Justification of ERP Investments Part 1: Quantifiable Benefits from an ERP System

  • Written By: Dr. Scott Hamilton
  • Published On: June 12 2009



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Originally published - February 13, 2004

Justification of ERP Investments*

The expected return on investment provides the cost justification and motivation for investing in ERP. There are quantifiable benefits as well as intangible benefits in the ERP investment decision. The quantifiable benefits have a bottom-line impact on profitability, asset turnover, and a potential effect on stock value.

This section discusses the quantifiable and the intangible benefits of an ERP system, which compares firm performance before and after implementing ERP. Other scenarios are encountered in justifying ERP investments. For example, a firm may be considering replacement versus upgrade or re-implementation of an ERP software package.

There are significant costs for not successfully implementing an ERP system. Manufacturers often pay more for the lack of systems than they would have paid for improved systems. They carry excess inventory or provide poor customer service, for instance. And manufacturers may invest in ERP without gaining the benefits because the systems are partially implemented, unsuccessfully implemented, or usage deteriorates over time.

*This is Part One of a four-part article reprinted from Maximizing Your ERP System by Dr. Scott Hamilton. Bridging the theory and realities of current ERP systems, Maximizing Your ERP System provides practical guidance for managing manufacturing in various environments. Drawing on case studies from Dr. Hamilton's first-hand experience in consulting with more than a thousand firms, it covers common problems and working solutions for how to effectively implement and use ERP systems. The book can be ordered on amazon.com. This excerpt on "Justification of ERP Investments" is presented in four parts:

  • Quantifiable benefits from an ERP system

  • The intangible effects of ERP

  • Costs of implementing an ERP system

  • Replacing or re-implementing an ERP system

Reprinted with permission of McGraw-Hill.

Quantifiable Benefits from an ERP System

Studies that surveyed manufacturers about the impact of ERP systems on firm performance indicate that company size and industry do not affect the results. Benefits have been indicated for large and small firms, whether they make standard or custom products or are in discrete or process manufacturing environments. This section explains the quantifiable benefits in terms of several areas of improvement.


Typical Benefits

The most significant quantifiable benefits involve reductions in inventory, material costs, and labor and overhead costs, as well as improvements in customer service and sales.

Inventory reduction. Improved planning and scheduling practices typically lead to inventory reductions of 20 percent or better. This provides not only a one time reduction in assets (and inventory typically constitutes a large proportion of assets), but also provides ongoing savings of the inventory carrying costs. The cost of carrying inventory includes not only interest but also the costs of warehousing, handling, obsolescence, insurance, taxes, damage, and shrinkage. With interest rates of 10 percent, the carrying costs can be 25 percent to 30 percent.

ERP systems lead to lower inventories because manufacturers can make and buy only what is needed. Demands rather than demand insensitive order points drive time phased plans. Deliveries can be coordinated to actual need dates; orders for unneeded material can be postponed or canceled. The bills of material ensure matched sets are obtained rather than too much of one component and not enough of another. Planned changes in the bills also prevent inventory build up of obsolete materials. With fewer part shortages and realistic schedules, manufacturing orders can be processed to completion faster and work-in-process inventories can be reduced. Implementation of JIT philosophies can further reduce manufacturing lead times and the corresponding inventories.

Material cost reductions. Improved procurement practices lead to better vendor negotiations for prices, typically resulting in cost reductions of 5 percent or better. Valid schedules permit purchasing people to focus on vendor negotiations and quality improvement rather than on expediting shortages and getting material at premium prices. ERP systems provide negotiation information, such as projected material requirements by commodity group and vendor performance statistics. Giving suppliers better visibility of future requirements helps them achieve efficiencies that can be passed on as lower material costs.

Labor cost reductions. Improved manufacturing practices lead to fewer shortages and interruptions, and less rework and overtime. Typical labor savings from successful ERP are a 10 percent reduction in direct and indirect labor costs. By minimizing rush jobs and parts shortages, less time is needed for expediting, material handling, extra setups, disruptions, and tracking split lots or jobs that have been set aside. Production supervisors have better visibility of required work and can adjust capacity or loads to meet schedules. Supervisors have more time for managing, directing and training people. Production personnel have more time to develop better methods and improve quality and throughput.

