank fees, we will ignore the bank's perspective.  But, it is good to know both and understand both sides of each strategy to understand who stands to gain in either and how best to negotiate, if needed.

One German bank in particular recently notified their balance-based compensation corporate account holders that their billing method will be changed to a fee-based method.  The reason cited for the change was the low interest environment and its currently financial impact.  Sometimes, Treasurers make the best decision possible in the interest of their company.  Other times, the decision is made for them.

Happy Analyzing!