Scott Beaver
Enterprise resource planning (ERP) systems deliver immense value by integrating core business functions, such as finance, inventory management, manufacturing, sales, project management and human resources (HR), with a single, unified platform that provides centralized access to critical data. With greater visibility into these functions, business leaders can increase efficiency, reduce costs and unlock new growth opportunities.
Quantifying that value — the return on investment (ROI) of your ERP — is crucial to building a business case that justifies an ERP investment in the first place. Further, the analysis that goes into quantifying the ROI of ERP helps businesses evaluate and anticipate the impact of an ERP system on their organizations and also refine their ERP approach over time so that the ERP’s value to the business continues to increase.
But because ERP systems have the potential to touch so many different aspects of a business, quantifying their impact — and, therefore, their ROI — can be complex. This is especially true for businesses migrating to cloud ERP systems, which deliver intangible benefits whose ROI is less easy to quantify in dollars. In this article, we break down the many benefits of ERP systems, how to accurately calculate their ROI and tips to help your company get the most value from its ERP investment.
Benefits of an ERP System
Before calculating the ROI of an ERP implementation, it is crucial to establish why your business is investing in an ERP and what it hopes to achieve. The following rundown of the benefits ERP systems can bring to a business, and how ERP generates those benefits, will help to articulate those expectations.
Data stored in a common database. ERP systems collect data from across an organization and house it all in a common database. That allows employees in general, and key business leaders in particular, to monitor the pulse of their business using a single, accurate and integrated view of business operations, from back-end finance processes and warehouse operations to lead generation and sales success.
Unified view limits silos. Working with a unified view of the organization breaks down data silos and saves a great deal of time when making informed business decisions. For instance, real-time insight into supply chains, inventory capacity and projected customer demand could help a manufacturer maximize output without exceeding the capabilities of its teams.
Allows for companies to scale quickly. Cloud-based ERP systems, in particular, offer an attractive growth platform, especially for companies that need to scale up quickly to manage the growing complexity of their operations. Take supply-chain logistics provider Green Rabbit, which specializes in fast delivery of perishable goods. Green Rabbit adopted a cloud-based ERP to rapidly expand from startup to countrywide operation, helping its customers deliver tens of thousands of orders across America, every day, with zero delays or inventory errors.
Mitigates human error. ERP systems also help businesses improve the timeliness of orders and payments with streamlined invoicing. In contrast, manual bookkeeping is slow and prone to human error, which can lead to unnecessary costs and delays. As the saying goes, time is money. The faster a business can process, ship and invoice an order, the faster it reaches the customer and the sooner the business gets paid.
Reduces personnel needed to accomplish tasks. Much of the value businesses derive from ERP systems stems from the way ERP integrates processes that involve multiple departments. Consider a standard procure-to-pay process, which involves many teams and touch points, from sales to warehousing to fulfillment.
With an ERP, stakeholders throughout this chain can track and manage the entire process from a single system. For instance, a salesperson who just closed a major account can check the status of the order at any time and keep their customer updated, without having to rely on anyone else. This process increases efficiency and saves money, helping to build stronger customer relationships built on accountability and trust.
How to Calculate the ROI of an ERP System
The benefits of ERP systems are well-documented, but calculating the return on investment of any given ERP implementation is a nuanced process. Before working through an example calculation, let’s explore three important distinctions: on-premises vs. cloud deployment model, “hard” vs. “soft” returns and initial implementation vs. ongoing usage.
The choice of deployment model has an important effect on ERP ROI calculations. Technically, the term “ROI” doesn’t even apply to cloud-based systems because they are generally paid for via monthly or yearly subscription fees, which are treated as operating expenses for accounting purposes. The “I” in ROI refers to a capital investment, and capital expenses require more complex accounting treatment. ROI does apply to on-premises systems, which typically require upfront capital expenditure to purchase the licenses and the computer hardware and infrastructure required to operate the software. Nonetheless, organizations that deploy cloud ERP use the principles of ROI to understand the value their ERP systems provide.
