How do you estimate the Return on Investment (ROI) of your business management system? What methodology should you use? Companies who identify their possible ROI — before the start of the ERP project (and measure it continuously throughout the implementation process) — stand to gain the most benefits from their ERP solution.
In this article, we explore a simple financial model that calculates the ROI for your implementation of an Enterprise Resource Planning (ERP) system.
The model itself is intentionally simple. We limit our analysis to only three (3) ways in which an ERP implementation generates a financial payback and apply to those cash flows the following techniques:
- Net Present Value of cash flows (NPV)
- Internal Rate of Return (IRR)
- Payback Period
The financial benefits that result from an ERP implementation differ significantly from company to company. So, it is important to note that this exercise is intended to introduce the concepts and encourage you to start thinking about the benefits that will result from your implementation.
Also, please note that the cash flow time horizon in this model is only five (5) years. ERP is a platform on which the business grows over the long term. I've worked with many firms that reaped benefits long after the initial implementation was completed. Consider the firms that earned quality certifications (SQF, ISO 9001, AS9100C) several years after implementing ERP. These firms will be the first to tell you that having a strong ERP foundation on which they run the business made the certification process easier, if not possible.
The heart of an ROI model is a time value of money analysis (please refer to the ROI diagram at the end of the article). In it we net costs versus benefits over a period of time and then — using the three methods above (NPV, IRR, Payback Period) — determine if there is a financial benefit. For this exercise, I chose three areas that provide a financial benefit as the result of most ERP implementations. There are many others, and they vary by implementation. For our purposes, they are:
- Reduced Inventory
- Improved Customer Service
- Reduced Operating Expense
Measuring the last two can be very subjective, and this model attempts to provide objective criteria that will result in the calculation of a reasonable value for each. There is no one correct way to determine the value of a benefit. Just remember that we are attempting to determine the improvement in cash flow that results from the ERP implementation. Another way to think of it: we are trying to quantify the pain we are experiencing today as a result of the way we are forced to operate the business, because we lack an integrated software platform. That pain is probably more expensive that you think. Let’s begin.
Excess inventory — and the wrong inventory — represent cash the business has expended that could have been invested in some other value added activity. Inventory sitting on a shelf — or the wrong shelf in the wrong site — that is not needed to achieve a desired service level could have been invested in research and development, a marketing campaign, or some other value-added activity. It is the cash flow that would have resulted in those other initiatives that represents the benefit from reducing cash locked up in excess inventory.
There are many ways in which ERP enables a firm to reduce its investment in inventory. Material Requirements Planning (MRP) and Master Production Scheduling (MPS) are the two features most commonly attributed to inventory reduction and with good reason. These complex algorithms match the procurement, production, and transfer of product to existing and projected supply and demand. Without this capability, planners frequently “round up” inventory to the quantity they believe is necessary to maintain an acceptable service level.
There are many other capabilities that a properly implemented ERP system provides that lead to inventory reduction. Visibility of historical patterns, existing inventory, and future supply and demand across the supply chain, purchasing, warehousing, manufacturing and sales enables managers to minimize inventory levels and still achieve high service levels relative to actual and forecast demand levels. I've also worked with firms that — because of their ERP implementation — went from a costly periodic inventory system (with time-consuming monthly counts fraught with inaccuracy) to a periodic inventory system. The savings were enormous.
There are many ways to calculate the cash flow from reducing inventory. In our simple ROI model we will provide four figures:
- Inventory value
- Inventory reduction %
- Annual shrinkage %
- Shrinkage reduction %
- Cost of capital
From these we will calculate two cash flows:
- Inventory reduction
- Shrinkage reduction
The inventory reduction percentage is the percentage by which we anticipate we will reduce inventory levels after implementing ERP. Please note that in many cases the nominal value of inventory does not go down after the implementation, but the firm finds that it is able to support higher levels of sales growth with the same inventory expenditure. The calculation is simple:
Inventory reduction = Inventory value * Inventory reduction % * Cost of capital
Why do we multiply by the Cost of capital? Because, if we simply deposit the value of inventory we saved into the bank, we reap no positive cash flow. It is only by investing this savings in some other initiative that we achieve a financial benefit.
The inventory shrinkage reduction calculation is also simple:
Inventory value * Annual shrinkage % * Shrinkage reduction %
Cost of capital does not come into play here because shrinkage represents a true cost to the business. Most firms find that the combination of making and buying what is needed (when it is needed) combined with the enhanced inventory visibility that ERP provides across the business results in lower levels of inventory write-offs.
In our model the value of these two calculations are combined into the Cash Flow line called Reduced Inventory. Also note that each savings is 0 in year 1 when the implementation takes place.
Customer service improvements are an important benefit derived from an ERP implementation, but they can be difficult to quantify and often very subjective. However, over the years I've received feedback from many clients after they have been implemented for several years. They normally say something such as:
We could not handle the level of sales activity we have today without ERP.
We were able to take on Customer X, who now represents 20% of our revenue, and could not have done so profitably without our ERP system.
In our model we quantify this benefit by providing three (3) figures:
- Customer service premium
- Annual revenue
- Net margin percentage
The subjective part of this analysis is the customer service premium. This is a broad percentage that represents the benefit we derive from improved customer service as a result of ERP. As we have seen already, these are multifaceted. Our ability to execute same-day, assemble-to-order service may be a competitive advantage that leads to more business or a pricing premium. Perhaps we are able to respond faster to customer requirements and questions resulting in a higher level of customer satisfaction. A customer service organization that is integrated with Engineering, Purchasing, Manufacturing and Fulfillment has significant operational advantages that lead to superior customer service. However we choose to quantify this, it needs to be reflected in our model. Here is the calculation in the sample model:
Annual revenue * Net margin percentage * Customer service premium
The idea here is that the cash flow that results from the improvement in customer server is based on our net margin. An increase in revenue is not a cash flow. We need to net out cost of goods sold other expenses determine a figure that represents the value of cash that can then be re-invested in the business.
