WHAT MY ERP COST? Assessing Risks for an Achievable ROI

Transcription

1 WHAT MY ERP COST? Assessing Risks for an Achievable ROI

2 Contents About the Author Introduction Who is Making the Decision Why is a Decision Necessary? Cost of an ERP System ROI Calculation About Indusa

3 About the Author Keith Reali, Solutions Architect, Indusa: Keith has over 35 years of experience in manufacturing as a Controller, Cost Accountant, and General Manager. In his positions he has been involved with evaluating numerous software purchases. His 25 years in positions of responsibility combine to provide client organizations with a resource to help improve operational effectiveness. In my encounters with customers looking for ERP systems, they often ask, How much will it cost? What follows is my response, but the gist is that ERP systems should not cost anything. I suppose asking your company to pay for something based on a total cost of ownership gets you off the accountability hook for the results of the decision. Maybe my financial background provides this perspective, but I believe purchasing an ERP software should be viewed as an investment, not an expenditure. As such, the benefits should pay back the investment over time. 3

4 Introduction Acritical component of evaluating any decision is risk. Risk is very subjective, but can severely affect the outcome of an investment. So in the discussion I want to talk to how the probability of an expected outcome should factor into the calculation. By assessing risks, and therefore becoming aware of their existence and magnitude, it is more likely that you will achieve the intended ROI. Choosing an ERP software can be challenging and filled with many anxious moments. Since ERP spans the entire enterprise and will forge the course of how you do business for at least the next five years, you can imagine the anxiety it creates for the person responsible for the outcome. This ROI uncertainty is probably the main reason so many companies are still limping along on outdated legacy systems. Who wants to be responsible for that decision? If it goes south, that person will get the blame. If it goes well, everyone else will take the credit. It takes a person with a strong will and confidence to see the ERP implementation through. Figure 1: Common selection criteria for ERPs 4

5 Who is Making the Decision? How do businesses make a decision about the right ERP software for their enterprise? A lot depends on who is making the decision. Enterprise software is complex because the solution will be used by so many different business units. Each business unit may evaluate the business needs from a different perspective. And then, whose needs take priority? Finance? Operations? Supply chain? How about IT? They all are important. Perhaps a democratic approach would be fair? Each representative would have one vote. But the IT department might argue, they have to maintain the system, so they should have more say. They are the technology experts. In most cases, finance is the driving force because they review investment spending. Operations will point out that business is about delivery to the customer, and they need tools that will help, as they are the driver of the business. These are all good arguments, but before we can answer the question of who, we need to investigate why. The truth is the why may be different in each organization, at different times, under varying circumstances. One answer is certain: ERP decision making will require a central figure to act as moderator. Someone that will listen, play devil s advocate in discussions, and objectively evaluate the merits of each benefit as it relates to the overall operation of the enterprise. 5

6 Why is a Decision Necessary? There are many reasons to purchase an ERP system. The most common is to replace older systems with capabilities that are required now but were not there when a previous purchase was made. Perhaps your business has outgrown your old system and the informational needs of the business today are more sophisticated or require more visibility. There is also a growing need for accessible and realtime data. Or perhaps your enterprise has been slowly accumulating separate applications and linking them together to accomplish individual business unit requirements with no overall strategy for the enterprise. I worked for an organization that maintained 30 separate applications that could be replaced with a few good enterprise tools. Imagine the cost of licensing and time to keep all those separate applications running. Not to mention the difficulty finding people with the skills to support all those applications. Another possibility could be that a decision is necessary for housekeeping purposes. A manager of IT once made the argument that he could do so much more, if he did not have to maintain the old legacy systems that keep breaking and didn t work well with newer technologies. He wanted to be more innovative and forward thinking, rather than just fixing the old solutions. The demand on today s ERP system to provide information quickly and accurately is greater than ever. Old systems allowed you to extract data into an outside database for manipulation and analysis; or, reports were created by sorting and arranging the same information in different ways. When I was a general manager, I marveled at my staff meetings when sales and operations would bring separate reports showing different perspectives of the same data. Sales would present an 6