There is also a useful distinction to be made between “hard” and “soft” ROI. Hard ROI refers to traditional returns that can be easily assigned a quantifiable financial value, such as incremental revenue gained or costs reduced. For instance, NetSuite ERP customers saw a 40% to 60% improvement in order process efficiency since implementation of their systems, and 40% to 55% saw a reduction in reporting times, both of which can be easily quantified in dollar figures and therefore fall in the category of hard ROI. On the other hand, soft ROI refers to intangible gains, such as a rise in employee morale or improved brand equity with customers. Both of these benefits can have an immense impact on a business’s bottom line, but the exact dollar value of their contribution is less clear.
ERP implementations have two main phases: the initial installation and then ongoing use by employees trying to make the most of the new technology. Within these, companies will often lean on their ERP vendors to help with the implementation and, in most cases, migrate data from their previous system to the new ERP. But employee training and ease of use are essential to maximizing the ROI of a new ERP system. This is why many successful implementations focus on employees’ initial training to learn the ins and outs of how their new system meets and exceeds their needs, and on user experience — the simple interfaces and mobile functionality, among other criteria, that makes the system easy to use over the long run.
ERP ROI Formula
Now let’s introduce the basic hard ERP ROI formula and work through an illustrative example:
ROI = (total value of investment – total cost of investment) / total cost of investment x 100%
Translating the formula into plain English, ERP ROI is the ratio of the gains delivered by an ERP investment (expressed as a dollar value) to the total cost of ownership (TCO), or investment. That ratio is expressed as a percentage. The TCO for an ERP includes the upfront cost of the solution and any expected costs throughout its life cycle. Traditionally, this formula would apply only to on-premises ERP, since TCO, by definition, refers to the capital expense of a purchased asset plus related ongoing operating expenses. So, even though technically not “TCO,” in the case of a cloud-based system, the equivalent costs would include monthly or yearly licensing fees to use the ERP software. The higher the ratio of gains to TCO (or its cloud equivalent), the higher the return on investment, or ROI.
Consider the example of a consumer goods manufacturer that implemented a cloud-based ERP system, paid via yearly subscription. The company needs to calculate the ROI of its new solution three years after going live, based on an upfront implementation cost of $50,000 and yearly fees of $100,000. That yields a three-year cloud-equivalent TCO of $350,000. Of course, this example is simplified to fit in this article; the manufacturer’s total cost might also include the cost of training employees to use the new ERP solution, implementation partner fees and others, in addition to upfront installation and yearly licensing fees, depending on the specific use case and ERP deployment model.
As for returns, the manufacturer has chosen to focus on hard costs, so it calculated the incremental sales growth, higher margins and lower production costs it can attribute to its ERP system, as shown in this table:
Benefit Year 0 Year 1 Year 2 Year 3 Total
Sales growth $0 $50,000 $80,000 $100,000 $230,000
Productivity gains $0 $30,000 $40,000 $90,000 $160,000
Cost savings $0 $60,000 $100,000 $115,000 $275,000
Total $0 $140,000 $220,000 $305,000 $665,000
The value provided by the software over this three-year period (ignoring inflation) is $665,000.
Plugging the total value of gains attributed to ERP and the manufacturer’s simplified total cost into the ERP ROI formula, we get ($665,000 – $350,000) / $350,000 x 100, which equals a 90% return on investment.
It’s important to emphasize that the gains in this example are also simplified. The total value a business can attribute to ERP will depend on the nature of the business and might include improvements in product, transportation or inventory carrying costs, increased order volumes, reduced head count and lower administrative costs. In addition to these hard returns, a company may also derive intangible benefits from its ERP implementation, like improved employee morale, which should also be factored into ROI calculations.
One final nuance to note is that some organizations prefer to measure the ROI of their ERP year over year rather than over the system’s life span. One approach for doing so is to use the formula outlined above and apply only the revenue and/or savings for that year. But this is not always ideal, as much of the upfront costs will not be repeated in subsequent years. For instance, employee training is most intensive in the first few months after installation and less so in subsequent years. Similarly, ERP returns tend to increase in the first couple of years after implementation, as new efficiencies and opportunities are unlocked, driving better returns, before flattening out into a steady state.
5 Tips to Increase the ROI of an ERP System
There is no one-size-fits-all way to maximize the ROI of an ERP implementation, as every business has specific goals and resources to work with. There are also industry-specific considerations — for instance, a service-based business like a marketing agency is not subject to the same supply-chain issues as a manufacturer.