Reduced Operating Expenses
The last of our three representative Cash Flow calculations is Reduced Operating Expenses. Many firms that successfully implement ERP find that they can — operationally — grow at a rate that exceeds their headcount growth rate. For example, purchasing may be able to handle 30% more purchase orders (POs) with the same staff. Each department often experiences this. Fulfillment may process more order lines and manufacturing more work orders at a rate or growth that is more than the corresponding increase in their staffing levels. In our model we provide the following figures:
- Loaded hourly cost per employee
- Number of employees
- Projected revenue growth rate
- Projected headcount growth rate
In the spirit of keeping our model simple the calculation is:
Loaded hourly cost per employee * 20801 * Number of employees * Projected revenue growth rate
Loaded hourly cost per employee * 20801 * Number of employees * Projected headcount growth rate
1Represents the number of hours per year each person works and annualizes the calculation.
Put another way, we are calculating what our increase in labor cost would be if it grew at the same rate as sales less what we expect the lower increase in labor costs to be as a result of our ERP implementation.
There are several considerations. Note: if the two rates are the same, then we expect no reduction in labor cost due to ERP, and this Cash Flow line will be 0. That, based on my experience, is highly unlikely. In fact, numerous times over the years I've had to assuage the fears of employees in various departments that their jobs were safe. For this reason, I always begin the implementation process by reinforcing the premise that the ERP system is being implemented as a platform for growth and as a means by which they will be more productive (and not fired).
Also, to keep this model easy to use, we have simply taken a global loaded hour cost. A more comprehensive model — perhaps for a larger organization — would use separate figures for both hourly cost and growth rate, for each department.
On the surface this may sound subjective, but, have a look around your organization for all of the time wasted because employees lack quick access to accurate, timely information across and even within departments. Time wasted waiting for information, acting on wrong and outdated information, or preparing the information in the first place is a real and significant cost that lowers productivity. A successful ERP implementation results in seamless generation and dissemination of routine as well as business critical information so that employees are working on value-added activities thereby increasing productivity and lowering operating expenses.
There are two cost lines in this model. The first line, Cost, represents the cost of the software license and implementation support in year 1. Figures in years 2 through 5 reflect ongoing maintenance and support costs.
Your staff’s involvement should also be included as a cost in the model. The second line, Staff Implementation, reflects the value of the time they must devote to the implementation. This is only included in Year 1 as after that they will be users reaping the benefits of that effort.
Time Value of Money
Ultimately, an ROI analysis seeks to evaluate the value of cash flow over a period of time to determine if it meets or exceeds a predetermined rate of return, sometimes called a hurdle rate. This model calculates the Net Present Value (NPV), the Internal Rate of Return (IRR) and the Payback Period.
Net Present Value is somewhat difficult to understand. It evaluates the cash flows over a period of time relative to a “hurdle rate” which we are calling the Cost of Capital in our model. If NPV is positive by even $1.00, then you have a rate of return that exceeds your hurdle rate. Anything greater than that is gravy. A negative value does not necessarily mean you have a bad investment; it simply means that the value of the cash flows discounted back to today does not clear the hurdle rate.
Internal Rate of Return is easier to understand but harder to calculate in that it is extrapolated. But, we will not concern ourselves with the calculation: Excel does a fine job of this. IRR equates the cash flows back to what we think of as a traditional interest rate. Interestingly, if you manipulate the numbers in your model so that the NPV is zero, you will find that the IRR equals your cost of capital.
Payback period is the point in time at which cumulative cash flows go from negative to positive. In our example this happens in the ninth month of the second year. Will this actually occur at that moment in time? No. There are so many cash flow assumptions and variables that cannot be accounted for in any model that it is really just an estimate. For example, we are assuming that all costs and savings occur at the beginning of each period. Further, there is an assumption inherent in this model that the implementation will take exactly one year when it could be accomplished in much less.
ROI analysis is not an exact science, even though it appears on the surface that it should be, as it is numerical in nature. Indeed, the easy part is the model itself. The challenge is determining where the current pain is in your business, what it is costing you, how ERP will address these problems, and what that solution is worth financially. The model presented in this article is intentionally simple and intended to start you thinking about the challenges your business faces in these and other areas. The formulae for each of the three benefits presented attempt to provide objective measures for each, but these will vary on a case by case basis, and there is no one way to do so.
Do not limit the scope of your analysis. Again, this model is only looking at three specific areas. Earlier, I mentioned the firms I've worked with who received a mandate from their largest customer to get ISO or other industry-specific quality certification. In each case, features in their ERP system made the process much easier. What is that worth? What would the loss of that customer cost? What additional customers did they gain as a result of the certification? There are others who found that thanks to lot/serial traceability, the cost and scope of recalls was reduced dramatically and in some cases avoided altogether. On the shop floor, visibility of the status and progress of work orders enables firms to quickly adjust the schedule to meet changing customer requirements. In accounting, the real-time flow of activity into the financials empowers management to assess the performance of the firm on an on-going basis and take action sooner.
All of these examples, and many others, translate into financial benefits that can be incorporated into your ROI analysis.
Wise Investments photo credit: PJ Chmiel on Flickr