For financial and accounting people (like most of us) “Cost/Benefit Analysis” is a familiar phrase, but to those who not come from accounting and financial background, this phrase could be a big question. Anyway, establishing the costs and benefits of an ERP project is essential. Here are some reasons why:
- High priority – Job 1 is to run the business. Very close to that in importance should be implementing ERP. It’s very difficult to keep ERP pegged as a very high priority if the relevant costs and benefits have not been established and bought into. If ERP doesn’t carry this high priority, the chances for success decrease.
- A solid commitment – Implementing ERP and ES means changing the way the business is run. Consequently, top management and operating management must be committed to making it happen. Without a solid projection of costs and benefits, the necessary degree of dedication may not be attained, and the chances for success will decrease sharply.
- One allocation of funds – By identifying costs thoroughly and completely before implementation, the company has to process only one spending authorization. This avoids repeated “trips to the well” (the board of directors, the corporate office, the executive committee) and their attendant delays during the life of the project. This factor leads some companies to combine ERP and ES into one project.
The people who attended first-cut education should now develop the cost/benefit study. Their objective is to develop a set of numbers to use in deciding for or against ERP. Do not, under any circumstances, allow yourselves to skip this step. Even though you may be convinced that you must do ERP and its benefits will be enormous, it’s essential that you go through this process, for the reasons mentioned above. To do otherwise is like attempting to build a house on a foundation of sand.
Let’s first focus on the likely areas of costs and benefits. After that, we’ll work through several sample cost/benefit analysis.
An easier way to group the costs let’s do it via the following ABC categories:
A = People, B = Data, C = Computer
Let’s take them in reverse order.
C = Computer
Include in this category the following costs:
1. New computer hardware necessary specifically for ERP or ES.
2. ES software for a combined ERP/ES project, and possibly supply chain bolt-ons for either ERP/ES or ERP only.
3. Systems people and others to:
[-]. Configure and enhance the ES software.
[-]. Install the software, test it, and debug it.
[-]. Interface the purchased software with existing systems that will remain in place after ERP and ES are implemented.
[-]. Assist in user training.
[-]. Develop documentation.
[-]. Provide system maintenance.
These people may already be on staff, may have to be hired, and/or may be temporary contract personnel. Please note: These costs can be very large. Software industry sources report cost ratios of up to 1:8 or more. In other words, for every dollar that a company spends on the purchased software, it may spend eight dollars for these installation activities.
4. Forms, supplies, miscellaneous.
5. Software maintenance costs. Be sure to include the any expected upgrades of the new software here.
6. Other anticipated charges from the software supplier (plus perhaps some contingency money for unanticipated charges).
B = Data
Include here the costs involved to get and maintain the necessary data:
1. Inventory record accuracy, which could involve:
[-]. New fences, gates, scales, shelves, bins, lift trucks, and other types of new equipment.
[-]. Mobile scanners on lift trucks to read bar codes on stock.
[-]. Costs associated with plant re-design, sometimes necessary to create and/or consolidate stockrooms.
[-]. Cycle counting costs.
[-]. Other increases in staffing necessary to achieve and maintain inventory accuracy.
2. Bill of material accuracy, structure, and completeness.
3. Routing accuracy.
4. Other elements of data such as forecasts, customer orders, item data, work center data, and so forth.
A = People.
Include here costs for:
1. The project team, typically full-time project leader and also the many other people identified with individual segments of the business.
2. Education, including travel and lodging.
3. Professional guidance.
4. Increases in the indirect payroll, either temporary or ongoing, not included elsewhere. Examples: include a new demand manager or master scheduler, additional material planning people, or another dispatcher. For most companies, this number is not large at all. For a few, usually with no planning function prior to ERP, it might be much higher.
These are the major categories of cost. So as an “accountant or controller“, you may rise the following questions (typically) – The Black color are your question, the red is the answer:
- Which of them can be eliminated? None; they’re all essential.
- Which one is most important? The A item, of course, because it involves the people.
- If, for whatever reason, it’s absolutely necessary to shave some money out of the project budget, from where should it come? Certainly not the A item.
- How about cutting back on the C item, the computer? Well, if you absolutely have to cut somewhere, that’s the best place to do it.
- But why on earth would we say to cut out computer costs with the strong ES linkage with ERP? The answer goes back to my previous post—installing ES without the proper ERP demand management, planning and scheduling tools will gain little.
Many companies have had decent success without major computer or information system changes by working hard on their ERP capability. Obviously, we recommend that you do both. But, if there is a serious shortage of resources, do the planning systems first and automate the information systems later. Later (on my next post), I’ll show you an example of the costs of the full ERP/ES combination. Companies are reporting costs for the total ERP/ES installation over $500 million for a large multinational corporation. In our ERP/ES example, the company will be an average-sized business unit with $500 million in sales and about 1000 people, and the projected costs are over $8 million to do the full job. This number is not based on conjecture but rather on the direct experience of many companies.
Now let’s look at the good news; the benefits.
. Increased sales, as a direct result of improved customer service. For some companies, the goal may be to retain sales lost to aggressive competition. In any case, the improved reliability of the total system means that sales are no longer lost due to internal clumsiness. ERP has enabled many companies to:
[-]. Ship on time virtually all the time.
[-]. Ship in less time than the competition.
[-]. Have their sales force spend their time selling, rather than expediting shipments and making excuses to customers over missed shipments.
In short, ERP can represent a significant competitive weapon.
. Increased direct labor productivity, resulting from the valid, attainable schedules which ERP can enable companies to have. Productivity is increased via:
[-]. Providing matched sets of components to the assembly areas, thereby eliminating much of the inefficiency and idle time often present.