Improved customer service and sales. Improved coordination of sales and production leads to better customer service and increased sales. Improvements in managing customer contacts, in making and meeting delivery promises, and in shorter order to ship lead times, lead to higher customer satisfaction and repeat orders. Sales people can focus on selling instead of verifying or apologizing for late deliveries. In custom product environments, configurations can be quickly identified and priced, often by sales personnel or even the customer rather than technical staff. Taken together, these improvements in customer service can lead to fewer lost sales and actual increases in sales, typically 10 percent or more.

ERP systems also provide the ability to react to changes in demand and diagnose delivery problems. Corrective actions can be taken early, such as determining shipment priorities, notifying customers of changes to promised delivery dates, or altering production schedules to satisfy demand.

Improved accounting controls. Improved collection procedures can reduce the number of days of outstanding receivables, thereby providing additional available cash. Underlying these improvements are fast accurate invoice creation directly from shipment transactions, timely customer statements, and follow through on delinquent accounts. Credit checking during order entry and improved handling of customer inquiries further reduces the number of problem accounts. Improved credit management and receivables practices typically reduce the days of outstanding receivables by 18 percent or better.

Trade credit can also be maximized by taking advantage of supplier discounts and cash planning, and paying only those invoices with matching receipts. This can lead to lower requirements for cash-on-hand.

ERP System Benefits on the Balance Sheet

Benefits from improved business processes and improved information provided by an ERP system can directly affect the balance sheet of a manufacturer. To illustrate this impact, a simplified balance sheet is shown in figure 3.1 for a typical manufacturer with annual revenue of $10 million. The biggest impacts will be on inventory and accounts receivable.

In the example, the company has $3 million in inventory and $2 million in outstanding accounts receivable. Based on prior research concerning industry averages for improvements, implementation of an ERP system can lead to a 20 percent inventory reduction and an 18 percent receivables reduction.

Figure 3.1 Summarized balance sheet for a typical $10 million firm

  Current Typical Improvement Benefit
Current assets    
Cash and other 500,000  

Accounts receivable

2,000,000 18%
356,200

Inventory

3,000,000 20%
600,000

Fixed assets

3,000,000  
Total assets $8,500,000  
$956,200
Current liabilities xxx,xxx  
Non current liabilities xxx,xxx  
Stockholder's equity xxx,xxx  
Total liabilities and equity xxx,xxx  

  • Inventory Reduction. A 20 percent inventory reduction results in $600,000 less inventory. Improved purchasing practices (that result in reduced material costs) could lower this number even more.

  • Accounts Receivable. Current accounts receivable represent seventy-three days of outstanding receivables. An 18 percent reduction (to sixty days' receivables) results in $356,200 of additional cash available for other uses.

ERP Benefits on the Income Statement

A simplified, summary income statement for the same $10 million manufacturer is shown in figure 3.2. For many manufacturers, the cost of sales ranges from 65 to 75 percent of sales (the example will use 75 percent). Using industry averages for each major benefit, the improved business processes and associated information system almost double the current pretax income.

  • Inventory Reduction. A 20 percent reduction in the current inventory of $3 million results in ongoing benefits of lower inventory carrying charges. Using a carrying cost of 25 percent results in $150,000 in lower carrying charges each year, identified here as part of the administrative expenses.

  • Material Cost Reductions. A 5 percent reduction in material costs because of improved purchasing practices results in annual savings of $225,000.

  • Labor Cost Reductions. A 10 percent reduction in labor costs because of less overtime and improved productivity results in annual savings of $100,000.

  • Increased Sales. Improvements in customer service typically lead to a 10 percent sales increase; this is not shown in figure 3.1.

Annual benefits totaling $475,000 in this example almost equals the current pretax income of $500,000.

Figure 3.2 Summarized income statement for a typical $10 million firm

  Current Typical Improvement Benefit
Sales $10,000,000 10%

Cost of sales

7,500,000  
Material 4,500,000 60%
Labor  1,000,000 13%
Overhead 2,000,000 27%
5% $225,000
10% $100,000
 

Administrative expenses

2,000,000   $150,000
Pretax income $ 500,000   $475,000

ERP Impact on Key Financial Ratios

Ration analysis provides another way to look at the impact of an ERP system. Three ratios illustrate the effect---two related to liquidity and one to operating performance.

