how to calculate ERP ROI

ERP ROI Calculation, How and What For?

EasyERP Team 14/04/2017

Can you get a positive ERP ROI when implementing Enterprise Resource Planning system? How to conduct ERP ROI measurement? What are key parameters? Is there a relevant and comprehensive formula?

First, let’s look over one practical business case as example.

Bob Benson, a financial manager of telecommunications company Aliant, has publicly stated that a three-year project of adoption of the ERP system was completed on time and did not go beyond the budget. In addition, four partner companies decided to create a single information system collecting 36 different financial administrative and personnel systems under one “umbrella” – PeopleSoft. ERP project, which came into action on the final stage, has surpassed initial expectations. The cost of ERP system implementation made up $ 20.2 million. Estimated annual savings in operating costs obtained from the system: $ 8 million, expected ERP ROI defined at 33 %.

Remember our previous article 10 tips to get the most of your ERP? It is most probably the 9th tip has captured your attention. The matter concerns the estimation of the ROI of Enterprise Resource Planning software. It is very important to evaluate your ERP ROI over the life of the ERP system. Technology investment is something like financial investment. Due to the fact that ROI fluctuates over the time, it becomes necessary to control and regulate your goals.

What is ROI?

ROI (Return on Investment), the abbreviation that designates the return on the investment ratio. In other words, it is an indicator that demonstrates how much money you managed to earn or to lose on one or another investment.

Today, one of the main factors of contributing to the increase of the activity (efficiency) of enterprises is the introduction of automated control systems. A market which is yet rapidly growing. Though without providing the correct structure and without considering the intended effect of their implementation, it becomes impossible to achieve the desired result. Hence, the whole purpose of the ERP.

ERP ROI: meaning & purpose

According to Aberdeen Group, organizations obtain the most benefits for the ERP system, if the possible ERP ROI was identified before the start of ERP project and evaluated continuously throughout the implementation process. The methodology of determining the ERP ROI helps you identify where the best effect for the particular business has been achieved. Unfortunately, many companies often avoid ERP ROI calculation when it comes to the selection of the system. So currently, ERP ROI has become an integral part of every company’s decision-making process.

Image: EasyERP

Return on Investment has become a universal tool in substantiating the effectiveness of IT projects. Why do we need to calculate ROI? Because ROI measurements in many circumstances improve chances of a successful completion of the project.

The key-parameters of measuring ERP ROI that are worth paying attention to:

●    Inventory level-reduction, by enhancing planning and control;
●    The improvement of the production efficiency that minimizes deficit and interruptions;
●    The reduction of the material costs by improving procurement and payment protocols;
●    The reduction of labor costs due to more efficient distribution and reduced staff overtime;
●    The increase of the revenue from taxes, led by better customer relationship;
●    The increase in GDP percentage;
●    The reduction of administrative costs;
●    The reduction of regulatory costs for compliance.

Why do we need to calculate ROI?

And how this process is being fulfilled? First of all, experts consider that software ROI calculation is based on the knowledge of instant tangible benefits as soon as the new software is installed. As ERP itself means an improvement in business processes, so that it requires some time to become measurable.

Looking to improve your business with ERP system?order now

Frankly speaking, this is not impossible but a little bit difficult. It depends mostly on deep analysis of your business. The cost of the adoption of ERP system is easy to access. And to see the expected results would really take some time, seems like. On the first step, while the ERP system installation, you need to gather all data. Make them understandable and readable for everyone. Why do you need this? In fact, such understandable data perfectly depicts the health of your business. As well as areas of product management, like: production process, accounts, invoices, sales, … productivity in general.

Benefits to keep track of

In order to calculate ERP ROI all the processes and data have to be given a dollar value. So that it is possible for you to calculate efficiency levels and increase. When it comes to calculation, this step is considered to be difficult, because you now have to evaluate monetary numbers of intangible data. Among these intangible data are: customer satisfaction, coil tracking, logistics, time management and project opportunity.

But for people who work in financial sector, especially those dealing with accounting, calculating ROI is easy as they work with tangible data. Moreover, it becomes easier for them to calculate prior year’s revenue and the costs.
We have previously discussed primary ERP benefits after its adoption. Now, in order to gain better understanding of it let us survey on these tangible and intangible benefits.

Thus, what tangible benefits does ERP system brings to light?

●    The increase in effectiveness of manufacturing as a result of effective management of the equipment;
●    Enhanced allocation of resources to lower costs on the workforce;
●    The improvement of the process of procurement to lower the cost of the materials;
●    Improved planning and control to shorten work-in-progress times;
●    Reduced double entry and errors through managing processes in one unified system;

Some intangible data to consider:

●    The strengthening of tighter sales cycle by better accounting control;
●    Enhanced customer service;
●    Standardized procedures;
●    Increase accuracy of inventory data;
●    Shorter order to shipment cycle.

