How to Understand The High TCO and Low ROI of ERP

Executive Summary

  • ERP is sold on the its financial benefits.
  • Learn why ERP systems have a high TCO and negative ROI.

Introduction

The Wikipedia definition of total cost of ownership (TCO) is as follows:

“Total cost of ownership (TCO) is a financial estimate whose purpose is to help consumers and enterprise managers determine direct and indirect costs of a product or system. It is a management accounting concept that can be used in full cost accounting or even ecological economics where it includes social costs.”

Background on TCO

We find TCO research incredibly illuminating. TCO is one of the most misunderstood, abused and underutilized tools for enterprise software decision-making. Our work on TCO has provided us with insight across multiple software categories. In fact, it is a mistake to limit the use of TCO to such a narrow range of decisions. Because we perform TCO for so many software categories, we know the following:

  • How the TCO varies based upon the size of the implementation.
  • How the TCO varies based upon the delivery method (SaaS or on-premises).
  • How TCO varies based upon the complexity of the implementation.
  • The average percentage that one can expect the implementation to cost for any one specific cost item, or for cost categories such as implementation, license, hardware, or maintenance and support.
  • Using ERP combined with 100 percent ERP vendor applications.
  • Using ERP combined with 100 percent best-of-breed solutions.
  • Open source ERP, 100 percent best-of-breed solutions.
  • No ERP, 100 percent best-of-breed solutions.
  • The risks of various software categories.

False Assumptions of ERP

The analyses include assumptions that are often not considered, such as realistic average implementation times. These implementation times, which are habitually underestimated by vendors and consulting companies, have been taken from actual projects. I can say unequivocally that from this database of knowledge we have been able to disprove many deeply entrenched concepts that drive IT decisions to poor outcomes. In our view, combining unbiased and highly detailed TCO calculations, along with an evaluation of comparative software functionality based on strong domain expertise, are two of the most important inputs to producing quality IT decisions.

Unfortunately, this knowledge is not resident within companies, and ERP software vendors (as well as consulting companies and IT analysts) have not informed companies as to the true TCO of ERP systems; it takes work to do this analysis, and probably more importantly, the ERP vendors do not want buying companies to know.

Various ERP TCO Studies Versus Our Estimates

The study What Managers Should Know About ERP/ERP II estimates the costs of ERP software licenses to be between 10 and 20 percent of the overall TCO, which is higher than we estimate. While the software license cost of most application categories averages 20 percent of the TCO, we estimate 8 percent of the TCO of Tier 1 ERP software is due to software license costs. ERP implementations take so long, and have so much customization, and therefore, maintenance expense. So it’s not that the software license cost is lower; the TCO is made so much larger by the customization and implementation expenses that the software license cost becomes a smaller percentage of the cost in comparison. The book, Control Your ERP Destiny: Reduce Project Costs, Mitigate Risks, and Design Better Business Solutions considers a reasonable estimate of the costs of ERP software to be 20 percent of the total project budget. According to this book, software vendors provide their potential customers with estimates (as do consulting companies) that consulting costs will be roughly twice the cost of the software. One independent source, called 180systems, actually estimates that consulting costs average 65 percent of the license costs (71 percent for larger customers and 59 percent for mid-sized customers). Below is a meta-analysis and comparison of my individual TCO analyses in this regard.

While the software vendor estimate of consulting costs holds true for my sample (although you can see that there is considerable variability), this does not correlate with our estimations because other TCO estimations that we have reviewed consistently underestimate the TCO of applications. Because license costs are explicit costs, they are the easiest to estimate, and thus the easiest to overestimate in relation to other costs.

Estimations from other sources are all over the map. Some entities recommend a rule of thumb of 1:1 between license and consulting costs. The software vendor e2benterprise recommends a ratio of between 1:3 to 1:4. We worked backward from these numbers and found that the estimations on the software license costs are solid, but the ratio of 1:4 only estimates consulting; it does not bring the total ERP cost even close to the estimations of the total costs of ERP. Additional costs such as the vendor support costs, hardware costs, and ongoing maintenance costs are well known. It is difficult to see why so much emphasis is placed on the software and implementation costs while maintenance costs are left out. Hardware costs are barely worth mentioning as they represent a small percentage of the overall TCO, but estimated maintenance costs must be included in decision-making.

The Brightwork Research & Analysis Estimates

On our website, we estimate software, hardware, implementation, and maintenance costs—both external costs and internal costs. The maintenance costs are incurred to keep the applications running, but also include maintenance of customizations. As 96 percent of ERP implementations require moderate or heavy customization, work is required to keep customizations up-todate with new releases and to augment the customizations, and this makes ERP software maintenance a high cost. An important aspect to consider when evaluating ERP TCO studies is that the consulting expenditures on most ERP projects are signifi cantly over-budget, something that ERP software vendors would not have included in their TCO estimates.

