Unsure about investing in an Enterprise Resource Planning system? A formal return-on-investment (ROI) study can give you the information you need to make the right decision. Sheldon Needle, president of CTSGuides, shares his insights on when and why companies should consider in-depth ROI assessments for ERP planning.
As most of us know, Return on Investment (ROI) is the standard for measuring the value of an investment of any kind. When you’re looking at making a major investment in a new ERP system, you’re undertaking a project that could make — or break — your company. How much will you spend to acquire and implement it? How long will it take for benefits to overtake your investment costs?
To properly compute ROI, a multitude of factors must be considered. Some of these factors are well known; others are much harder to evaluate. For a variety of reasons, many companies don’t bother with a formal ROI study. They’ll do some quick computations on the back of an envelope and make a decision based on that. In my experience, it’s worth the time and effort to go through a formal ROI study before making a major investment in ERP. Here are some of my thoughts on when and why it’s worth the time and effort to undertake a formal ROI study.
Smaller companies may not want to bother with a formal study. A good ROI case can be made for ERP if, for example, a company has trouble controlling its inventory because it lacks an automated inventory control system. This was the case for my company a while back. I purchased a minicomputer system that provided basic real-time inventory data. Within 18 months our revenues grew 100% — while our inventory investment had grown only 25% to meet demand. We saw a huge positive impact on our cash flow and a very high ROI that paid for our entire hardware and software investment within two years.
A question of survival
Another instance in which a formal ROI study may not be needed is when a company clearly needs a new ERP system for long-term survival. I’m talking about a situation in which an ERP system is needed to have productive office staff, warehouse and plant operation so a company will be competitive in terms of product pricing, quality and service.
The role of Business Process Reengineering in ERP choice
Business technology can improve a company’s revenue in any number of ways, including:
- Gaining more customers through cost efficiencies that enable competitive pricing
- Greater shop throughput so human and machine resources can be used optimally
- Real-time statistical reporting of machine efficiencies and throughput with quality variances
- More effective communication through alerts, document access, and real-time shop floor reports, etc.
- Meeting customer expectations through on-time deliveries using ERP capacity planning
- Minimizing stock outs and production delays through better inventory control
- More efficient factory floor by eliminating, combining or improving processes.
Knowing the areas in which your company needs to improve will drive your choice of a new ERP system. However, you’ll need to do more than just sit down with staff and make a list of potential improvements. I recommend performing a true Business Process Reengineering (BPR) study. This often requires bringing in an outside expert with a fresh perspective. That expert will work with staff to assess systems and eliminate duplicative or low value work — a process that involves a major, upfront commitment from key management and operating personnel. This type of BPR study is essential for any $10M+ company because it becomes the foundation for choosing the right ERP system — a system with workflow designed that most closely matches your (now documented) operations.
No matter how much effort you put into ROI predictions and BPR studies, you won’t know all costs and benefits until after your new system is installed and your staff is fully using it. At that point you should be achieving significant benefits and tracking them in terms of ROI. I find it takes most companies a couple of years to reach that point. It’s worth noting that once you have ERP applications deployed (such as business intelligence, dashboards, real-time shop floor reporting, workflows/alerts, and mobile data capture), you will likely find other ways to use ERP technology that you hadn’t considered before.
Let’s talk costs
Now that we have identified potential revenue benefits, what about costs? In the past few years, there has been a quiet revolution in ERP systems pricing that gives buyers more cash-friendly options. Current pricing models include:
- Traditional outright purchase: You purchase the software outright, along with implementation and training and first-year maintenance. Subsequent annual maintenance is typically 18 to 22% of the current retail price of the software.
- Software as a Service (Saas): You pay per month, per number of users, with maintenance costs built into the per-user price. This usually includes an option to buy the software outright after five years.
- Revenue-based or size-based: Your charges are based on company-revenue size, transaction volume or the amount of server space required for your data. With this model your costs can fluctuate year to year.
Regardless of what plan is offered, you will have to pay for implementation and training up front.
Figure in your other costs for ERP
In addition to direct fees paid for the ERP system, implementation, and training, there are other costs to budget for. These include:
- Cost of your team’s time to evaluate and select a system: This cost can be substantial, with the process taking many months. There may be significant opportunity cost as well, because during the search, staff may not be able to perform all their usual tasks. I estimate that as many as 25% of ERP search projects do not result in a buying decision, resulting in a significant waste of resources.
- Information overhead: The system will provide all kinds of great data, but staff time is required to analyze it.
- Staff additions: To get maximum value from a new ERP solution, it’s often necessary to add or replace staff to get needed skills.
- Additional applications and reports: Once an ERP system is in place, you may find the need to buy additional software modules (for tasks such as quality, configuration control or finite scheduling). The creation of new, custom reports can also be a significant expense.
- Staff turnover: This cost is often overlooked. If there are staff changes, and new people need to be trained on the system, it can be costly and disruptive.
- Consultants: Many companies can benefit greatly by using a software professional to aid in the selection and installation of an ERP system. Smaller companies can justify 10 or 15% of software cost while larger companies, with more to lose, can go up to 20 to 30% of the software cost, depending on the scope of the project.
- Closed-loop ROI: Progressive companies should also do a post-installation study to determine if they achieved the benefits and ROI they were expecting.
To cover these additional costs, I recommend adding a minimum of 10% to the vendor’s bottom-line quote.
A major component of acquiring and successfully using a new ERP system involves the process of performing an ROI study and engaging in BPR work prior to beginning the search. A proper ROI study will set the stage for a successful ERP evaluation and selection project, because it forces management and staff to look at everything they are doing and how improved technology support will ultimately go to the bottom line. This occurs through more effective utilization of all company assets — people, machines, or goods and services created and sold.
About the author
Sheldon Needle is President of CTSGuides – the first company to do independent research and evaluations of mid-market solutions for accounting, manufacturing and construction. His services have been used by Microsoft, IBM and Salesforce.com, among others. For more information, see http://ctsguides.com.