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ERP Guide : ERP functioning systems

Tutorial by:      Date: 2016-04-11 03:44:23

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In this section explains how ERP supports the management and operations of an organisation. he
explanation is based on two well-known management models: the value chain and the supply chain.
Firstly, the predecessors of ERP are presented. Ater this, the early applications of ERP in manufacturing
companies are discussed. Finally, several extensions to ERP are given: industry solutions, improvement
of best practices, and data integration in the supply chain.

The value chain and the supply chain

Modern ERP systems support all management and operations processes in a company. How this functions
is explained in this section on the basis of a strategic management model that has been developed in
the 1980s by the famous American strategy researcher Michael Porter: the value chain [Porter, 1986].

The value chain for a manufacturing company

The value chain is depicted in this picture. he model assumes a simple manufacturing company. he
processes in this company are split in two categories. he irst category consists of primary processes,
processes that are characteristic for the type of organisation. In a manufacturing company, primary
processes are purchasing of raw materials, manufacturing, distribution of inished products, sales &
marketing, and ater sales service. he second category of processes consists of secondary processes,
processes the existence of which does not depend on the type of company but that occur in most
organisations: procurement, technology & maintenance, human resource management, and inance &
other support.

Business management and operations of an organisation add value by combining primary and secondary
processes to create a proit margin. he primary processes, starting with purchasing raw materials and
ending with ater sales service, form a chain of consecutive links. hese two aspects of the model, adding
value and a chain of processes, have given it its name: the value chain.

The value chain was originally developed for manufacturing companies. It can however simply be
adapted for other types of organisations. In a consultancy company for example, the primary processes
raw material purchasing, manufacturing and distribution will not exist, while advisory service will be
the most important primary process. In a trading company, procurement is most likely a primary rather
than a secondary process.

The value chain describes processes within the boundaries of one organisation. A related concept is the
demand & supply chain (or: supply chain). he supply chain consists of two or more organisations that
have a supplier-customer relationship or an other form of cooperation. A supply chain can be considered
a chain of value chains. In the next sections of this chapter, the history and current functioning of ERP
are illustrated by using the concepts of the value chain and the supply chain.

The predecessors of ERP

ERP has its origins in manufacturing companies. In the late 1960s and the early 1970s of the last century
powerful computers became afordable for large manufacturers. hey used the computers to automate
their production planning.

The irst planning technique that was automated was Material Requirements Planning (or: MRP). MRP
calculates the amount of raw materials required to manufacture a customer order. he calculation method
is best explained by means of an example. Suppose that a manufacturing company produces and sells
tables. he raw materials for the tables are purchased. For every table the following raw materials are
required: four legs, a table top and eight screws. he company does not have warehouses for raw materials
or tables. he supplier of legs has a lead time of two days, the other suppliers have a lead time of one
day, and the production of a table also takes a day. In Table 2.1 the MRP production plan is presented
for the company when the demand on four consecutive days is 2, 1, 7 and 3 tables.

MRP production plan for tables

The example in above Table represents a very simple production process for one inished product that is
assembled with three raw materials. Even this very simple process already requires quite a few calculations,
and small changes in demand require a complete recalculation.

In reality, such very simple processes rarely exist. Production of a range of inished products using more
than three raw materials, several production processes, and intermediate inventories can be planned
with MRP, but the manual calculation of the MRP schema becomes too time-consuming for realistic
planning purposes. he advent of the powerful computer created lexibility and speed in the calculation
of alternative production plans, and allowed manufacturing companies to plan their more complex
production processes with MRP.

MRP was a step forward in production planning, but the technique has some clear shortcomings. Firstly,
in order to use MRP efectively, customer demand has to be known in advance. Secondly, MRP does not
take production capacity restrictions into account and implicitly assumes that every customer order can
always be produced. In order the remedy these shortcomings and make the planning technique more
widely applicable MRP has been extended with capacity planning. As of that time the technique became
known as Manufacturing Resource Planning (or: MRPII).

Both MRP and MRPII are best practices for planning of production processes. he MRP and MRPII
systems on the market can therefore be considered predecessors of ERP. hey are not yet full blown
ERP systems because their application remains within the manufacturing link in the value chain. By
implementing MRP or MRPII systems companies do apply best practices, but they do not realise the
other important characteristic of ERP systems: data integration.

The irst ERP systems – data integration for manufacturing companies

The irst fully-ledged ERP systems became available in the late 1970s [Boot, 2003]. hey allowed data
integration in one computer system for both the primary processes and the secondary inancial processes
of an organisation.

In order to clarify how this data integration was realised in the irst generation of ERP systems, the
example of the table manufacturing company is taken further in this section. Firstly, assume that ater
the production process the tables are stored in a warehouse next to the shop. he sales people in the shop
sell tables from the warehouse to customers. Customers always pay cash and carry the tables home with
them. he physical low of sales transactions therefore only consists of tables and cash. he administrative
low consists of data in the inventory records and the inancial records.

