ROI Calculation of ERP Systems

When you propose to buy ERP software, most likely your boss, especially Finance
manager will ask you to figure out the ROI (Return of Investment). It’s happen to me & I
had no idea how to calculate the ROI. I could not imagine how to convert increasing of
productivity and efficiency to amount of Dollar (or Rupiah in my country). Couple days
ago I found an interesting white paper from SunFish ERP talking about ROI calculation.
Hopefully it can help us to develop ROI analysis for selecting proper ERP system.

ROI is simply the sum of benefitsof an Investment divided by sum of the costs,
expressed in percentage terms, normally over three years. Before I am going to show
some example calculation, please remember that ROI is not silver bullet to analyze all IT
decisions and not all IT benefits can be quantified.Benefits from an ERP project vary by
company, industry, solution and vendor. No standard calculation or estimation method
can sufficiently project the benefits applicable to any specific situation. However,
following a structured method of analysis will lead to a reasonable estimation of
expectation of benefits. It is difficult to completely, accurately calculate the expected ROI
before an implementation and even the actual achieved ROI after implementation.

Benefits Calculation
The components of benefits could be varied by industry. Benefit component of
manufacturing industry would be different from trading industry. It should be noted that
an ERP systems does not, itself, optimize a company’s operations, but rather the system
allows for improved transparency and provides tools to allow the users to perform
optimization that was not previously possible.

The following benefits calculation does not cover all benefits and could be not suit for
your company but it can inspire to find some other suitable benefits

1. Inventory Reduction. Reduction of inventory levels including raw materials, WIP

(Work In Process) and finished goods. By reducing inventory levels, the financial value
stored in that inventory become cash on the balance sheet and is available for other
investment. Typically proper implementation of an ERP software will lead to between
10% and 30% reduction in general inventory level. The following calculation is therefore
applicable :

(Value of Raw Material + WIP + Finished Goods Inventory) * Estimated Reduction Rate
= Increased Cash from Inventory

The benefit of Increased Cash can then be assigned a yearly value based on the
company’s IRR (Internal Rate Return) as in the example calculation below :

USD. 1,000,000 (Inventory) * 15% (reduction rate) * 20% (IRR) = USD. 30,000 per year
2. Improved Process Efficiency. The ERP application automates each of the company’s
major business processes, working in an integrated cyclical fashion starting from the
procurement of materials, warehouse management, machine maintenance and through
sales management. Automation of these processes increase speed and reduce errors that
impact to reduce rework and overtime. The benefits vary by company, for example your
company will get saving labor cost as reward of reducing overtime cost. You can also add
benefit of reducing overhead costs, such as paper, electricity, telephone, etc.Assume that
in a year your company reduces labor cost to 10% and overhead cost to 20%. The
following calculation is therefore applicable:

Labor Cost * 10% + Overhead Cost * 20% = Year 1 Process Cost Savings

Note : the saving may different from year to year

3. Improved Vendor Relations. Some ERP software provides features of tracking all
vendors, RFQ’s, previous purchases and term of purchases. It’s an important tool for
improving vendor relationship. For some companies, such relationship can reduce
procurement costs. Saving will vary. The benefit calculation could be :

Vendor Procurement Cost * Reduced procurement cost (%) = Procurement Savings

4. Waste Reduction. Raw materials represent a significant cost of production and a

variety of factors can cause waste to occur in production, especially waste occurring
through theft, expiration and improper mixing. Although some amount of waste is
unavoidable, a major of waste can be eliminated through proper ratio management and
the automated inventory control available of some ERP software. Although a specific of
potential waste reduction can be difficult the following calculation is applicable :

Value of Wastage * Estimated Reduction Rate = Waste Reduction Savings

Costs Calculation
Cost calculation includes a variety of aspects and is intended to provide a detailed
overview of the TCO (Total Cost of Ownership) in consideration of the initial and long
term cost of purchasing, implementing and maintaining the ERP application. The
following points provide the basis for calculation of cost.

1. Software License. The software license cost is easily determined by totaling the cost
of software required for the application as provided by the vendor, and including any
third party license necessary to operate application.

2. Implementation Costs. The implementation costs as provided by the vendor should

represent the total implementation cost, including consulting, configuration, software
customization, data conversion, training and initial support.
3. Hardware Costs. This cost covers cost of servers, workstation and network in
implementing ERP software

4. Internal Training. Internal training costs represent the cost to the company of lost
productivity and increased overtime required to the new system

5. Change Management. Change management costs represent the ongoing productivity

costs associated with transitioning staff from the traditional method to the revised
business process adopted when utilizing ERP software

6. Internal Conversion. ERP software requires a variety of data to be gathered and

prepared for the system to be effective. While much of this data is typically available,
some of data is typically unavailable and requires effort by the company to collect.
Internal Conversion costs represent the cost of collecting and formatting data.