7 analysis of production flaws, and production would present data to support their position that sales was at fault. In a real-time world, information has to be immediate and accurate. As one client put it, a single source of the truth. I sat in those staff meetings with a laptop in front of me verifying details behind the reports. No matter what they said, the raw data told me the truth as it related to the performance of the entire business. In today s world, decisions have to be made quickly. Information needs to be real time and at the fingertips of managers making decisions. ERP systems in the past were viewed as accounting systems. Today, ERP systems provide integrated information across the enterprise, allowing better visibility of data to facilitate better and more reliable "The focus of this Magic Quadrant is on ERP systems that support a single-instance strategy for multientity midmarket and upper midmarket companies. User-centric improvements focused on usability and deeper integration on analytical capabilities is at the core of leading systems." Gartner Figure 2: Gartner ERP Magic Quadrant

8 decisions from CRM activity, order management, supply chain, demand forecasting, resource planning and product costing. And yes, ERP systems sort the data all out in the financial ledgers in more detail than ever before. What is the best ERP system for your company? How should you decide? Should you base it on a recommendation of a friend? Well, if your friend knows the unique business processes of your particular company, then you might give it some merit. More likely, you ll need to weigh multiple factors. What about a system that you worked with at another company? Why not? You made it work at that company, why not in your present company? Again, be sure your business model is supported by that system. Two different businesses in the same vertical can operate with completely different processes. They can look at different metrics, manage orders differently, and prioritize demand using different tools. And don t lose track of the fact that ERP systems will force change upon users that they may not handle well. To aid change management, a system that provides a familiar user experience will go a long way to getting acceptance. I ve seen companies that successfully implemented ERP systems, but the success had nothing to do with the software. In the 90s, I was involved in the selection of an ERP system. The vendor set up a visit to an existing customer to show us how well their software worked. After the visit, my CFO remarked that it was pretty impressive software. I had to point out that any software would have had the same results. The remarkable thing to me was that the president and the controller were so like-minded in their approach to their business. If one started a sentence, the other could almost finish without missing an adjective. It points out that people may have more to do with the success of an ERP system than the software. I disclose this because I believe that deciding on an ERP system should be approached as any investment for the company would be. It is not just an outlay of cash. It needs to be paid back. The greatest lesson I learned about that approach was when I once requested $50,000 to purchase an application. When my 8

9 VP signed the appropriation he immediately took out a notepad and wrote, IOU $50,000. He had me sign it and then he put it in his drawer. He warned me that he had the right to pull it out in 6 months and ask, Where is my $50,000? He never did that, but I was always prepared to answer that question. I made sure that I could demonstrate that the benefit in real dollars turned out to be $500,000. But the point was made. Since then I have never requested any funding unless I was willing to come back and answer that question. Will you be? To treat the decision as an investment, start with identifying the benefits and attach real measurable dollars to the benefit. For example, if you say the new system will be used to reduce inventory, by how much? To what level? In what time period? If you have to specify, then you will know what to measure. When your IOU is called in, you can point to that measure and pay your debt. Benefits can come in the form of increased revenue, reduced costs, or increased volume or output. There are intangibles that may enter into the decision, but if you cannot attach real measurable dollars to the benefit, it has no effect on Return on Investment (ROI). Another part of the equation that finance executives like to look at is the payback period. That is, the amount of time required to recover the investment. With software, the payback period is commonly around five years. Some might argue that technology advances so quickly, that even five years is too long. Others could argue that their last ERP system lasted 10 years, so why not use a longer period? Each company s standard may be different. You should understand what your company policy is. An acceptable ROI is another policy that is established by the financial officer and will vary among different companies. In any event, if benefits are greater than costs, does the system really cost anything? 9

10 Cost of an ERP System Money spent on the acquisition of an ERP system is an investment. Accounting principles may allow you to capitalize a certain portion and expense another, but that is just about tax recognition. It is all an investment in the business and should be treated as an investment that must be paid back. This often gets confused because software is not like a building or a piece of equipment that you can see and touch. Buying and implementing an ERP system can be more expensive and deployment more involved, because the system affects all of the business units across the enterprise. The transition will involve change management, as acceptance is necessary from the beginning to the end of the business process. In identifying opportunities to realize benefits to the entire organization, key roles from each business unit must be in agreement and accept their role in achieving the benefits identified in the analysis. In essence, they need to co-sign the IOU before the investment is made. The dynamics of calculating cost can be confusing. There are examples of ways to reduce costs, but what about the cost of doing nothing? Occasionally, companies will make a decision to not decide. The decision process is so overwhelming at times, some executives put it off or just decide to forego the decision since there is no immediately apparent reason to decide. This is probably the biggest reason many companies are still on 10 year old ERP systems. But not deciding has consequences. It may be justified 10