Before the implementation of an ERP system the physical and administrative lows of the sales transactions
were the following. he physical low was straight-forward: ater having received the cash from the
customer, the sales person handed over the table to the customer.

The administrative low was signiicantly more complex, as several people had to carry out a number of
administrative actions. he irst action was carried out by the sales person: writing two copies of a sales
slip with the number of tables and the price, one for the customer and one for the inancial department.
he second action was executed by the inancial department: for each sales slip the corresponding number
of tables was processed in the inventory records, and the increase in cash and the proit of the transaction
in the inancial records1. his was mostly done periodically, for instance weekly, which meant that the
administrative processing of transactions was always lagging behind the physical low of transactions.

Ater the implementation of the ERP system the physical and administrative low of sales transactions
are integrated. he physical low remains unchanged: ater having received the cash from the customer,
the sales person hands over the table to the customer.

Because of the data integration characteristic of the ERP system, the administrative low becomes much
simpler. he sales person enters the sales transaction into the ERP system. he system processes the
transaction in both the inventory records and the inancial records, which are both part of the integrated
ERP system. Once entered and processed, the new data are immediately available for all processes in
the value chain of the company.

This stylised example demonstrates the beneits of the data integration characteristic of ERP. he example
shows that ERP allows more eicient processes: the data of the sales transaction can be entered on the
spot during the transaction, en the second data entry by the inancial department is no longer needed.

However, more beneits of data integration can be identiied. ERP eliminates the elapsed time between the
physical transaction and the corresponding administrative transaction, which means that the inventory
records are always up-to-date. his leads to lower safety stocks levels while the number of out-ofstock
situations does not increase. he manufacturing department in the value chain can realise better
coordination between demand and production, which enables better use of MRP and MRPII. he
procurement department can negotiate better deals with the suppliers of table tops, legs and screws
because manufacturing can be planned better. Marketing has access to more accurate data and can
therefore anticipate market developments. Finance can report on revenue and proitability at any time.

In real companies, the management and operations are much more complex than in the stylised
example presented above. he potential beneits of data integration increase in realistic settings where
the company’s processes are more complex. he irst generation of ERP systems, which were relatively
simple and only enabled data integration between the primary processes and the secondary inancial
processes of manufacturing companies, already allowed signiicant improvements in the management
and operations of organisations that implemented these systems.

ERP extensions – Data integration for other value chains

The early ERP systems realised data integration between the processes in the value chain of manufacturing
companies, and focused on the integration between primary and inancial processes. It is therefore not
surprising that in the early 1980s ERP was mainly implemented by manufacturing companies.
During the 1980s ERP expanded over the full value chain including all secondary processes of
manufacturing companies. Important steps were set to enable integration of the various secondary
processes. Examples of this data integration are:

• Human resource management with Finance: the automated entry of salary payments in the
inancial records realises higher eiciency in payroll processing.
• Human resource management with Manufacturing: the integration of time and attendance
data with manufacturing processes enables a higher eiciency, and also creates a better
insight in capacity, productivity and capacity utilisation, which allows better decision
making on human resources.
• Technology & maintenance with primary processes: the integration of machine maintenance
with primary processes allows better production planning. In order to guarantee shipment
of customer orders, safety stock production can be planned before a longer period of
preventive maintenance that leads to machine unavailability.
• Procurement with Finance: ERP supports data integration between the raw material
purchasing process on the one hand and the inancial records on the other hand. Dispatch
of purchase orders, booking of goods received, and payment of invoices are activities that
do not exclusively take place for raw materials, but also for other goods and services. When
ERP usage is extended to all procurement processes, this does not only make purchasing
more eicient, but can also create a better understanding of price diferences, supplier
performance and purchase volumes per supplier.

In addition to extensions for manufacturing companies, ERP suppliers also adapted their systems for
companies with value chains other than manufacturing. Four examples of value chains are presented in
below picture. he irst example depicts trading companies, which can be considered simpliied manufacturing
companies, namely without production processes. his implies that ERP can be implemented by trading
companies if they leave out the modelling of production processes.

The second example covers service companies. Primary processes in service companies difer considerably
from those in manufacturing companies. As an example: in a temporary labour agency time and
attendance registration is not a secondary process, but an essential element of all primary processes.
An ERP system that supports time and attendance registration processes and integrates them with the
inancial records improves a temporary labour agency’s insight into capacity, productivity and idle time

Financial service providers have fundamentally diferent value chains. An insurer can be modelled as a
company with two types of primary processes: policy processing and claims processing. ERP can realise
data integration between these two primary processes and the inancial records.

Value chains for four types of companie

The ERP systems that have been developed in the 1980s have been extended to support a variety of
processes in organisations with diferent types of value chains. During this decade, ERP mainly expanded
by ofering increasing levels of data integration between primary and secondary processes for a wide
variety of value chains..

