In continuation of our previous article on ERP ROI calculation, we take a deeper look at ERP TCO – total cost of ownership. As an integral part of product/service efficiency calculation, TCO though, is not the easiest thing to grasp. Here’s why.
First of all, the term itself. Established nearly 30 years ago in 80-ies, and most prominently defined by Gartner Research.
For IT, TCO includes hardware and software acquisition, management and support, communications, end-user expenses and the opportunity cost of downtime, training and other productivity losses.
ERP system cost should largely consider the context of a lifecycle cost or total cost of ownership (ERP TCO). Up-front cost for hardware, software and implementation, as well as one should not omit the support and maintenance costs too. Most ERP system vendors charge an annual maintenance fee, approx. 15 – 20% of the whole purchase price. This is a positive thing, as it ensures the continuous product support, bug fix services, system updates etc.
When calculating ERP TCO you’d better include all possible costs, even the non-obvious ones. Also, important to collectively agree on what is included in TCO. Whether you take a classic Gartner’s definition or a more restricted one excluding certain categories, it is key that everyone knows clearly the elements covered. Insurance, for example. It is a cost, so you need to include it in the TCO calculation. Or don’t you? Or take data breach, the costs of repair and business reputation risks. Those are elements of the general definition. If taking those into account, similarly, one should consider risk management costs as well.
ERP TCO Elements
Now, let’s list all the ERP TCO elements and then review them. They are twenty one as follows:
- System hardware and software costs
- Server hardware and software costs
- Workstation hardware and software costs
- Installation and integration costs
- Data migration costs
- Risk management costs
- Infrastructure enhancement costs
- Power costs
- Quality assurance/testing costs
- Downtime and outage costs
- Reduced productivity costs
- Security risks
- Backup systems and recovery costs
- User training costs
- Process audit costs
- Process re-engineering costs
- Insurance costs
- Special personnel costs
- Project management costs
- Future upgrade costs
- Legacy system take-down costs
Data migration is most probably the core component of ERP implementation. Even if its actually just a kind of upgrade from version 1.0 to version 1.1 of the same ERP system, you should handle data conversion carefully. Let alone the adoption of the brand new system as a whole. So, supervise and make sure proper executives take ownership of their data. Then test at every process level – to ensure the integrity of the data. As example, making a sales order will be impossible when the table of addresses cannot be read. So test everything and do it gradually – from everyday transactions to complex business events. Retest afterwards (unexpected things happen, therefore test and retest until you are confident the whole system works).
Risk management costs should cover potential vulnerabilities, upgrade availability, future license management etc. Reduced productivity costs deal with user adoption time period, decreased money-making ability. Security issues include potential breaches, loss of brand reputation, recovery and future prevention matters.
Why is knowing your ERP TCO generally useful? With it one can obtain goals, like:
- analyze the scope of intended ERP implementation;
- calculate a rough implementation cost for planning and capital allocation purposes;
- measure ROI of the ERP system;
- keep track of licensing costs, professional services, hardware, internal support etc.
Many additional costs can appear in the process. Beside hardware upgrades, maintenance, bug fixes, or basic implementation support, companies may face hidden costs as well. And you better watch out for them not to get confused ERP TCO figures later on. Labor costs – several parts to it like training time, testing time, data conversion time. Obviously, everyone knows the huge effort implementation process demands, so one better measure it as accurately as possible.
Retraining, retesting, re-engineering,…and possibly fear. Some of the employees can quit during the ERP implementation, some need the upfront training. These are costs too. In addition, you most definitely will face at least one or two items that is going to need re-engineering and arranging according to your situation. And hardest of all, you can not be 100% certain of a successful future of your ERP project. Add your employees here: some of them will adapt poorly, some will work slower than expected. And it all adds up.
Furthermore, spending more money than planned, also regards customization. In some cases, you can not re-engineer every process, so that customization would be the only option. And it is a costly factor. Similarly, not all cost-reduction estimations are going to be realized. Mainly, ERP cost reduction hopes are connected to less personnel. So some employees will have to be actually fired.
How to lower TCO
To break it down to savings, let us see how much of every dollar is spent for each component of ERP system. The number of module and user licenses matters the most. Since according to a general estimate, ERP licensing costs about $3000 per user in total. Comparing the ratio of components, researchers state that in every $1 spent on deploying the ERP system, hence an average of 44 cents goes on licensing.
Maintenance fees are considered at 15 – 25% of the licensing costs. Among the main reasons why companies pay these fees is, actually, to get updates to products. Maintenance is usually calculated at 12 cents of every $1 spent. In this regard, how are support services different, one may ask? Implementing the ERP system requires both technical and project management skills of high level.
That is why many companies hire consultants for professional support. Services here comprise project planning, installation, configuration, data migration, employee training, and launch supervision. These services are commonly affiliated with licensing costs and placed at same cost ratio, e.g. at 44 cents for every $1 spent.
How to calculate ERP TCO
The total cost of ownership for enterprise software (ERP TCO) is the summation of all direct and indirect costs incurred by the software. And it is a critical part of the ROI calculation, as we’ve mentioned above. When taken as a whole, that is quite a huge list. This, consequently, means TCO calculation is not as simple as it might appear.
However, TCO figure should be accurate (See more in our previous post about ERP ROI). The more inclusive calculation is, the more beneficial it will be. Three main and basic types of costs are: startup costs (deploying new software into production), operational costs (maintenance expenses while the software is in production), retirement costs (when retiring the software).
- Software: usually an up-front software cost plus user licenses.
- Hardware: the cost of servers and storage space, or backup and disaster systems (does not apply to cloud-based options).
- Implementation: setting up, configuring, testing the software, getting it into production. Also may include setting up backups, disaster recovery, etc.
- Data migration: moving data from the old system to the new one, data format changes.
- User licenses: named users and/or simultaneous users.
- Training: teaching employees to use the software.
- External system interface: as no enterprise software system operates separately, it will require integration with other systems in place.
- Maintenance & support: typically costs around 20% – 25% of the total purchase price per year.
- Bug fix patches: applies to all types of software.
- User licenses: as the number of users grows, the company must purchase new licenses. When the number of users falls, there are no refunds – such is the market practice. These licenses are typically priced per month, though some may require an annual contract.
- Training: new users and employees come and go, and they need training.
- New functionality: if the business environment changes or new regulations come into effect. May include documentation and project management costs.
- User & administrative support: the cost of help-desk and system admins, or even maybe a few developers who will be supporting the system.
- Disaster recovery & availability: ranging from backups to regular testing sessions.
- Data center: the costs of running the software, like power, cooling, floor space. May also include indirect costs like security, maintenance, management etc.
- Downtime: the cost to the business when the software is literally unavailable.
- Upgrades: Off-the-shelf software usually has upgrades over its life-cycle, custom software may come in a new version. Does not apply to cloud software as it mostly has permanent updates.
- Security: keeping an application secure, does not apply to cloud software.
Finally, retirement costs:
- Data export: extracting existing data in a suitable format.
- Archived systems: old custom software better be available for reference. So you need to keep it running on servers in the data center, with their associated costs.
- Expired licenses: all user licenses to keep audit trails, though no need to pay full user costs of the older system.