Life cycle of ERP

Having discussed these values let us draw our attention to expenditures and costs on the installation of the ERP system. Here, to calculate the efficiency of the future enterprise resource planning system it is necessary to estimate the upcoming costs over the lifetime of the system. The life cycle of the system can be divided into 5 stages:

1.    Selection
2.    Acquisition
3.    Implementation
4.    Operation
5.    Improvement

Now, we will try to systematize the resulting costs at each stage of the life of ERP system:

●    Equipment (Hardware costs)
●    System Software
●    Support plans
●    License fees
●    Consulting fees
●    Adoption costs

These fees are, in fact, regarded to be tangible and are inseparable while calculating your ERP ROI. Another important fact to take into consideration is the time you are going to use your ERP system and what your anticipated-monetary expectations are.

Most probably you know that the most of ERP’s primary benefits come from reduction in the workforce and operational costs. Smart companies recognize that identifying benefits is a prerequisite for estimating an investment’s value.

Image: EasyERP

Before you come to the calculation of your ROI ERP actually, ask yourself two questions: How long will I use my ERP system? What are my anticipate-monetary benefits of its use?

Number of years

The big question mark for your ERP ROI calculation is the number of years over which to accumulate costs and benefits. One can do that based on a simple desired rate, e.g. the ROI at 5-10-15 years. Or based on an expected product life cycle.

Choose a number of years for the calculation is that is clear to everyone. Additionally, make it as visible note on every analysis document as possible. Make sure that everyone involved in a calculating or decision-making role understands and follows the set number of years. You must also keep in mind that a true ROI calculation should be based upon real life business scenarios, and quantifiable results.

ROI calculation formula

Virtually, there are many formulas of calculating ERP ROI such as textbook algorithms for measuring, or ROI as a percentage for given period. Opposite to what some may believe, there is not one perfect formula for all situations. There are a number of them available for use within the selection process. While the correct formula depends on the actual purchase, the organizational structure, much as the available project information.

Firstly, let us come back to our fees and play a bit with them. We will put them into one entity, which we will call TCO. What is TCO?

TCO (total Cost of your Ownership) – financial estimation, which aims at assisting buyers and owners in determining the direct and indirect costs of a product or system.

Thus, let us assume that your TCO counts $ 100.000. You plan to utilize your ERP system for 5 years and your anticipated increase in profits is 10%. What formula to use? The most generally accepted one is the following:

ROI= TCO / Years + TCO * Anticipated Profits Increase

For example: ROI= (100.000/5+ 100.000*10%) = 30.000 $. As you can see, ROI counts 30.000 $.

Image: EasyERP
ERP ROI= (TCO / Years) + (TCO * Anticipated Profits Increase)Click To Tweet

Consider everything and select

The ROI you obtain is apt to fluctuate over the time. So it becomes significant to quantify all bottle-necks of your business. Consequently, it will allow you to gauge the benefits of implementation and improve project success.

In result, after ERP ROI is measured, rises another question – how to select the corresponding ERP system? The suggested way out is the following: try to write down all weak sides you came across previous year running the business. For instance, be it either inconsistent data, slow responses to the problems, or manual data entry, etc.

Now, logically, you are looking for the various solutions and ask yourself – how to make solve this? Sticking to our examples above we may say that ERP system will help to solve the following:

●    Inconsistent data -> operate with one central data;
●    Slow solutions to the problems -> enhance employee activity;
●    Manual data entry -> automate data entry;
●    Delays in order and shipment become solved by improved planning.

After you have found the weak sides and are eager to improve them you can quantify costs (same as obstacles) to determine your ERP ROI.

Alternative ROI formula

The next formula of calculating ROI we are going to present is a common standard, many companies are applying. As far as a future of IT purchase is concerned the following formula could be proper in certain cases. Still, some may choose to ignore ROI entirely and utilize an approach based on payback period or net present value (NPV).

Caution is needed when looking solely at payback period. Because this method fails to consider the true life of the software and thus the total return on investment. Due to this, calculations using ROI or NPV are preferred.

ROI= Net Benefits / Project Investment

In conclusion, we can state, that the success of your business and ERP ROI depends mostly on you, your analysis of your business. Define tangible and intangible benefits to calculate your ROI. Define weak sides of your business and do everything to make them stronger.

Image: EasyERP
ROI= Net Benefits / Project InvestmentClick To Tweet

Summary

Return on Investment (ROI) is the method business leaders use to determine which investments to make. Also, it determines the financial success of most investments. Quite simply, ROI is a comparison of the expected benefit of a particular investment measured in monetary units, compared to the cost of that investment in the same monetary units. Mind, that the effectiveness of the ERP depends on the effectiveness of business that incorporates it.

Chatra