Following on my previous post about Cost/Benefit Analysis Of ERP Implementation, here is the more chocolate. The example! To illustrate the process, let’s create a hypothetical company with the following characteristics:
Annual sales: $500 million
Number of plants: 2
Distribution centers: 3
Manufacturing process: Fabrication and assembly
Product: A complex assembled make-to-order product, with many options
Pre-tax net profit: 10 percent of sales
Annual direct labor cost: $25 million
Annual purchase volume (production materials): $150 million
Annual cost of goods sold: $300 million
Current inventories: $50 million
Now, let’s take a look at its projected costs and benefits both for a combined ERP/ES implementation and then for an ERP only project.
First, a warning!:
Beware! The numbers that follow are not your company’s numbers. They are sample numbers only. They may be too high or too low for your specific situation. With that caution, let’s examine the numbers. Below figure contains our estimates for the sample company. Costs are divided into one time (acquisition) costs and recurring (annual operating) costs . . . and are in our three categories: C = Computer, B = Data, A = People.
Note that we have not tried to adjust the payout period or the rate of return for the obvious tax consequences of expenses versus capital.
This is for simplicity (but also recognizes that the great majority of the costs are current expenses and that expenses considered as capital investment represent a relatively small number). You may want to make the more accurate, tax-sensitive calculation for your operation. These numbers are interesting, for several reasons.
First, they indicate the total ERP/ES project will pay for itself in seven to eight months after full implementation.
Second, the lost opportunity cost of a one-month delay is $1,049,250. This very powerful number should be made highly visible during the entire project, for several reasons:
1. It imparts a sense of urgency (“We really do need to get ERP and ES implemented as soon as we can”).
2. It helps to establish priorities (“This project really is the number two priority in the company”).
3. It brings the resource allocation issue into clearer focus. Regarding this last point, think back to the concept of the three knobs from my previous post—work to be done, time available in which to do it, and resources that can be applied. Recall that any two of these elements can be held constant by varying the third.
Too often in the past, companies have assumed their only option is to increase the time. They assumed (often incorrectly) that both the work load and resources are fixed. The result of this assumption:
A stretched-out implementation, with its attendant decrease in the odds for success.
Making everyone aware of the cost of a one-month delay can help companies avoid that trap. But the key people really must believe the numbers. For example, let’s assume the company’s in a bind on the project schedule. They’re short of people in a key function. The choices are:
1. Delay the implementation for three months. Cost: $3,147,750 ($1,049K x 3).
2. Stay on schedule by getting temporary help from outside the company (to free up the company’s people to work on ERP and ES, not to work on these projects themselves). Cost: $300,000.
Few will deny $300,000 is a lot of money. But, it’s a whole lot less than $3,147,750. Yes, we know this is obvious, but you would be amazed at how many companies forget the real cost of delayed benefits.
So far in this example, we’ve been talking about costs (expenses) and benefits (income). Cash flow is another important financial consideration, and there’s good news and bad news here.
First, the bad news: A company must spend virtually all of the $8 million (one-time costs) before getting anything back. The good news: Enormous amounts of cash are freed up, largely as a result of the inventory decrease.
The cost/benefit analysis for the total effort projects an inventory reduction of $10 million (10 percent of $25 million raw material and work in progress and 30 percent of $25 million in finished product). This represents incoming cash flow. (See the worksheet for details.)
The company does have negative cash flow in year 1 since most costs occur (as with virtually every project) before savings materialize. However, while the cumulative cash position is still negative at the end of year 2, the project will have generated over $5 million of cash for that year. By year 3, you are generating cash in a big way.
How many large projects has your company undertaken that have no cash impact in the second year with full savings in the third? We bet not many. For our example company, ERP and ES appear to be very attractive: An excellent return on investment (193 percent) and substantial amounts of cash delivered to the bank.
The major difference between doing ERP and ES together or doing just ERP is the enhanced speed and accuracy of information flow when using an ES. Every decision from forecasting to sales to production will be more accurate and faster and will thus generate added benefits.
However, you can still have an impressive change in your business with ERP even with a non-integrated information system. Presumed that the ERP project would fund one of several attractive supply chain software packages available but this would be a standalone assist to the forecasting/planning effort. There may be some added costs if ES comes after ERP due to the need to connect the ERP wiring to ES. However, this cost should be relatively small compared to the rest of the project.
Here’s a familiar question: “Does size matter?” In terms of the payout, not as much as you might think. For a very small company, the challenge usually is resources. There are simply too few people to add a major effort such as this without risk to the basic business. Too often, small companies (and, to be fair, large ones also) will hire consultants to install ES and will ignore the ERP potential. These companies are usually very disappointed when they realize the costs have not brought along the benefits.
Large, multinational companies should be able to allocate resources and should find that the benefits are even more strategic. The problem with larger companies is trying to get all parts of the company, worldwide, to adhere to a common set of principles and practices. If pulling together all aspects of the company is difficult, it is recommended that the project be attacked one business unit at a time. The impact for the total company will be delayed but the more enlightened business units that do install the total project will see rapid results.
Here are a few final thoughts on cost/benefit analysis (in the case you are attempting to implement ERP and are on the stage to calculate the cost/benefit):
1. What it has been trying to illustrate here is primarily the process of cost/benefit analysis, not how to format the numbers. Use whatever format the corporate office requires. For internal use within the business unit, however, keep it simple—two or three pages should do just fine. This is a format I found to be most helpful for operational and project management purposes.
2. We’ve dealt mostly with out-of-pocket costs. For example, the opportunity costs of the managers’ time have not been applied to the project; these people are on the exempt payroll and have a job to do, regardless of how many hours will be involved. Some companies don’t do it that way. They include the estimated costs of management’s time in order to decide on the relative merits of competing projects. This is also a valid approach and can certainly be followed.
3. Get widespread participation in the cost/benefit process. Have all of the key departments involved. Avoid the trap of cost justifying the entire project on the basis of inventory reduction alone. It’s probably possible to do it that way and come up with the necessary payback and return on investment numbers. Unfortunately, it sends exactly the wrong message to the rest of the company. It says: “This is an inventory reduction project,” and that’s wrong. We are talking about a whole lot more than that.
4. We did include a contingency to increase costs and decrease savings. Many companies do this as a normal way to justify any project. If yours does not, then you can choose to delete this piece of conservatism. However, it is encouraged the use of contingency to avoid distractions during the project if surprises happen. Nothing is more discouraging than being forced to explain a change in costs or benefits even if the total project has not changed in financial benefit.
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