ERP: Justifying the Cost

ERP: Justifying the Cost | Compare Business Products 2012

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ERP: Justifying the Cost
ERP systems have now been around for long enough so that most CEOs are quite convinced about
the benefts they can bring to a company. There are numerous case studies about how installing an
ERP has made operations more streamlined, effcient and agile. The situation is even better now
since a large number of solutions are available that cater to different companies both in terms of size
and business verticals.
Even though there is no doubt about the effcacy of the ERP solution, these solutions can be a fairly
large investment for a company to make. Therefore, most company Boards would look for a well
reasoned return on investment calculation before they give you a go-ahead. This whitepaper sets out
to help you make a convincing business case to justify the cost of an ERP solution.
There are many benefts that accrue from deploying an ERP system. Many of these are tangible or
quantifable in nature; you can calculate the savings immediately. However, there are other benefts
as well, and while these may not be quantifed so easily, these benefts are very important as well.
This whitepaper looks at both tangible and intangible benefts of deploying an ERP solution and
attempts to give you good justifcation for the costs involved. In the frst section of this paper, we
examine the quantifable benefts of deploying an ERP solution.
Inventory Reduction
In a typical successful ERP installation in a production company, a 20% inventory reduction becomes
a commonly achieved benchmark. This is not only a one time savings of 20% of your inventory
cost but there is a recurring element to it as well in terms of lower warehousing costs, handling and
transportation and reduced damage and obsolescence etc. Together, these can contribute another
5% to 10% to your inventory related savings. Therefore the overall savings in inventory and its
management alone can be of the order of 30% of the total inventory related your company manages.
There are other benefts too besides simply reducing the inventory and its carrying costs. While
ensuring a reduced inventory, the ERP also ensures that only the useful items of inventory would be
stocked. Since inventory would only be acquired based on actual requirements, a buildup of obsolete
material would be prevented and there would be fewer shortages of parts. An implementation of just
in time stocking can ensure that manufacturing is leaner and funds are better utilized to meet more
important business needs.
ERP: Justifying the Cost | Compare Business Products 2012
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ERP: Justifying the Cost
Reduction in Material Costs
An ERP leads to improved procurement practices. Since your forecasting improves, your company
is able to place orders well in time and avoid emergency purchases. As a result, the purchase
department is able to obtain better terms and conditions from vendors. Since you are able to give
your vendors a better forecast of your demands, they in turn are able to plan their production
better and can pass on part of the savings to you. Better demand forecast allows your purchase
staff to obtain better terms from your vendors and eventually this can mean a 5% reduction in your
purchasing costs.
Lower Cost of Labor
Since your manufacturing practices improve with the advent of the ERP, your work schedule will
suffer from fewer outages and interruptions. This can directly translate to reduced need for re-work
and reduced overtime payments for the same amount of production. Better forecasting of demand
and an improved work fow also means that you are required to do a smaller number of rush jobs as
compared to the time before you had installed the ERP. This reduces the requirements to re-set up
your machines and tools and improves the throughput in your factory. All of these add up to lower
production costs and better quality. It has been estimated that a well used ERP can bring down your
direct and indirect labor costs by as much as 10% by reducing overtime and re-work and speeding up
the fow of work on the shop foor.
Improved Sales and Customer Service
Another major impact of the ERP solution lies in improvements in Sales and Customer Service. Better
coordination within the company and streamlined production leads to improved sales. The lead time
to ship orders reduces and new customer requirements can be priced and produced quickly. In many
cases, customers are themselves able to interact with the system to fnd out costs and specifcations
directly without having to go through salesmen.
Yet another advantage of the ERP is in making the entire production system more agile. Such a
system allows customers to alter their demands fairly late into the production cycle. This improves
customer loyalty and brings about a better business environment. Your customers are able to
determine the dates of delivery more accurately. Your own agility to meet unforeseen customer
demand improves.
ERP: Justifying the Cost | Compare Business Products 2012
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ERP: Justifying the Cost
All of the above capabilities add to sales and customer retention. As a result, a company running
a good ERP system sees fewer lost sales, an increase in overall sales and far greater customer
satisfaction. This increase can be as much as 10% of the previous sales value.
Improved Accounting and Cash Flow
Companies that run ERP systems report a reduction of the number of days for their accounts
receivable. This occurs because of better accounting, billing and reconciliation procedures. There
is a closer follow up on outstanding or delinquent accounts and the efforts of executives are better
channelized towards reducing such accounts.
By simply reducing the days the receivables are outstanding, an ERP can improve your cash fow
considerably. Besides this, the ERP also allows you to improve trade credit utilization by taking
advantage of any possible supplier discounts and credit facilities. You can also plan your cash
utilization much better because the needs are forecasted accurately. This leads to a reduced
requirement of cash.
Impact of the ERP on Financial Ratios
The preceding few paragraphs showed the impact of the ERP on cash fow and the bottom line of
the company. There are other benefts to the company as well. These can be measured in terms of a
number of its operating ratios.
Three ratios are often closely monitored by the senior management. These are
Inventory turnover ratio
Days of receivables ratio
Return on Assets
Here is how each of these gets better
Inventory Turnover - A high inventory turnover means better material management. Low turnover
means that the inventory is stocked with material that is not really required or that the inventory is
overstocked. In a typical company, the turnover was about 2.5 times a month. With an ERP bringing
about streamlining of the inventory, this increased to 3.1.