  • Inventory turnover (Cost of Sales/Inventory). Low inventory turnover can indicate possible overstocking and obsolescence. It may also indicate deeper problems of too much of the wrong kind of inventory which can create shortages of needed inventory for production and sales. High turnover indicates better liquidity and superior materials management and merchandising. Given the example $10 million company, the current number of inventory turns is 2.5. With a 20 percent inventory reduction, the number of inventory turns increases to 3.1.

  • Days of Receivables (365 * 1/(Sales/Receivables)). This ratio expresses the average time in days that receivables are outstanding. It is a measure of the management of credit and collections. Generally, the greater the number of days outstanding, the greater the probability of delinquencies in accounts receivable. The lower the number of days, the greater the cash availability. With an 18 percent reduction in receivables, the current days receivable of seventy-three days can be reduced to sixty. This means $356,200 is available for other purposes.

  • Return on Assets (Profit Before Taxes/Total Assets). This ratio measures the effectiveness of management in employing the resources available to it. Several calculations are necessary to determine the return on assets. In this example, the return on assets can be improved from 5.9 to 12.9 by effectively implementing an ERP system.

Performance evaluation based on ratio analysis can also use comparisons between one's own company and similar firms in terms of size and industry. The Annual Statement Studies provide comparative ratios for this purpose. This use of comparative ratio analysis will use the same three ratios for inventory turnover, days receivable, and return on assets. To perform the analysis, you identify the median and upper quartile ratios for firms in the same industry. These roughly correspond to average and good performance. By comparing the ratios with your firm's current performance, you can calculate how much better your company should be performing to be competitive. The same analysis can be performed using the "BenchmarkReport.com" website.

Using the inventory turns ratio for the example $10 million manufacturer, assume the Annual Statement Studies indicate that the median and upper quartile are four and six turns for other firms in the same industry. Average performance of four inventory turns translates into an expected inventory of $1.875 million ($7.5 million divided by four). If the example firm had this ratio, it would have had $1.125 million less in inventory. With inventory carrying costs at 25 percent, this would produce savings of $281,250 each year.

For the days receivable ratio, assume the Annual Statement Studies indicate that sixty and fifty days are the median and upper quartile. The days receivable in the example $10 million manufacturer is currently seventy-three days; an improvement to sixty days would reduce receivables by $356,200 (using a daily sales rate of $27,400 and a thirteen day reduction). This means that cash is available for other purposes.

Note that the return on assets ratio is 5.9 for the example company. Assuming the Annual Statement Studies indicate the return on assets is ten and fifteen for firms in the same industry at the median and upper quartiles, improving the return on assets to equivalent levels would mean increased profits or asset turnover.

ERP Impact on Stock Price

If the integration and improved information of an ERP system results in a better balance sheet and increased profits, these improvements should impact stock price for the company. Although stock price is affected by a variety of factors, the typical effect of improved profits and balance sheet ratios can be estimated. Using the already described example of $10 million manufacturer and typical benefits, and assuming 100,000 shares outstanding and an existing stock price of $30.00 per share, , the stock price exhibits the effects of an effective ERP, as figure 3.3 shows. With a price/earnings multiplier of six, the stock price for the example company could be increased from $30 to $58.80 per share.

Figure 3.3 Calculating the potential stock appreciation

  Before ERP After ERP
Before tax profit $500,000.00 $980,000.00
Earnings per share $ 5.00 $9.80
Current stock price $30.00 6 * 9.80 = $58.80
Multiplier 6 6

These calculations suggest that ERP systems can lead to significant impacts on financial results, including the balance sheet, income statement, key ratios, and stock price.

This concludes Part One of a four-part article reprinted from Maximizing Your ERP System by Dr. Scott Hamilton. Bridging the theory and realities of current ERP systems, Maximizing Your ERP System provides practical guidance for managing manufacturing in various environments. Drawing on case studies from Dr. Hamilton's first-hand experience in consulting with more than a thousand firms, it covers common problems and working solutions for how to effectively implement and use ERP systems. The book can be ordered on amazon.com. This excerpt on "Justification of ERP Investments" is presented in four parts:

Reprinted with permission of McGraw-Hill.


About the Author

Scott Hamilton consults and teaches globally on SCM and ERP issues. He authored Maximizing Your ERP System and previous books on Dynamics AX and NAV. Scott has won the rarely given Microsoft MVP Award for Dynamics AX, and Microsoft’s Excellence in Innovation Award. He can be reached at ScottHamiltonPhD@aol.com.







 
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