As the Aberdeen Group has written, “companies gain the most benefits from their ERP solution if the possible return on investment (ROI) was identified before the start of the ERP project and measured continuously throughout the implementation process.”
In order to calculate the net return of your ERP investment, it’s important to have a handle on both the costs and the benefits associated with the ERP project. Whereas the cost of the ERP system and its implementation are fairly easy to calculate, the benefits of the new system will be much harder to quantify if the dollars and cents of the status quo aren’t well known.
Since no company has limitless resources, it seems like ERP ROI should be part of every company’s decision making process. Companies expect expenditures to produce a visible return. Smart companies recognize that identifying benefits is a prerequisite for assessing an investment’s value. Those companies often require a formal cost and benefit analysis prior to an investment’s being made.
Typically, ROI users calculate two basic measures. The simpler measure is the payback period, or the length of time it takes for the cumulative return to equal the cumulative investment cost. Ordinarily, investment spending must occur before the investment starts producing benefits. The longer an investment’s payback period, the riskier and less attractive the investment is. Similarly, the larger the initial investment, the riskier and less attractive it is; and not surprisingly, larger investments usually take longer to payback. These days, organizations want very short payback periods, preferably “yesterday.”
The more complicated measure, which is most commonly to what “ROI” refers, can include additional, intimidating calculation variations. It depicts ROI as an annualized percentage, which then can be compared to the annual percentage return from competing proposed alternative investments. For example, an essentially risk-free bank certificate of deposit might pay interest at a rate of 3 percent per year. A proposed alternative investment would need to promise a somewhat greater annual return in order to compensate for the increased risk, such as the possibility that the proposed approach won’t provide the expected benefits, or won’t be completed within the expected time period or for the expected cost.
Quite frequently, ROI is by-passed when selecting an ERP system. It may be deemed too difficult to calculate or too time consuming to monitor. Often it is thought that the benefits fall into intangible and unmeasurable benefits. While there are intangible returns, there are also numerous tangible ones that are simpler to measure.
Key ERP ROI Measurement Parameters
- Reduced level of inventory through improved planning and control.
- Improved production efficiency which minimizes shortages and interruptions.
- Reduced materials cost through improved procurement and payment protocols.
- Reduced labor cost through better allocation of staff and reduced overtime.
- Increased sales revenue, driven by better managed customer relationships.
- Increased gross margin percentage.
- Reduced administrative costs.
- Reduced regulatory compliance costs.
And there are plenty of other achievable benefits, both tangible and intangible. Properly implemented and managed, ERP can be a significant driver of ROI. For the CFO, the first order of business is to determine the desired ERP benefits so that the process can be well-measured.