ERP: Justifying the Cost | Compare Business Products 2012
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ERP: Justifying the Cost
Days of receivables ratio this represents the number of days in average that receivables
are outstanding. During this time the cash is blocked and no interest is being earned. In many
cases, ERP reduced this to about 60 days from a pre ERP average of about 73. This is a serious
improvement in cash fow brought about only by an improvement in billing, accounting and follow-up.
Return on Assets this ratio is a good example of the effciency of the management in managing
the company. In a number of cases, this ratio has been found to have doubled from an average value
of around 6 to around 13 post implementation of the ERP.
A Worked Example
In a typical case of a factory with $10 million annual revenue, the largest impact was found to be
in the inventory and in the accounts receivable. Such a company typically has around $3 million
in inventory and about $2 million in receivables at any given time. A reduction of around 25% in
inventory costs means $750,000 in freed up capital and reducing receivables by 18% (a typical
value) implies a net improvement in cash fow by about $360,000. Just these two heads alone add
$1.1 million to the cash availability. If you add other savings such as those due to better purchasing,
reduced labor and re-work costs and better customer care and sales, total savings are even larger
and reach about $1.2 million.
Yet another view of the same company could look at the cost of sales and the improvements to it due
to the ERP.
Taking the same company with $10 million in sales, the cost to produce and sell is around 75% of the
cost of sales. The remaining 25% represents the cost of running the company and the pretax proft.
If there are improvements of 5% in material cost, 10% in labor and 7.5% in administrative expenses,
Current Assets Value Improvements Benefits
Cash and others $5,00,000
Accounts receivable $2,000,000 18% $360,000
Inventory $3,000,000 25% $750,000
Fixed Assets $3,000,000 $1,110,000
Total Assets $8,500,000
ERP: Justifying the Cost | Compare Business Products 2012
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ERP: Justifying the Cost
then the net improvement due to the ERP can be as much as the pretax proft itself. Such a situation
is shown in the table below:
What company can ignore such a beneft?
Intangible Improvements Due to ERP
Besides the fairly easily measured improvements in effciencies and production and cash fows, there
are many improvements that are more intangible in nature but are equally important to the company.
These are also important considerations when you decide to go in for an ERP implementation. Many
of these intangible improvements are critical to the future success of the company.
Improvement in Process Design and Production
Since the ERP uses a common database that runs through the factory foor as well as through the
design section, it allows far better control over process design and production. This ensures that
any planned changes to product specifcation are well controlled and do not create inconsistencies
in design. In case any emergency changes are required, the changes are communicated to all
concerned sections (including inventory and procurement and purchase) well in time. This results in
greater stability and agility of the manufacturing process and allows for a faster response time.
In many cases, the ERP itself can incorporate the design and engineering rules that support or deny
confguration changes. As a result, customers or sales persons can see for themselves the changes
that are possible and those that are not. New cost estimates can be calculated on the fy.
Current Improvement Impact
Sales $10,000,000
Material $7,500,000 (60%) 5% $225,000
Labor $1,000,000 (13%) 10% $100,000
Overheads $2,000,000 (27%)
Admin Expense $2,000,000 7.5% $150,000
Pretax Proft $500,000 $475,000
ERP: Justifying the Cost | Compare Business Products 2012
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ERP: Justifying the Cost
Improvement in Accounting Procedures
Since the entire organization runs over a common database, there is no longer any need for duplicate
accounting fles. This improves accuracy and speeds up the accounting process. Product costing
is rapid and the various cost structures such as those of material, production, labor etc are clearly
visible.
As each order moves through the production line, the accounting and recording statements are
automatically generated and the general ledgers are kept updated. Customer invoices are generated
automatically with the proper verifcations. As a result, various time-based reporting statements
can be generated with ease without any additional work. This improves the accuracy of control and
timeliness of reports. Decision support tools work on actual data rather than on projections. It is
obvious that in such a case, the quality of the decisions will be better.
Improvement in MIS Functions
The ERP system is implemented as a composite software package and this has a number of benefts
when it comes to Management Information Systems. The MIS is no longer required to collate
information from different data sources and is able to offer an instantaneous view into the companys
fundamentals. The MIS staff is able to service user needs better as a result of this integration.
A Word about Costs
There are several elements to the costs of the ERP solution you buy. Some of the major elements
are listed below and explained briefy
Software - This is what catches the eye to begin with. Prices can begin from tens of thousand dollars
and run into millions. If you add the cost of customization of the software, you could easily increase
by cost by $100,000 or more. It makes sense to look at a package that is a close ft with your needs
so that the customization is minimized.
Hardware This will depend on what you already have and how much of it can be reused. Many
times, you cannot disturb whatever existing systems you are already using and hence will perforce
have to go ahead and acquire new hardware.
Consultancy and Assistance you need to budget for consultancy and training costs. In some
cases, these can be provided by the vendor within the cost of the solution itself. Even if this is
ERP: Justifying the Cost | Compare Business Products 2012
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ERP: Justifying the Cost
provided for, it would be wise to cater for about 25% of the software cost as ongoing maintenance
and upgrade costs.
In Conclusion
There is no denying that deploying an ERP solution is a major event in the life of a company. The
costs involved are substantial and not every member on the Board understands the benefts that
the ERP can bring. Well defned cost versus benefts analysis would help even die-hard skeptics be
convinced that an ERP implementation represents a growth plan for the future.