Part 1: Quantifiable Benefits from an ERP System
by Dr. Scott Hamilton* - February 10, 2004
1. Justification of ERP Investments
2. Quantifiable Benefits from an ERP System
3. ERP System Benefits on the Balance Sheet
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
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.
* 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.
* About the Author
Dr. Scott Hamilton has specialized in information systems for manufacturing
and distribution for three decades as a consultant, developer, user, and
researcher. Scott has consulted for over a thousand firms worldwide,
conducted several hundred executive seminars, and helped design several
influential ERP packages. He previously co-authored the APICS CIRM textbook
on How Information Systems Impact Organizational Strategy and recently
authored Managing Your Supply Chain Using Microsoft Navision. Dr. Hamilton
is currently working closely with Microsoft partners involved with
manufacturing and distribution, and can be reached at
ScottHamiltonPhD@aol.com or 612-963-1163.