[-]. Reducing sharply the amount of expediting, lot splitting, emergency changeovers, short runs, and so forth in the fabrication areas.
[-]. Requiring much less unplanned overtime, because the forward visibility is so much better.
. Reduced purchase cost. ERP provides the tools to give suppliers valid schedules and better forward visibility. Once the customer company gets out of the order-launch-and-expedite mode, its suppliers can produce the customer’s items more efficiently, at lower cost. A portion of these savings can be passed back to the buying company to be used either for increased profits or reduced product pricing which can mean increased sales and profits. Further, valid schedules can free the buyers from a life of expediting and paper shuffling, so that they can do the important parts of their jobs (sourcing, negotiation, contracting, value analysis, cost reduction, etc.). Therefore, these savings don’t come solely from lower prices but rather from reducing total purchase costs. Survey results: Companies report an average reduction in total purchased costs of 7 percent; the Class A companies got 13 percent. In many companies, the single largest financial benefit from ERP comes from purchase cost reduction.
. Reduced inventories. Effective demand management, planning, and scheduling result in valid schedules. Valid schedules mean matched sets of components, which means making the products on schedule and shipping them on time. This typically results in lower inventories at all, or at least most, levels—raw material, work-in-process, finished goods.
For most companies, the four benefit areas identified above are the big ones. However, there are other benefits that are potentially very significant and should not be overlooked. So, they include:
. Reduced obsolescence, from an enhanced ability to manage engineering changes, better forward visibility, and an overall smaller risk of obsolescence due to lower inventories in general. This is often a hidden cost at most companies and no one likes to focus on the stuff that is sold at discount or thrown away. However, it can be very large and certainly requires attention.
. Reduced quality costs. Valid schedules can result in a more stable environment, which can mean less scrap. Eliminating the end of the month lump, where perhaps 75 percent of the shipments go out in the last 25 percent of the month, can lead to reduced warranty costs.
. Reduced premium freight, both inbound, by having a better handle on what’s needed, and outbound, by being able to ship on time. Many companies are delighted when they can air express a shipment to fulfill a customer order without thinking about the money that they could have saved with an on-time land shipment.
. Elimination of the annual physical inventory. If the inventory numbers are accurate enough for ERP, they’ll be more than good enough for the balance sheet. Many Class A and B companies don’t take annual physical inventories. This can be a substantial savings in some companies. It can include not only the costs of taking the inventory itself but also the costs of disrupting production, since many companies can’t produce while they count.
. Reduced floor space. As raw material, work-in-process, and finished inventories drop sharply, space is freed up. As a result, you may not need to expand the plant or build the new warehouse or rent more office space for some time to come. Do a mental connection between ERP and your building plans. You may not need as much—or any—new brick and mortar once you get really good at manufacturing. Don’t build a white elephant.
. Improved cash flow. Lower inventories mean quicker conversion of purchased material and labor costs into cash.
. Increased productivity of the indirect workforce. ERP will help not only the direct production associates to be more productive but also the indirect folks. An obvious example is the large expediting group maintained by some companies. Under ERP, this group should no longer be needed, and its members could be absorbed into other, more productive jobs. Another aspect of this, more subtle and perhaps difficult to quantify, is the increased productivity of the supervisors and managers. That includes engineers, quality control people, production supervisors and managers, vice presidents of marketing, and let’s not forget about the guy or gal in the corner office—the general manager. They should all be able to do their jobs better when the company is operating with a valid game plan and an effective set of tools to help them execute it.
Let’s look at several ways to do a cost/benefit analysis:
Method-1: Middle management sells up.
Operating managers put together the cost/benefit analysis and then attempt to sell the project to their bosses. If top management has been to first-cut education, there should be no need for them to be sold. Rather, they and their key managers should be evaluating specifically how ERP will benefit their company and what it’ll cost to get to Class A. This method is not recommended!.
Method-2: Top management decree.
The executive group does the cost/benefit analysis and then decrees that the company will implement ERP. This doesn’t allow for building the kind of consensus and teamwork that’s so important. This method is not recommended!.
Method-3: Joint venture.
This is the recommended approach. The cost/benefit analysis should be done by those executives and managers who’ll be held accountable for achieving the projected benefits within the framework of the identified costs. Here’s how to do it:
- A given department head, let’s say the manager of sales administration and customer service, attends first-cut education.
- The vice president of the sales and marketing department attends first-cut education.
- Upon returning to the company, both persons do some homework, focusing on what benefits the sales side of the business would get from a Class A ERP system, plus what costs might be involved.
- In one or several sessions, they develop their numbers. In this example, the most likely benefit would be increased sales resulting from improved customer service, and the biggest cost elements might be in education and training.
This process is also done in the other key functional areas of the business. Then the numbers are consolidated into a single statement of costs and benefits in all of the key areas of the business (finance, manufacturing, logistics, product development, etc.).
Please note the participatory nature of the joint venture approach. Since both top management and operating management are involved, it promotes consensus up and down the organization, as well as cross functionally.
A word of caution!: Be “fiscally“ conservative. When in doubt, estimate the costs to the high side and the benefits low. If you’re not sure whether certain costs may be necessary in a given area, include them. Tag them as contingency if you like, but get ’em in there. There’s little risk that this approach will make your cost/benefit numbers unattractive because ERP is such a high payback project. Therefore, be conservative. Don’t promise more than you can deliver.
To make this cake even sweeter 🙂 on my next post, I’ll give you EXAMPLEof the costs and benefits to illustrate the potential. You know that your company will have different numbers, but we want to show that a conservative approach still gives big savings.