11 by thinking that if a decision is made, I will have to spend money. If no decision is made, it s actually a cost savings. Right? Possibly. But what happens, when your customers find it difficult to do business with you? Do sales drop? If your competitor is using a customer portal, can they deliver their product faster and at a more competitive price? What will that cost your business? What about the cost of supporting old systems? Will it be easier to attract IT people to work on old technology or would it be more attractive to work on new technology which may be more in line with their most recent training? Older technology has a tendency to be limited in functionality, and costs more to maintain the interfaces, that are standard in the newer versions. Without people to support the old systems, how long will it take you to recover from a system outage? At what cost? Avoiding that decision should be considered in the analysis. This may be done by comparing the capability of the software and identifying what functions or features will help in avoiding or replacing existing costs today. The reduction of those costs can be used to offset a portion of the Total Cost of Ownership (TCO) and increase the CROA. 11

12 ROI Calculation The definition of ROI, in this example, is the five year cash flow benefit divided by the total cost of ownership.* (5 Year Cash Flow Benefit-Total Asset Cost)/Total Asset Cost An example would be a system that has a TCO of $2,800,000 to purchase and implement that could reduce inventory by $5,000,000; allow the reduction of five positions at a cost of $200,000 per year; and, reduce product costs by $400,000 per year. In its simplest form, the inventory reduction would create a reduction of carrying costs, increasing cash flow by a rate equal to the reduction multiplied by the carrying cost; $5,000,000 x 10% = $500,000. The headcount reduction, a continuous month after month product cost savings over five years totaling $3,000,000 of Cash Flow from Operations. Our calculation would $3,500, =.25 or 25% $2,800,000 look like this: But there are other factors that we will examine that will affect the ROI. I use a five year period just as an example. Many companies may say they have been on their current system for as long as 10 years, but the assumption is that beyond five years, a company s benefit may decrease as compared to more upto-date solutions that become available in the marketplace. Caution should be used in identifying the benefits. Benefits must be tangible and measurable; and someone needs to commit to achieving them. In order for the benefits to be tangible they must be able to be calculated and a metric identified to quantify the progress towards achievement of them. In doing this, you will be able to measure your progress and know when you have met your goal. Peter Drucker professed that, what gets managed, gets improved. A variation of this has to do with metrics. Stated differently, what gets measured, gets improved. *Check with your accounting department for your company s policy. 12

13 Opportunities In a survey Optimization trends in ERP usage" by market research firm Gate Point (2013), a survey of 62 Fortune 500 companies were asked about their ERP implementation. The top five expected benefits from the new system were: 32% - Reduced level of inventory through improved planning and control 27% - Reduced labor cost through better allocation of staff and reduced overtime 26% - Improved production efficiency which minimizes shortages and interruptions 20% - Increased sales revenue, driven by better managed customer relationships (Order Management) 11% - Reduced administrative costs (Time to Close) Other benefits that were identified included: Reduced materials cost through improved procurement and payment protocols Increased gross margin percentage Reduced regulatory compliance costs In my IOU story above, it s important to note that I would not be able to pay my debt with make believe money. It would require concrete, verifiable examples in order to demonstrate the benefits of the investment. You can t pay the IOU back with intangible benefits. Therefore, the first step in developing a business case for the ERP system is to identify what the software is going to do for the business. The first input in our business case calculator is to identify the opportunities, to realize the benefits we intend to achieve by investing in this system. The power of the IOU analogy is that someone will need to sign the IOU. That typically is the person that is willing to accept the responsibility of achieving that benefit. The who is not necessary in calculating the ROI, but is very critical in achieving the ROI. The suggestion is not to use the benefit in the analysis unless someone has accepted that challenge. The first step in completing our calculator is to identify opportunities to realize benefits to the company. 13

