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ERP: Justifying the Cost

ERP: Justifying the Cost

ERP systems have now been around for long enough so that most CEOs are quite convinced about the benefits they can bring to a company. There are numerous case studies about how installing an ERP has made operations more streamlined, efficient 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 efficacy 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 benefits that accrue from deploying an ERP system. Many of these are tangible or quantifiable in nature; you can calculate the savings immediately. However, there are other benefits as well, and while these may not be quantified so easily, these benefits are very important as well. This whitepaper looks at both tangible and intangible benefits of deploying an ERP solution and attempts to give you good justification for the costs involved. In the first section of this paper, we examine the quantifiable benefits 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 benefits 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.

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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 flow 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 flow of work on the shop floor.

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 find out costs and specifications 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.

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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 flow 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 flow and the bottom line of the company. There are other benefits 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.

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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 flow brought about only by an improvement in billing, accounting and follow-up. Return on Assets this ratio is a good example of the efficiency 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 flow 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.
Current Assets Cash and others Accounts receivable Inventory Fixed Assets Total Assets $5,00,000 $2,000,000 $3,000,000 $3,000,000 $8,500,000 18% 25% $360,000 $750,000 $1,110,000 Improvements Benefits

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 profit. If there are improvements of 5% in material cost, 10% in labor and 7.5% in

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ERP: Justifying the Cost

administrative expenses, then the net improvement due to the ERP can be as much as the pretax profit itself. Such a situation is shown in the table below:
Current Sales Material Labor Overheads Admin Expense Pretax Profit $10,000,000 $7,500,000 $1,000,000 $2,000,000 $2,000,000 $500,000 (60%) (13%) (27%) 7.5% $150,000 $475,000 5% 10% $225,000 $100,000 Improvement Impact

What company can ignore such a benefit?

Intangible Improvements Due to ERP

Besides the fairly easily measured improvements in efficiencies and production and cash flows, 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 floor 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 specification 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 configuration changes. As a result, customers or sales persons can see for themselves the

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ERP: Justifying the Cost

changes that are possible and those that are not. New cost estimates can be calculated on the fly.

Improvement in Accounting Procedures

Since the entire organization runs over a common database, there is no longer any need for duplicate accounting files. 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 verifications. 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 benefits 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 briefly 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 fit with your needs so that the customization is minimized.

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ERP: Justifying the Cost

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 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 benefits that the ERP can bring. Well defined cost versus benefits analysis would help even diehard skeptics be convinced that an ERP implementation represents a growth plan for the future.

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