Calculating the impact of an ERP implementation: your strongest argument for stakeholders
06.05.2024
Implementing ERP is an investment in the company’s future. However, stakeholders care not only about potential benefits, such as streamlined business processes, but also about the implementation’s impact on performance.
A detailed understanding of the metrics that determine whether an implementation pays off, along with a well-framed request, enables an organization implementing an ERP system to calculate how effective the implementation will be.
How do you calculate the impact of your ERP project?
The impact of an ERP implementation can be calculated with an express method, which gives a high-level estimate, or with a second method that provides a more detailed assessment based on a set of metrics.
For a high-level assessment of implementation effectiveness, two metrics are used: return on investment (ROI) and total cost of ownership (TCO). Keep in mind that TCO includes not only implementation costs, but also subsequent costs of maintenance, customization, and so on.
Return on investment (ROI) is the amount of money a company can recoup after investing in a project or software. ROI is also used to measure efficiency by comparing the returns on an organization’s various investments.
The ROI formula is as follows:
Where Net Profit is the difference between revenue and TCO.
For accurate calculations, it is important to define the metrics that will be tracked and used to calculate the return. These include both quantitative metrics (for example, the cost of purchasing software and hardware, faster inventory turnover, and higher labor productivity) and qualitative ones (for example, greater customer loyalty thanks to more efficient customer service). Depending on its requirements and goals, a company may develop its own metrics for analyzing how effective the system implementation is. These metrics are usually based on an assessment of the benefits of implementing the ERP system and the costs of using it.
Therefore, the company goals and objectives that the ERP system is meant to address should be defined in line with the business strategy. To accurately estimate the expected return on investment, you need to answer one question: which metrics do we want to improve?
For example:
- Achieve or exceed the target level of performance (KPIs, etc.);
- Improve planning and monitoring of financial and operational plans;
- Improve customer relationships (analysis of loyalty metrics, feedback, etc.);
- Increase sales;
- Reduce order processing time;
- Cut production and operating costs;
- Reduce investment in inventory;
- Shorten the time needed to develop new products and bring them to market.
The list could go on; it all depends on the specific situation in each organization.
According to recent data from international researchers, companies that implement an ERP system properly can achieve significant results (market averages):
- 15% reduction in operating and administrative expenses
- 2% savings in working capital
- 25% shorter product sales cycle;
- 35% reduction in selling expenses
- 12% reduction in accounts receivable
- 25% faster turnover of funds tied up in settlements.
Once you have identified the outcome metrics (let’s call them operational metrics) that affect net profit, you can move on to detailed calculations of how effective the ERP implementation is from a financial standpoint, where we will calculate the key financial outcome metrics.
The most accurate way to calculate project return is to compare the outcome (financial) metrics with and without (“With – Without”) putting the ERP system into full production use.
This method is used when the project’s cash flow cannot be separated from the company’s cash flow. In any time interval, the cash flow of a project integrated into the company equals the company’s cash flow with the project minus its cash flow without the project. The first step is to determine the delta (the difference between the baseline and the analyzed cash flow).
The difference between the baseline cash flow (without ERP) and the analyzed cash flow (with the product implemented) in each time interval t:
CFbase – cash flow under the baseline scenario,
CFalt – cash flow under the analyzed alternative
The “with the project – without the project” principle is also applied in the form “with one project – with another project” when choosing the most effective of several mutually exclusive, economically integrated projects (replacement projects).
Next, with a properly built cash flow based on the with-and-without (“With – Without”) ERP implementation method, you can move on to the key investment project metrics, such as:
- Net present value (NPV)
- Internal rate of return (IRR)
- Supplementary criteria include the discounted payback period (DPB)
Plug the cash flow delta calculated above into the formulas below. The result is the very estimate of the ERP implementation’s impact that we are after.
Net present value (NPV)
K – discount rate (required rate of return)
Decision rules:
Projects with a net present value greater than zero are accepted. Among mutually exclusive projects, the one with the highest NPV is chosen.
If a company listed on an efficient market accepts a project with a positive NPV, the company’s market capitalization should increase by that project’s NPV once the decision is made:
Scope of application:
Evaluating any individual project with fixed start and end dates.
Advantage:
Directly aligned with management’s primary goal of maximizing shareholder equity value; NPV>0 means the project’s return exceeds the discount rate, i.e., the return that the capital market requires on investments with the same level of risk.
Disadvantages:
- Requires justification of the discount rate;
- Does not allow projects of different durations to be compared.
Internal rate of return (IRR)
Decision rules:
Projects whose internal rate of return exceeds the cost of capital are accepted. Among mutually exclusive projects, the one with the highest IRR is chosen.
Scope of application:
Comparing the returns of the processes underlying the projects.
Advantage:
Expresses the project’s return, as the financial result of the investment, in a single figure;
Does not depend on the choice of discount rate, since it is determined solely by the project’s own cash flow.
Disadvantages:
- Difficult to interpret when there are multiple values;
- Does not correctly account for reinvestment of the returns;
- Does not reflect the scale of the project.
By the definitions of NPV and IRR, in any “conventional” investment project—that is, one whose cash flows change sign only once, from negative to positive—if NPV>0, then IRR>k.
Thus, when many independent projects are evaluated, the NPV and IRR criteria do not contradict each other.
However, when mutually exclusive projects are compared in pairs, situations sometimes arise where NPV1>NPV2 while IRR1<IRR2, i.e., the NPV and IRR criteria contradict each other. This is usually caused by different growth rates of the compared projects’ cash flows (for example, the cash flows of project 1 grow over time, while those of project 2 decline).
When NPV and IRR conflict, remember the fundamental goal of a business (increasing shareholder equity value) and give preference to the NPV criterion.
Discounted payback period (DPB)
Scope of application:
A supplementary metric used to screen out projects that take unjustifiably long to deliver benefits
Advantage:
Simplicity
Main disadvantage:
It completely ignores the project value generated after the target payback period. That is why DPB is not recommended as the primary decision-making criterion.
Don’t want to dig into formulas?
We will help you calculate the payback period of a 1C:ERP implementation at your company.
We will run an express assessment completely free of charge, and you will receive a register of your company’s business processes. On top of that, we will calculate the projected savings from implementing the ERP system.
Just send a request to our chatbot
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