How To Calculate ERP Return On Investment (ROI) For Your Business?
Suppose you’ve decided to implement an ERP solution for your business and plan to take it to the next level, it is evident that investing an extensive amount of money in ERP is not a cakewalk, as it requires to justify the budget and the expenditure.
But how will you calculate the budget required for an ERP system? Nowadays, most CFOs will want the ERP committee to justify the budget allocated to an ERP project by showing the Return On Investment(ROI).
For doing so, there are two components required:
- What will the ERP project cost?
- What are the savings, efficiencies and goodwill from the project?
A quote from ERP Focus says, “If you cannot reasonably predict earnings from your ERP that sufficiently outweigh your system costs, you should probably look for another place to spend your money.”
How to calculate the investment for implementing an ERP system?
For calculating the investment of an ERP system, there are a few components to be considered. It is always better to have a five-year budget that covers the initial investment and the Total Cost of Ownership(TCO) over the same period. The total cost of license, implementation, training, and maintenance cost of the software, all put together will give the TCO.
Let’s detail the necessary components:
Cost Of Software:
There are two deployment models in an ERP system, for which the pricing structure is different. They are the On-premise ERP and cloud-based ERP.
- On-premise ERP:The on-premise ERP are hosted on the company’s servers and purchased via a hefty, one-off license fee. While you use this model, you need to update your hardware so that the ERP can run on it.
- Cloud ERP:The ERP software hosted on third-party servers and accessed through the internet is the cloud ERPs. The pricing system of these ERPs follows the per-user-per-month model. There is no need to update your hardware, but as long as you use the system, you need to pay the monthly user fees.
Software Upgrade Investment:
Every software needs at least one primary system upgrade every year. So, it is necessary to evaluate the cost of the upgrade. These costs mainly depend on whether or not the ERP solution is on-premise or cloud-based.
The pricing for on-premise is based on the size of business or the number of users required. Hence, these ERP systems require significant investment upfront and annual maintenance, including upgrade costs.
The cloud software pricing is based on an annual or monthly subscription. The cloud-based ERP software upgrades and enhancements release on an ongoing basis, with costs baked into the subscription.
It is necessary to invest in consultancy to ease the upgrade implementation, user acceptance testing, training users in new functionality and support. Doing so will also enhance your ROI. The consultancy costs also depend on whether the software is on-premise or cloud-based.
The consultancy costs for on-premise software is higher, as the consultant should visit your premises to train your staff. It incurs more investment because of things like travel, consultant fees and more hours invested in arranging training. While in cloud-based software, all of the resources are online-based.
Initial Implementation Cost:
There are multiple methods to implement an ERP solution. The methodology you choose will provide you with the implementation budget. The costs include but are not limited to:
- Software installation
- System blueprint documentation
- System Configuration
- Reporting Configuration
- User Training
- Admin training
- Data conversion (test and live integration)
- User acceptance testing
- Pre Go-live preparation
- Go live
- The post-Go-live support
- Month-end support
Investment On the Internal Staff:
The ERP implementation also requires some support from the internal team members. The team members are necessary for:
- User Acceptance Testing
- Extracting data from legacy systems
- Attend user training
- Attend project meetings
- Help with functional requirements.
The costs mentioned above are some typical project costs that should be considered while implementing the ERP software. We recommend you to carefully quantify these costs before investing, as they help you accurately weigh ERP business benefits and costs.
After evaluating the total investment required for implementing an ERP system, it is now time to focus on the Return On Investment (ROI) of the ERP.
Is the ERP Solution Worth the Investment?
Evaluating the ERP Return On Investment is one of the fundamentals to undertake before proceeding to rollout. But now the question that arises is how do you calculate ROI of an ERP system?
While calculating the ROI, you need to compare the expected costs to the benefits (tangible or intangible) from system implementation over 5-10 years. Now let’s get a brief idea on what are the tangible and intangible benefits of an ERP system.
What Are The Tangible & Intangible Benefits?
The benefits that are measurable in monetary terms are tangible, while those that are not measurable in financial terms but have a huge business impact are intangible benefits. Any interest, either tangible or intangible, will affect the business. Today, we’ll list a few advantages that the executives and managers will see once their company implements an ERP solution.
Let’s list a few tangible benefits of implementing an ERP system:
- Minimizes the overall operating costs
- Increased inventory turns or billable hours
- Accelerating response time for returns or recalls
- Improved customer service
- A decrease in material costs
Having known tangible benefits, it is also essential to know about the intangible benefits of ERP software implementation:
- Improved staff retention
- Increases efficiency
- Effectively fix errors
- Centralizing documentation online
- Enables faster decision making
- It facilitates strategic planning
- Standard reporting
- Faster access to data for timely decision making
The ROI Equation
After having placed the monetary value for each benefit and cost, now you can roughly calculate the ROI, wherein the equation says:
Suppose that we assume an ERP system costs $100,000, while this cost will include the components like the software cost, upgrade fees, implementation costs, the consultancy costs, the investment on internal staff and many others.
Now that we have the total cost of investment, we need to calculate the sum of all the tangible and intangible benefits. Let’s assume that the overall benefits over five years will be $150,000.
Hence, the Return On Investment of an ERP will be calculated as follows:
ROI = [150,000 – 100,000] / 100,000
= 0.5 or 50%
As, now you have the exact value of returns on your investment, you have a clear idea on whether to invest in this ERP software or not. In this case, the annual return is 10% per year on average. Usually, the performances are not the same every year. It is because more costs incurred during the first months or years, while the benefits expected will be small initially and grow over time. The returns from the first year may be harmful, but after two or three years, you will realize the real gain from the software.
ERP ROI Calculation In The Past
In the earlier days, the ROI studies went through in a very detailed form. The organizations took an item for the cost of goods and operating costs. Later, they assigned a percentage of improvement for each. Then, the ones calculating the ERP ROI would determine the percentage savings and sum of each line to get the total of what was theoretically possible.
It was a time-consuming process, as a lot of time was spent to determine the current values and decide what appropriate amount will be the percentage of improvement.
In their situation, there was no assurance that the company would see any returns, and there was no proof that the vendor’s solution would provide a different performance from another vendor’s solution. Hence, it is a must to have a monetary gain calculated before funding the project.
Business executives use the ROI method to determine which investments to make. ERP ROI is also the financial success of most investments. Eventually, ROI is a comparison of the expected benefit of an investment in monetary units to the cost of that investment in the same monetary units. Always ensure that the effectiveness of ERP depends on the efficiency of the business that incorporates it.
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