14 in our ROI calculation. In our example, the first benefit we identify is an opportunity to manage inventory more effectively. It will require us to identify what that means. Figure 3: ERP ROI Calculator Opportunity Snapshot In the context of opportunities to improve recurring business performance, think of three factors: increased revenue, decreased cost, or increased volume. These factors are disguised as different discussion topics, but if you stop and think next time you are discussing ways to improve profitability, you will be able to categorize them in one of these three areas. Benefits come in only two forms A one-time reduction in working capital requirements that allows the funds to be used for other working capital requirements A recurring cash flow A reduction of working capital requirements is most often reflected on the balance sheet however, that reduction can also have an impact If the objective is to lower your inventory balance, with all other factors remaining the same then you can only achieve that once. But the reduction will cause an effect on your income statement. It can be calculated by identifying your current value, and what value level you intend to achieve. Our example identifies a current value of inventory of $32,700,000 and a target of $27,700,000 or an annual benefit of $500,000 annually. The money that was tied up in holding inventory can now be utilized for something else. In our analysis, freed money would be used to pay back the investment in the ERP system. If we input a carrying cost of 10% and multiply the reduction of $5 million by this our result is a $500,000 annual benefit to our income. Our calculator shows the monthly benefit of $41,667 and multiplies it out to an annual benefit of 14

15 $500,000. The first line of the calculator is only for the inventory reduction as the benefits on this line use the carrying cost percentage. The second type of benefit comes from a recurring event, other than inventory, that will happen over and over again, resulting in a constant cash flow month after month. This could be in the area of labor, material, or overhead reductions that could be achieved as a result of the functions that the ERP will improve. In the context of opportunities to improve recurring business performance, think of three factors: increased revenue, decreased cost, or increased volume. These factors are disguised as different discussion topics, but if you stop and think next time you are discussing ways to improve profitability, you will be able to categorize them in one of these three areas. A reduction in personnel or an improvement in productivity is a cost saving that once achieved would benefit the company every month. In the calculation, identify the monthly cost savings for the reduction in headcount and the increased productivity. By identifying the current monthly dollar amount that appears on our income statement today and subtracting what the expected amount would be after the benefits are realized, the calculated benefit is the monthly cash flow from the realized opportunity. Notice that if no is entered in the 1 time column, the formula multiplies the monthly benefit by 12 to arrive at an annual benefit. In the case of an inventory reduction, which is a one-time reduction, the 1 Time entry is a yes. The formula does not multiply the benefit but simply takes the calculated benefit. Figure 4: Example with ERP Calculator 15

16 Identify as many benefits as you care to, but be certain that along with the calculation you describe what feature of the ERP software will be used to realize the benefit; how it will be used differently than today; the area responsible for the process change; and, how long it will take to achieve the improvement. The last point will be discussed in the section about risk. Be careful about guarantees. Nothing is a sure thing. Impact Year and Risk The point of this section is to warn of the risk involved in projecting benefits and how time can affect the outcome. If you are going to be signing the IOU, don t get caught short as a result of time. But let s finish the calculation and see how the resulting adjustment for time affects our results. Not everyone achieved what they expected when they thought they would. No one reduces inventory in a day unless they are scrapping it or liquidating. Don t expect to manage your resources on the floor to the level that you desire on day one. Change is hard and it takes time. How much time? Let s see what out test sample tells us. While 32% of Gate Point s survey sample identified inventory reduction as the biggest opportunity when implementing ERP, only 16% realized the goals they set for themselves. Only half of those that set that goal were able to reduce inventory. Those that did achieve their goal did not realize the benefit until the third year after they implemented their ERP software. Time is a factor in our calculation. In the calculation, if we identified inventory benefits happening in the third year, some accountant may have used it in his cash flow projections for that year. Your IOU possibly could come due in the year you projected. In the simple analysis we are computing, we are not taking into account the time value of money, some companies do and some companies don t.* For cash flow benefits, the calculation is affected by the year that is first impacted and is accumulated for each year after that. i.e. (5 years Impact years) x Annual benefit = 5 year return. *Check with your accounting department for your company s policy on computing net present value. 16

17 27% of companies set a goal of personnel reduction as a benefit of implementing their ERP system. In the follow up survey, only 12% realized the reduction of savings they had identified at the beginning, which is only a 44% success rate. Those that did hit their goal did not do so until the second year after implementation. If they had promised it from the time the system was in place, they would come up short by two years of benefit or $480,000. In our example in Figure5, the annual benefit of reducing headcount by three is $240,000 per year. We calculate that the benefit will only be realized in years 3-5, so the five year return is $720,000 or $240,000 x 3. Our five year return is reduced based on the impact year when the benefit is realized. To complete the top five benefits that were identified at the start, all were achieved in the third year after implementation. 26% of companies identified improved productivity as a goal, and 20% realized the benefit. 20% targeted improved order management and 36% of respondents said they were actually able to do this, far exceeding expectations when they were starting out. Perhaps less tangible was the expectation that the ERP automation would reduce the amount of time to close the company s books by 11% of the companies in the survey. Figure 5: ERP Calculator Calculating 5 Year Return 17