ERP extensions – Sophisticated best practices

In the late 1980s and the early 1990s of the last century the best practices ofered in ERP systems became
more and more sophisticated. In addition to the traditional MRP and MRPII methods, other planning
algorithms were built in to better support production processes. Examples of these algorithms are
Available to Promise (or: ATP) and Capable to Produce (or: CTP). When a customer order is entered,
both algorithms check whether the ordered product is in stock or will be in stock on the shipment date
requested by the customer. If the product will not be in stock, ATP checks whether a production run
has already been planned that will manufacture the product on time for the requested shipment date.
CTP goes even further: if the forecast is that a requested product will not be on stock, the algorithm
automatically checks the availability of raw material, issues raw materials replenishment orders if required,
and plans a production run in which the product will be manufactured.

Support for production processes has also improved considerably because ERP was adapted for application
of new developments in information technology. Bar code recognition, Radio Frequency Identiication
(or: RFID), integration of automated warehouses, management of machine instructions and many other
IT possibilities are available in the ERP systems that are currently on the market.

Originally, ERP systems mainly supported manufacturing processes. In recent years this has changed.
Today, ERP also ofers support for best practices for Sales & Marketing in Customer Relationship
Management (or: CRM) modules: sales order analysis, product portfolio analysis, customer proitability
analysis, support for special ofers, bonuses and discounts, and sales forecasts. he support for Finance
is no longer restricted to transaction processing, but also covers Business Intelligence (or: BI): the ERP
systems can provide proitability analyses, detailed reports, and consolidated inancial statements for
companies and their subsidiaries. Human resources departments use ERP for payroll processing, but
also for recruitment, training and education, promotions and succession planning. Some ERP systems
also support the so called Employee Self Service, which enables employees to enter holidays, sickness
leave and expense claims into the ERP system themselves. his leads to higher eiciency in the human
resources departments.

ERP also became more suitable for multinational organisations. Originally, most ERP systems were based
on the English language, while nowadays the screens are available in almost any language, including
those that use a diferent character set, like Russian, Japanese or Chinese. All inancial transactions can be
processed in multiple currencies. Country-speciic habits and requirements, such as the drats payment
method that is still very common in Southern Europe, or VAT rates that vary per country have been
embedded in ERP. he most extensive ERP systems even support payroll accounting in all countries,
which is quite complex as a result of continuous changes in national labour and tax legislation.

Altogether, modern ERP systems ofer sophisticated best practices and data integration for the primary
and secondary processes of organisations in a variety of industries. When a business process is designed
according to one of the standardised best practices enforced by the ERP system, the whole management,
execution and information processing of the process can be supported eiciently.

ERP extensions – Data integration in the supply chain

In the last decade ERP has ofered increasing options for data integration beyond the boundaries of the
own organisation. ERP systems no longer only support the value chain of one organisation in isolation,
but also ofer data integration and best practices between organisations in supply chains.

The oldest and most frequently used form of transaction processing integration over several organisations
in a supply chain is Electronic Data Interchange (or: EDI). EDI is based on so-called messages, coded
transactions that are exchanged between organisations in the supply chain. he messages are characterised
by a speciic standardised format that depends on the coding schema that is applied. In he Netherlands,
a commonly-used coding schema is EDIFACT, which also has several extension tailor-made to the
needs of certain industries. he exact content of a message depends on the type of the transaction that
is being processed. Frequently-used message types are orders, invoices, packing slips, tracking-andtracing
messages and proofs-of-delivery. In below picture an example of a packing slip for a box of carpet
tiles is presented.

Example of an EDI code

Data integration between a customer and a supplier that use EDI is executed in the following way. In
order to place an order at the supplier, a purchaser at the customer creates an order in the customer’s
ERP system. he ERP system then creates a ile, writes the coded EDI order message to the ile, and
sends this ile to an EDI processing company. his company checks the accuracy of the message and
the origin of the message, and then forwards it to the supplier. he supplier interprets the message,
manually or automatically, for instance by importing it into its own ERP system. Finally, the supplier
processes the order.

Another example of data integration in the supply chain is information exchange between a company
and its bank. For the automation of payments and receipts the term Electronic Fund Transfer (or: EFT) is
used. For EFT, country-speciic standards exist, just like for EDI. In Belgium, most banks use the ISABEL
standard, and in many Anglo-Saxon countries most banks employ BACS. In he Netherlands, there is not
yet one standard, as most banks have created their own coding schema. ERP systems normally support
several diferent coding schemas for payments and receipts.

In addition to EDI and EFT the Extensible Mark-up Language (or: XML) has gained ground for the coding
of various types of messages in the supply chain. he development of the XML standard is coordinated
by a dedicated world-wide organisation, that monitors and stimulates world-wide standardisation of the
coding schemas. Tax authorities have adopted XML extensions to enable electronic iling of tax returns,
and the expectation is that within a few years, companies will also have to ile their annual reports in
Extensible Business Reporting Language (or: XBRL), an XML-based coding schema that was designed
speciically for inancial reporting. XML will probably also become the standard for electronic invoicing.

In the coming years, data integration between customers, suppliers, distributors, banks, government
agencies and other parties in the supply chain will be extended more and more. ERP systems currently
already support several standards for data integration in the supply chain, and in the next few years, this
support will become more and more powerful.

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