Introduction to ERP and designing a business case for ERP

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Introduction to ERP and designing a business case for ERP

ERP: Making It Happen: The Implementers' Guide to Success with Enterprise Resource Planning
Chapter 5, Getting Ready

In this excerpt, find an introduction to ERP and learn what questions you should ask before deciding on implementation. Discover how to build a business case for ERP and who should be educated before implementation begins.

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ERP: Making It Happen: The Implementers' Guide to Success with Enterprise Resource Planning, Ch. 5
Table of contents:
Preparing an ERP implementation plan: ERP audit and assessment
Introduction to ERP and designing a business case for ERP
ERP cost benefit analysis for stand-alone projects

FIRST-CUT EDUCATION

Key people need to learn about ERP before they can do a proper job of creating the vision statement and estimating costs and benefits. They need to learn five crucial elements:

1. What is ERP?
2. Is it for us? Does it make sense for our business?
3. What will it cost?
4. What will it save? What are the benefits we'll get if we do it the right way and get to Class A?

and finally, if the company does not have Enterprise Software, but needs/wants it,

5. What are the linkages with ES and should we do both at the same time?

 
This excerpt from ERP: Making It Happen: The Implementers' Guide to Success with Enterprise Resource Planning by Thomas F. Wallace and Michael H. Kremzar is reprinted here with permission from John Wiley & Sons, Inc.; Copyright 2001.

Some individuals may go through first-cut education prior to audit/ assessment. Either they will not be aware of the value of the audit/ assessment step or may want to become familiar with ERP prior to audit/assessment. The sequence is not important; the critical issue is to make sure that both steps are done. A management team should make a decision to proceed with ERP (or any other major initiative, for that matter) only after doing both audit/assessment I and first-cut education.

Some companies attempt to cost justify ERP before they understand what it's all about. Almost invariably, they'll underestimate the costs involved in implementation. They'll feel ERP is part of the computer system to order material. Therefore, most of the costs will be computer related and already funded with ES or other software projects. As a result, the project will not be properly funded.

Further, these companies almost always underestimate the benefits. If they think ERP is a computer system to order material, then most of the benefits will come from inventory reduction. It then becomes very difficult to peg the ERP implementation as a high priority in the company. The obvious moral of the story: First, learn about it; then do the cost/benefit analysis.

Who needs first-cut education? For a typical company, these people would be:

  • Top management.

The CEO or general manager and the vice presidents of engineering, finance, manufacturing, and the marketing/sales departments. Basically, this should be the leadership team of the company or business unit.

  • Operating management.

Managers from the sales department, customer service, logistics, production, information systems, engineering, accounting, materials, and supply chain management. Sales manager, customer service manager, production manager, logistics manager, systems manager, production control manager, purchasing manager, engineering manager, accounting manager. Obviously, the composition of this group can vary greatly from company to company. In smaller companies, top management and operating management are often one and the same. Larger companies may have senior vice presidents, directors, and others who would need early education on ERP. The guidelines to follow are:

1. Don't send many more people through first-cut education than necessary, since the final decision to implement hasn't yet been made.

2. On the other hand, be certain to include all key people -- informal leaders as well as formal -- who'll be held accountable for both costs and benefits. Their goal is to make an informed decision.

Sometimes companies have a difficult time convincing certain senior managers, possibly the general manager, to go through a first-cut education process. This can be a very serious problem, and Chapter 7 will address it in detail.

VISION STATEMENT

In this step, the executives and operating managers who participated in first-cut education develop a written vision of the company's transformation: what will we look like and what new competitive capabilities will be in place following the implementation of ERP (and perhaps the ES/ERP combination). The statement must be written in a way that can be measured easily, so it'll be obvious when you get there.

This step is easy to skip. It's easy to feel that it takes more time and effort than it's worth. Not true. The reverse is actually the case: It's not much work, and it's worth its weight in gold. It's an essential part of laying the foundation for a successful project, along with the cost/benefit step. In fact, without a clear vision of the future, no sane person would embark on the journey to work through the major changes required.

The vision statement serves as a framework for consistent decision making over the life of the project, and can serve as a rallying point for the entire company. More immediately, the vision statement will serve as direct input to downstream steps on the Proven Path: cost/benefit analysis; establishment of performance goals; and development of the demand management, planning, and scheduling processes. Input to the preparation of the vision statement includes:

1. The executives' and managers' knowledge of:

  • The company and its problems. (Where are we today?)
  • Its strategic direction. (Where are we going?)
  • Its operating environment. (What does the marketplace require?)
  • Its competition. (What level of performance would gain us a competitive advantage in that marketplace?)


2. The recommendations made in audit/assessment I.
3. What was learned in first-cut education.

Brevity is good; less is more. Ideally, the vision statement will consist of one page. Some great vision statements are little more than one paragraph. It should be visceral, and it should drive action.

Since it's a relatively brief document, it shouldn't take a long time to prepare. One or several meetings should do the job, with heavy involvement by the general manager. However, if the vision is not clear and accepted by the leadership, or if it is not aligned with the company's strategy, don't go further. Remember, if the team doesn't know where they are going, everyone will work hard in different, and often conflicting directions.

One last point: Don't release the ERP vision statement quite yet. Remember, you haven't yet made a formal go/no-go decision. That'll come a bit later.

COST/BENEFIT ANALYSIS

Establishing the costs and benefits of an ERP project is essential. Here are some reasons why:

1. High priority.

Job 1 is to run the business. Very close to that in importance should be implementing ERP. It's very difficult to keep ERP pegged as a very high priority if the relevant costs and benefits have not been established and bought into. If ERP doesn't carry this high priority, the chances for success decrease.

2. A solid commitment.

Implementing ERP and ES means changing the way the business is run. Consequently, top management and operating management must be committed to making it happen. Without a solid projection of costs and benefits, the necessary degree of dedication may not be attained, and the chances for success will decrease sharply.

3. One allocation of funds.

By identifying costs thoroughly and completely before implementation, the company has to process only one spending authorization. This avoids repeated "trips to the well" (the board of directors, the corporate office, the executive committee) and their attendant delays during the life of the project. This factor leads some companies to combine ERP and ES into one project.

The people who attended first-cut education should now develop the cost/benefit study. Their objective is to develop a set of numbers to use in deciding for or against ERP. Do not, under any circumstances, allow yourselves to skip this step. Even though you may be convinced that you must do ERP and its benefits will be enormous, it's essential that you go through this process, for the reasons mentioned above. To do otherwise is like attempting to build a house on a foundation of sand.

Let's first focus on the likely areas of costs and benefits. After that, we'll work through several sample cost/benefit analyses.

Costs

A good way to group the costs is via our ABC categories: A = People, B = Data, C = Computer. Let's take them in reverse order.

C = Computer.

Include in this category the following costs:

1. New computer hardware necessary specifically for ERP or ES.
2. ES software for a combined ERP/ES project, and possibly supply chain bolt-ons for either ERP/ES or ERP only.
3. Systems people and others to:

  • Configure and enhance the ES software.
  • Install the software, test it, and debug it.
  • Interface the purchased software with existing systems that will remain in place after ERP and ES are implemented.
  • Assist in user training.
  • Develop documentation.
  • Provide system maintenance.

These people may already be on staff, may have to be hired, and/or may be temporary contract personnel. Please note: These costs can be very large. Software industry sources report cost ratios of up to 1:8 or more. In other words, for every dollar that a company spends on the purchased software, it may spend eight dollars for these installation activities.

4. Forms, supplies, miscellaneous.
5. Software maintenance costs. Be sure to include the any expected upgrades of the new software here.
6. Other anticipated charges from the software supplier (plus perhaps some contingency money for unanticipated charges).

B = Data.

Include here the costs involved to get and maintain the necessary data:

1. Inventory record accuracy, which could involve:

  • New fences, gates, scales, shelves, bins, lift trucks, and other types of new equipment.
  • Mobile scanners on lift trucks to read bar codes on stock.
  • Costs associated with plant re-design, sometimes necessary to create and/or consolidate stockrooms.
  • Cycle counting costs.
  • Other increases in staffing necessary to achieve and maintain inventory accuracy.


2. Bill of material accuracy, structure, and completeness.
3. Routing accuracy.
4. Other elements of data such as forecasts, customer orders, item data, work center data, and so forth.

A = People.

Include here costs for:

1. The project team, typically full-time project leader and also the many other people identified with individual segments of the business.
2. Education, including travel and lodging.
3. Professional guidance.
4. Increases in the indirect payroll, either temporary or ongoing, not included elsewhere. Examples include a new demand manager or master scheduler, additional material planning people, or another dispatcher. For most companies, this number is not large at all. For a few, usually with no planning function prior to ERP, it might be much higher.

These are the major categories of cost. Which of them can be eliminated? None; they're all essential. Which one is most important? The A item, of course, because it involves the people. If, for whatever reason, it's absolutely necessary to shave some money out of the project budget, from where should it come? Certainly not the A item. How about cutting back on the C item, the computer? Well, if you absolutely have to cut somewhere, that's the best place to do it. But why on earth would we say to cut out computer costs with the strong ES linkage with ERP?

The answer goes back to Chapter 1-- installing ES without the proper ERP demand management, planning and scheduling tools will gain little. Many companies have had decent success without major computer or information system changes by working hard on their ERP capability. Obviously, we recommend that you do both. But, if there is a serious shortage of resources, do the planning systems first and automate the information systems later. Later in this chapter, we'll show you an example of the costs of the full ERP/ES combination and also ERP alone.

Companies are reporting costs for the total ERP/ES installation over $500 million for a large multinational corporation. In our ERP/ES example, the company is an average-sized business unit with $500 million in sales and about 1000 people, and the projected costs are over $8 million to do the full job. This number is not based on conjecture but rather on the direct experience of many companies. Our sample company doing ERP alone (no ES, a much less intensive software effort) shows considerably lower costs, but still a big swallow at $3.9 million. These are big numbers; it's a big project.

Benefits

Now let's look at the good news, the benefits.

1. Increased sales, as a direct result of improved customer service. For some companies, the goal may be to retain sales lost to aggressive competition. In any case, the improved reliability of the total system means that sales are no longer lost due to internal clumsiness. ERP has enabled many companies to:

  • Ship on time virtually all the time.
  • Ship in less time than the competition.
  • Have their sales force spend their time selling, rather than expediting shipments and making excuses to customers over missed shipments.

In short, ERP can represent a significant competitive weapon. Surveys of ERP-using companiesi have verified improved customer service gains of 15 percent for all respondents; 26 percent for the companies who identified themselves as Class A. For most companies, better customer service means more sales.

2. Increased direct labor productivity, resulting from the valid, attainable schedules which ERP can enable companies to have. Productivity is increased via:

  • Providing matched sets of components to the assembly areas, thereby eliminating much of the inefficiency and idle time often present.
  • Reducing sharply the amount of expediting, lot splitting, emergency changeovers, short runs, and so forth in the fabrication areas.
  • Requiring much less unplanned overtime, because the forward visibility is so much better.

Survey results show respondents reporting an average productivity gain of 11 percent; the Class A users got 20 percent. Think of the value to the bottom line of that kind of productivity gain!

3. Reduced purchase cost. ERP provides the tools to give suppliers valid schedules and better forward visibility. Once the customer company gets out of the order-launch-and-expedite mode, its suppliers can produce the customer's items more efficiently, at lower cost. A portion of these savings can be passed back to the buying company to be used either for increased profits or reduced product pricing which can mean increased sales and profits.

Further, valid schedules can free the buyers from a life of expediting and paper shuffling, so that they can do the important parts of their jobs (sourcing, negotiation, contracting, value analysis, cost reduction, etc.). Therefore, these savings don't come solely from lower prices but rather from reducing total purchase costs. Survey results: Companies report an average reduction in total purchased costs of 7 percent; the Class A companies got 13 percent. In many companies, the single largest financial benefit from ERP comes from purchase cost reduction.

4. Reduced inventories. Effective demand management, planning, and scheduling result in valid schedules.Valid schedules mean matched sets of components, which means making the products on schedule and shipping them on time. This typically results in lower inventories at all, or at least most, levels—raw material, work-inprocess, finished goods.

For most companies, the four benefit areas identified above are the big ones. However, there are other benefits that are potentially very significant and should not be overlooked. They include:

5. Reduced obsolescence, from an enhanced ability to manage engineering changes, better forward visibility, and an overall smaller risk of obsolescence due to lower inventories in general. This is often a hidden cost at most companies and no one likes to focus on the stuff that is sold at discount or thrown away. However, it can be very large and certainly requires attention.

6. Reduced quality costs. Valid schedules can result in a more stable environment, which can mean less scrap. Eliminating the endof- the month lump, where perhaps 75 percent of the shipments go out in the last 25 percent of the month, can lead to reduced warranty costs.

7. Reduced premium freight, both inbound, by having a better handle on what's needed, and outbound, by being able to ship on time. Many companies are delighted when they can air express a shipment to fulfill a customer order without thinking about the money that they could have saved with an on-time land shipment.

8. Elimination of the annual physical inventory. If the inventory numbers are accurate enough for ERP, they'll be more than good enough for the balance sheet. Many Class A and B companies don't take annual physical inventories. This can be a substantial savings in some companies. It can include not only the costs of taking the inventory itself but also the costs of disrupting production, since many companies can't produce while they count.

9. Reduced floor space. As raw material, work-in-process, and finished inventories drop sharply, space is freed up. As a result, you may not need to expand the plant or build the new warehouse or rent more office space for some time to come. Do a mental connection between ERP and your building plans. You may not need as much -- or any -- new brick and mortar once you get really good at manufacturing. Don't build a white elephant.

10. Improved cash flow. Lower inventories mean quicker conversion of purchased material and labor costs into cash.

11. Increased productivity of the indirect workforce. ERP will help not only the direct production associates to be more productive but also the indirect folks. An obvious example is the large expediting group maintained by some companies. Under ERP, this group should no longer be needed, and its members could be absorbed into other, more productive jobs.

Another aspect of this, more subtle and perhaps difficult to quantify, is the increased productivity of the supervisors and managers. That includes engineers, quality control people, production supervisors and managers, vice presidents of marketing, and let's not forget about the guy or gal in the corner office -- the general manager. They should all be able to do their jobs better when the company is operating with a valid game plan and an effective set of tools to help them execute it.

They'll have more fun, also. More satisfaction from a job well done. More of a feeling of accomplishment. That's called quality of life and, while it's almost impossible to quantify that benefit, it may be the most important one of all.

Responsibility

A question often asked is: "Who should do the cost/benefit analysis? Who should put the numbers together?" First of all, it should not be a one-person process -- it's much too important for that. Second, the process should not be confined to a single group. Let's look at several ways to do a cost/benefit analysis:

Method 1: Middle management sells up.

Operating managers put together the cost/benefit analysis and then attempt to sell the project to their bosses. If top management has been to first-cut education, there should be no need for them to be sold. Rather, they and their key managers should be evaluating specifically how ERP will benefit their company and what it'll cost to get to Class A.

This method is not recommended.

Method 2: Top management decree.

The executive group does the cost/benefit analysis and then decrees that the company will implement ERP. This doesn't allow for building the kind of consensus and teamwork that's so important.

This method is not recommended.

Method 3: Joint venture.

This is the recommended approach. The cost/benefit analysis should be done by those executives and managers who'll be held accountable for achieving the projected benefits within the framework of the identified costs. Here's how to do it:

1. A given department head, let's say the manager of sales administration and customer service, attends first-cut education.
2. The vice president of the sales and marketing department attends first-cut education.
3. Upon returning to the company, both persons do some homework, focusing on what benefits the sales side of the business would get from a Class A ERP system, plus what costs might be involved.
4. In one or several sessions, they develop their numbers. In this example, the most likely benefit would be increased sales resulting from improved customer service, and the biggest cost elements might be in education and training.
5. This process is also done in the other key functional areas of the business. Then the numbers are consolidated into a single statement of costs and benefits in all of the key areas of the business (finance, manufacturing, logistics, product development, etc.).

Please note the participatory nature of the joint venture approach. Since both top management and operating management are involved, it promotes consensus up and down the organization, as well as cross functionally. We've found it to be far better than the other approaches identified above.

A word of caution: Be fiscally conservative. When in doubt, estimate the costs to the high side and the benefits low. If you're not sure whether certain costs may be necessary in a given area, include them. Tag them as contingency if you like, but get 'em in there. There's little risk that this approach will make your cost/benefit numbers unattractive because ERP is such a high payback project. Therefore, be conservative. Don't promise more than you can deliver.

We'll give you an example of the costs and benefits to illustrate the potential. You know that your company will have different numbers, but we want to show that a conservative approach still gives big savings. Note that the dramatic savings that are shown are still VERY conservative.

Examples of Cost/Benefit Analysis

To illustrate the process, let's create a hypothetical company with the following characteristics:

Annual sales: $500 million
Employees: 1000
Number of plants: 2
Distribution centers: 3
Manufacturing process: Fabrication and assembly
Product: A complex assembled make-to-order product, with many options
Pretax 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

Combined ERP/ES

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. Do not use them. They may be too high or too low for your specific situation. Using them could be hazardous to the health of your company and your career.

With that caution, let's examine the numbers. Figure 5-2 contains our estimates for the sample company. Costs are divided into onetime (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 Chapter 2 -- 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 Figure 5-3 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.

 

 

Figure 5-2 Sample Cost/Benefit Analysis: Full ERP/ES
COSTS
Item One Time Recurring Comments
C - Computer
Hardware $400,000   Costs primarily for workstations.
Software 500,000 $75,000 Can vary widely, based on package.
Systems and programming 2,500,000 200,000 Adapting the software to your company, and training in its use. These costs are pegged here at 5 times the software purchase cost.
B - Data
Inventory record accuracy 700,000 100,000 Includes new equipment and added cycle counters.
Bill of material accuracy and structure 200,000   Bills will need to be restructured into the modular format. Experienced engineers will be needed for this step.
Routing accuracy 100,000    
Forecasting 200,000 100,000 Full time person for Sales forecasting. Needs to come on board early.
A - People
Project Team 1,200,000   Six full-time equivalent people for two years.
Education 800,000 100,000 Includes costs for education time and teaching the new ES interactions to the organization.
Professional guidance 400,000 50,000 4 days per month during installation.
SUB-TOTAL $7,000,000 $725,000  
Contingency $8,050,000 $834,000  
15% 1,050,000 109,000 A conservative precaution against surprises.
TOTAL $9,100,000 $943,000  
BENEFITS
Item Current % Improvement Annual Benefits Comments
Sales $500,000,000 7% at 10% $3,500,000 Modest improvement due to improved product availability at the profit margin of 10%.
Direct labor productivity 25,000,000 10% 2,500,000 Reductions in idle time, overtime, layoffs, and other items caused by the lack of planning and information flow.
Purchase cost 150,000,000 5% 7,500,000 Better planning and information will reduce total purchase costs.
Inventories       One time cash flow:
Raw Material and WIP 25,000,000 10% at 15% 380,000 2,500,000
Finished goods 25,000,000 30% at 15% 1,130,000 7,500,000
Obsolescence 500,000 30% 150,000
Premium freight 1,000,000 50% 500,000 Produce and ship on time reduces emergencies.
SUB-TOTAL     $15,660,000 $10,000,000 One time cash flow.
Less costs for:
Contingency   15% -2,349,000 1,500,000
Recurring     -720,000
NET ANNUAL BENEFITS     $12,591,000 $8,500,000 One time cash flow.
Cost of a one month delay (Total/12) $1,049,250
Payback time (One Time Cost/monthly benefits) 7.7 months
Return on investment (Annual benefits/One Time Costs) 193%

 

 

Figure 5-3 Projected Cash Flow from ERP/ES
Year Annual Cumulative Comments
1 -$6,440,000 -$6,440,000 80% of remaining costs
2 -1,610,000   Remainder (20%) of one-time cost
  -417,000   6 months of recurring cost
  +5,036,400   40% of annual benefit
  +2,125,000   25% of inventory reduction
  +5134,000 -$1,306,000
3 -834,000   Annual recurring cost
  +12,591,000   Gross annual benefits
  +6,475,000
  +18,233,000 +$16,926,000 Balance 75% of inventory reduction
      Total cash flow at end of year 3

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This was first published in January 2009