18 After three years, 44% reported that they could close faster than before the new software was used. In reporting the follow up results, it should be noted that there is risk in not reaching our goals for the system. In Figure 5, we adjust the five year return by the probability of achieving the desired benefit. In the case of headcount reduction, the five year return is reduced by the probability of success of 56%. This is a more realistic benefit that will not subject the signer of the IOU to the risk of not performing to all expectations. In our example, I am reducing the five year return by the probability of achieving the benefit based on what the survey told us was actually achieved in our survey after implementation. There is manipulation that can happen at this point. Five Year Return x Probability of Success = Adjusted Estimated Benefit Too often, the person preparing the analysis is tempted to reduce this risk probability in order to get a result that supports approval. You can estimate your own probability based on comfort level with risk, the experience your company has had in the past with projects, or a number of other factors. Just be certain that you are prepared to explain why you used a certain probability. If you rate probability too high, you may find yourself explaining the confidence if you don t have a performance history of hitting goals, or you could be accused of using a higher probability just to Figure 6: ERP Calculator Snapshot - Assessing Risk Probability 18

19 get approval. If you rate probability too low, you may not justify the investment and find yourself explaining why you are the right person to lead the initiative if there isn t much chance of success. Now that we have analyzed the financial impact of the decision, we arrive at an adjusted benefit of the decision. In order to calculate the return on the investment, it is necessary to compare these benefits to our total outlay for the software, including licensing, services, and any internal costs that will be incurred. Some companies overlook the internal costs like the time spent by the company s employees. It is a matter of policy, but I like to point out costs such as overtime and the cost of hiring temps to do some of the activities that the internal employee can t accomplish because of working on the project. Take the case of a purchasing manager that is required to spend 20 hours a week on implementation from development to deployment. If he is also the primary buyer of a class of material, he may need to delegate that activity to someone else, causing the department to bring in a temp to help out. Since the need for the temp is a result of the project, I like to include the cost of the temp in the cost of the investment. Be sure to check with your accounting department to see how they view these costs. In Figure 7 below, we compare the adjusted benefits to the total investment. In our example, the benefits outweigh the investment by $1,228,200 over the five year period. If we divide this surplus by the investment, the CROA calculates to 22%. The investment will be paid back with interest over this period. Every company will have policies and practices that determine their investment criteria. In our example, we made some assumptions that served our purposes for illustration. Again, the emphasis should be on knowing how your company s policies will affect your calculation Figure 7: ERP Calculator Snapshot Comparing Adjusted Benefits to Total Investment 19

20 What I ve tried to illustrate is how to justify a company s investment in an ERP tool; a tool that will span all business units within an organization. The calculation quantifies the cash flow benefits and compares them to the total cost of ownership (TCO) in order to understand that the time required to pay back the investment over time should be less than the period that we are expecting to realize the benefits. Most importantly, and unlike other calculators, this tool assesses risk and its associated probability, so that you and your team can understand what the real, achievable ROI is for an ERP investment. If you can navigate this formula, you will understand why an ERP software does not cost a company anything, and instead can actually provide a realistic ROI. 20

21 About Indusa For global midmarket organizations, Indusa is an innovative technology partner that provides end-to-end enterprise software solutions and services to deliver business results, improve productivity, increase efficiency, and reduce costs. With offices in the United States and India, Indusa has a global team of experts to deliver transformative technology solutions to meet all of the needs of our clients from consulting to maintenance, in our core practices Microsoft Dynamics AX ERP, Dynamics CRM, SharePoint, Enterprise Mobility, QA/Testing, and Custom Application Management. Quick Facts Established in 1989: over 25 years of experience Headquartered near Chicago (USA) with development centres in India Microsoft partner with Gold and Silver competencies Blended delivery model as per your comfort: onsite, offsite, offshore, or a mix Over 90% of team working on Microsoft-related technology projects are certified Microsoft CSAT index: 100% on KPIs 80% of our customers stay with us for over 8 years T: W: