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ERP Guide : Method for cost beneit analysis

Tutorial by:      Date: 2016-05-17 05:49:50

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Many methods are available for the evaluation of information technology related projects. After a thorough review of literature, Andresen [2001] found 82 of such methods. These methods are suitable for an ERP cost benefit analysis only if they have a financial outcome, and are complete and integrated. None of the methods described by Andresen satisfies all three criteria. Therefore, a method for cost benefit analysis is presented below that combines the strengths of a number of methods.

In general, organizations have several investment opportunities, and a limited investment budget that is insufficient for carrying out all investment opportunities. The management of the organization has to create an optimal portfolio of investments, by selecting those investment opportunities that collectively do not exceed the investment budget and maximize the value of the investments.

A well-known method that is used to choose between investment opportunities is the Net Present Value (or: NPV) method. Methods specifically developed for IT investments also exist, such as Information Economics [Parker & Benson, 1988] or one of the various grid methods [Berghout & Meertens, 1992].

These methods are multi-criteria methods: they use several measures to allow comparison of investment opportunities, and NPV is often one of them. General methods, that can not only be used for evaluation of IT investments, are the Internal Rate of Return (or: IRR), or the Payback Period method. It can be shown on theoretical grounds that these measures are not as strong as the NPV.

An NPV calculation is based on the costs and benefits of an investment during the whole life cycle of that investment. Various authors describe the use of NPV specifically for ERP [Murphy & Simon, 2001; Zalm & Noordam, 2003], or for general IT investments [Verhoef, 2004]. The NPV for an investment is calculated by filling in the costs and benefits in the following formula:

(8.1) NPV = Σ t=0,T [Rt / (1+d)t]

A brief description of the various symbols in the formula is in order here; a more detailed explanation of the Net Present Value method can be found in standard text books for corporate finance, such as Brealy & Myers [2000] or Hawawini & Viallet [2011].

Firstly the symbol T, the time horizon over which the NPV is calculated. For an ERP implementation, T is normally measured in years, but for short-term investments quarters or months can also be applied.

According to the theory of the NPV, T should be the length of the life cycle of the investment. For ERP this implies that costs and benefits for a period of at least eight years should be estimated. A time horizon of this length is practically not feasible given the large inaccuracy in the estimates. A time horizon that is too short also does not paint a good picture for ERP, because the benefits of an ERP implementation only become visible three years after the initial investment. A commonly-used length for the time horizon in ERP ex ante evaluation is therefore five years. T in the formula therefore often is set to 5.

The second symbol in the formula is Rt, which indicates the return of the investment in period t. The return for time period t is calculated as the total benefits in the period t minus the total costs in the same period t.

The last and most complicated symbol in the formula is d. his symbol stands for the discount rate. It is the compensation that the organization has to pay to its shareholders and banks in order to get the investment financed, and for these reason, it is also known as the cost of capital. Theoretically, the cost of capital can be determined on various levels: for the organization as a whole, for a division or subsidiary, or for a specific project. In practice, the cost of capital for the whole organization is normally used. For companies with a listing on a stock market, the cost of capital can be calculated; for other organizations, estimates have to be made. In general, the cost of capital for organizations lies between five and fifteen percent.

The NPV method can only be applied if all costs and benefits of the ERP investment are expressed in financial terms. Gathering all required information is not an easy task for the costs, and for the benefits it is often even more complicated. A method to determine the benefits of an ERP investment in financial terms has been designed by Murphy & Simon [2001]. In Table 8.1 their method is explained on the basis of an ERP example.

 Quantifying ERP beneits

A valid comparison between an ERP implementation and other investment opportunities is possible only if the list of costs and benefits for each of the investments is as complete as possible. In an ERP implementation, five categories of costs and benefits can be distinguished, each with a number of subcategories [Sneller, 2004]. In Table 8.2, these categories are listed.

 Costs and beneits of an ERP implementation

The first category consists of project costs spent during the configuration & roll out and go live phases of the ERP life cycle. These are normally one-of costs. This category has five subcategories. The first two are licenses of the ERP system, and the costs that implementation partners claim for configuration and localization. Additional software development costs need to be made for conversion of data from the current IT systems to the ERP system, and for interfaces with IT systems that will continue to be used even after the introduction of the ERP system. The IT architecture has to be adapted to meet the requirements of the ERP system. Finally, the hours of internal staff need to be taken into account, as well as the costs of the training.

The next two categories are costs and benefits in the onward & upward phases of the ERP life cycle.

These costs are mostly recurring in every period of the life cycle.

Firstly, the ERP system will have operational benefits. The characteristics of ERP, data integration and support for best practices, can lead to three subcategories of financial benefits. The first two, reduction of working capital and reduction of costs are confirmed in surveys and other forms of empirical academic research. The last subcategory, additional revenue as a result of an ERP implementation, is mainly a theoretical effect of ERP, in practice this is not often confirmed as an ERP benefit.

The second category consists of costs for keeping the ERP system up and running after the go live. The subcategories mentioned here are often used in benchmark research [Gartner, 2001]. It is possible that the costs of system maintenance decrease after the implementation of ERP, but it is also possible that it is more expensive to keep the ERP system up and running than to keep previous systems in the air.

The last two categories in the table ensure the integration between the cost benefit analyses on the one hand, and the functional it and risk analyses on the other hand. For integration with the functional it analysis, the costs and benefits of process modification and software modification need to be included in the cost benefit analysis, while for the integration with the risk analysis, the costs associated with the risk mitigating measures and the safeguarding of the key success factors need to be added.

By the combined usage of the NPV method, the method of Murphy & Simon for translation of benefits in financial terms, and the incorporation of the outcomes of the functional it analysis and the risk analysis, a cost benefit analysis will be executed that satisfies the criteria of a good cost benefit analysis: it has a financial outcome, and it is complete and integrated.

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