When a proposal is put forward for implementing an ERP system, two questions are invariably asked i) How much it is going to cost ii) What is the pay back period. It is always preferable to have a cost benefit analysis before embarking on ERP project. A properly done ROI analysis builds a business case for the project. The organization is in a better position to make a decision, set goals and deadlines. This analysis will also create a base that can be used to measure future performance of the system.
ROI in the context of an ERP project
A ROI for ERP project represents metric of completed due diligence and a time phased plan that define when money will be needed and what for it will be used. ROI calculation is made by dividing monetary gain by amount spent. While it is easier to calculate the expenditure for an ERP project, it is difficult to determine the gain, as several gains from the project are intangible and not quantifiable. Typically, ROI involves a pay back period, which is the length of time taken for the cumulative expenditure equals cumulative cost of investment.
Tangible and Intangibles benefits of ERP
Some of the quantifiable and tangible benefits of ERP system are mentioned below: Implementation of ERP, however, does not lead to headcount reduction (redundancies of few lower ended positions of payroll and accounts payable gets counterbalanced by additional higher paid IT staff).
Reduced level of inventory, including raw material, work in progress and finished goods, through improved planning and control.
Reduced materials cost through improved procurement and accounts payable practices, less obsolescence and wastage.
Reduced labor cost through better allocation and reduction of overtime of workmen directly involved with production such as technicians and skilled workers.
Improved production throughput through better scheduling of critical equipment and sub contracting operations, there by minimizing shortages, interruption and rework.
Reduction in the cost of after sales services.
In addition to tangible benefits, following intangible benefits also occur:
Integration of information resulting efficiency, transparency and effective MIS.
Error reduction, accuracy of inventory record.
Improved customer service, on time shipment, shorter order to shipment cycle.
Establishment of standardized procedures.
Improved accounting control and shorter sales to cash cycle.
Legal and regulatory compliance.
Calculation of ROI
There is no standard method of calculation of ROI for an ERP project but a structured method of analysis is achievable. It may be too cumbersome and subjective to factor in intangible benefits. But these factors are important for creating an overall business case and in many instances, where ROI is not calculated, form a base line objective for the project.
First step is to determine cost of various components of the project such as consulting fees, license fees, modification and implementation cost, hardware cost etc. Maintenance fees for a pre determined period (say for three or five years) should be added to arrive at Total Cost of Ownership over the specified period. The estimated expenditure should be time phased over the period, used to calculate TCO.
Next step is the more difficult part which is to estimate expected benefits over a period of time. For estimating these figures, there should be wide consultation and reference to statistics emanating from various survey reports. Benefits will largely occur from the reduction of inventory level, operation cost, labor cost and improved production. Whereas the last three elements will have a direct impact on profit and loss account, the reduction in inventory will cause release of additional cash which can be assigned to a yearly value of saving, based on organizationâ€™s standard internal rate of return.
Relationship between time phased cost and benefit will project a time phased ROI, which will be negative at the outset and will turn positive over the pay back period.
ROI is a bit problematic particularly in term of unquantifiable figures. But it offer a measure of success or otherwise of the project. ROI measurements help in many circumstances specially buy in from project stakeholders, which enhance chances of a successful completion of the project.