That said, the following five tips can help you to squeeze extra value from your ROI system, whether you opt for an on-premises, cloud-based or hybrid ERP solution.
Prioritize training. The only way to nearly guarantee that a new ERP system delivers returns is for employees to embrace new ways of working and use the software to its full potential. Employee training will increase the cost of a new ERP implementation in the early days, seemingly reducing its ROI, but these up-front investments pay off quickly — and then they begin to pay long-term returns that swing the ratio back in a positive direction. In contrast, employees who are not trained and encouraged to use a new ERP have been known to continue using spreadsheets and manual processes, significantly reducing the impact of this major software investment.
Get buy-in from the top. ERP implementations live and die by the breadth of a company’s vision and commitment to using the new solution. Every executive, department head and manager must be on board with the new ERP and understand its critical role in helping drive growth and success. This is the key to transformation and to bringing employees along for the journey. Take Fulton & Roark, a leading retailer of men’s grooming products. It got its new ERP system up and running in just 20 days and saw its year-on-year sales jump 50%, all without increasing head count. Much of its success is due to the fact that the project was initiated by its co-founders, whose enthusiasm and vision trickled down to every team and employee.
Never stop evaluating. Another key to maximizing ERP ROI is to constantly evaluate and refine your approach. At least once per year, business leaders are advised to take stock of their costs and returns from the ERP solution, compare them to their baselines and consider new ways of cutting costs and extracting value from the system and the data it provides. NetSuite’s cloud-based ERP allows businesses to set departmental and companywide key performance indicators (KPIs) and track them religiously to ensure they are constantly improving their performance. Crucially, this helps keep a company on track to reach its specific goals, in addition to broader cost and time savings.
Be realistic about costs and benefits. It is notoriously difficult to estimate the cost of a new technology implementation, especially for small or midsize companies transitioning to a more sophisticated way of working. Many businesses turn to their ERP vendor or implementation partner for guidance on timelines, costs and how to train employees effectively and efficiently. It is equally important to accurately measure the benefits of a new ERP to gain a complete picture of ROI, including both tangible and intangible benefits. For instance, N&N Moving Supplies reduced its payroll processing time by 84%, freeing up staff for more value-added activities, leading to a boost in employee morale that, in turn, drove performance gains.
Avoid common ERP pitfalls. A number of common pitfalls hold businesses back from realizing the full potential of their ERP systems. The most common trap is treating ERP implementations like a traditional technology deployment, with a single upfront cost and short-term payback period. In reality, most successful ERP implementations are rolled out in phases over time, with ROI calculated at each milestone.
It is also important to know when to stop measuring ROI, especially for cloud-based ERP systems. In the case of a capital expense, like a piece of machinery with an estimated life span of 10 years, it is easy to quantify its cost and return each year and to stop calculating them once the machine is decommissioned. In the case of cloud-based software, however, there is rarely a set time frame, especially as upgrades and updates occur automatically. At some point, the new ERP simply becomes part of the business’s standard operating procedure, and so ROI is no longer measured.
Finally, it is crucial to be self-aware and rigorous when setting metrics and calculating ROI. Not all businesses have the bandwidth or expertise to calculate metrics like internal rate of return (IRR) or hurdle rate, which is understandable given they are focused on core strategy and growth. A prudent approach is to start by setting and aligning business requirements with departmental goals, such as the elimination of silos or integration between processes. To that end, NetSuite offers Business Needs Evaluation scorecards and TCO scorecards to its customers to assist with this exercise and bring rigor to their ROI calculations.
Conclusion
ERP systems are large and complex, and they touch every part of a business organization, from finance to customer service. It is challenging enough to analyze an ERP’s impact across all of these operations, much less calculate returns across different lines of business that come in different forms and at different times in an ERP’s life cycle. But a successfully implemented ERP can provide your business with unparalleled insight into its performance, opening up new opportunities to drive revenue while cutting costs and saving valuable time. This is where the true ROI of ERP comes to light and where the tips outlined above can ensure maximal returns.
This is also why many businesses choose a cloud-based ERP. With no IT infrastructure or resource changes to manage, businesses can gain visibility across their operations, expand their core management platform and gain a clear vision for the ROI they hope to achieve from their implementation.