Generally speaking, a 100 percent success rate is assumed for implementations (strange, as the real success rate is far lower than this) when vendors estimate TCO for ERP and enterprise software. However, if the project goes over-budget or fails, the estimates provided by the software vendor do not apply, and neither do our estimates. We have observed this as a problem in terms of how projections are performed and I explain this in the book Enterprise Software Risk: Controlling the Main Risk Factors on IT Projects. We are currently developing risk estimators for all analyzed applications; these risk estimates auto-adjust based on the application, the consulting partner used, and the stated capabilities of the company. The company can perform their own interactive analysis right on our website.

Is the TCO of Failed Implementations Included?

What is the TCO for software that is never implemented? I have interviewed for several projects (and worked on a few projects) that were re-implementations, where the software failed to go live.

That failure may have taken a year and a half; the company focused on other things and then decided to re-implement the software two and a half years after it began the first implementation. If the software is taken live the second time, most likely the project will have a negative ROI. The standard ERP TCO calculators we provide would not apply. Therefore, a question that anyone with an interest in ERP estimation should ask is: If 60 percent of ERP implementations fail, and if the vast majority of ERP implementations miss their deadlines by signifi cant durations, why are TCO estimations still based upon assumptions that do not include these very critical factors?

There is little disagreement on the fact that companies repeatedly underestimate the costs of ERP systems.

“In ERP systems, having clear criteria for success is particularly important since the cost and risk of these valuable technological investments must be reviewed in light of possible payoffs. Mabert, et al. (2001) put the total ERP implementation cost at tens of millions of dollars for a medium-sized company and $300 to $500 million for large international corporations.”Measures of Success in Project Implementing Enterprise Resource Planning

According to Aberdeen, the average number of users per ERP software vendor is as follows (we used Aberdeen’s numbers for this purpose, although Aberdeen’s TCO studies were not used in this book):

There are significant price differences if just the aggregate license revenues are compared among a sample of ERP vendors. However, this difference in license revenue is primarily driven by the differences in the average number of users. On average, the Tier 1 ERP vendors such as Oracle and SAP have a much larger customer base, as measured here by the number of users. This relationship is so strong that a regression performed between just the number of users and the software cost results in a 96.75 R Squared, as the following graphic shows.

The average number of users for Microsoft is more comparable to Lawson, QAD and Infor than they are to Oracle and SAP.

Even though it is well known that ERP does not lower costs, the actual cost of ERP goes well beyond the direct cost of the software, but extends to the indirect costs such as the costs of maintenance, the costs of adjusting the functionality in other systems in order to make it compliant with how ERP works, to increased needs for customization, to losses in ineffi ciency as mediocre ERP functionality is used in place of better functionality that could be obtained by buying specialized software. In the vast majority of cases, companies did not perform TCO analyses prior to purchasing ERP systems. It is now long forgotten that ERP systems were sold based on the concept that they would lower costs (the idea that an ERP system could have a low TCO is laughable even in the present day). Since then, ERP systems have proven to be very expensive, not only to implement but also to maintain, as the following quotation explains.

“ERP systems were expensive, too, costing companies more than they had ever paid for software when costs had been based on per workstation usage. But that price tag was dwarfed by the installation charges, because companies had to hire brigades of outside consultants, often for a number of years, to actually get the software up and running. While the average installation cost $15 million, large organizations ended up spending hundreds of millions of dollars.”The Trouble with Enterprise Software

How Mistakes With Respect to ERP

The long-lived mistakes with respect to ERP have affected every part of IT today. ERP systems have proved to be much more expensive than even the highest “generalized” cost estimates (even though 80 percent of the time companies did no real estimation), and ERP systems now consume a very substantial portion of the overall IT budget, particularly for companies that purchased from the most expensive Tier 1 ERP software vendors. The high investment in ERP negates investment in other possible applications, even though most of these other applications would have a higher ROI than ERP. All ERP ever offered was basic functionality, and any company that has basic functionality consuming the majority of its IT budget has a serious problem of resource allocation. By that measure, an enormous number of companies have this problem. The direct cost of ERP systems has continued to increase. When companies give so many modules over to one vendor, they also give up a lot of negotiating leverage. The ERP vendors use this leverage to:

  • Sell uncompetitive software in other areas of the same account.
  • Increase the cost of the yearly support contract. The TCO of on-premises ERP systems is generally considered to be high compared to other application categories. It is quite amazing that writers who cover ERP implementations do not bring up these issues with any frequency. Various articles will discuss how expensive ERP systems seem, but the enormous elephant in the room—the leverage of ERP vendors—is unaddressed.

Conclusion

TCO on ERP is not analyzed outside of academics. Vendors, consulting companies and paid off IT analysts and IT media have conveniently circumvented the question of the TCO and ROI of ERP, because it leads to all the wrong answers.

Financial Disclosure

Financial Bias Disclosure

Neither this article nor any other article on the Brightwork website is paid for by a software vendor, including Oracle, SAP or their competitors. As part of our commitment to publishing independent, unbiased research; no paid media placements, commissions or incentives of any nature are allowed.

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References

The Real Story on ERP

ERPThe Real Story Behind ERP: Separating Fiction From Reality

How This Book is Structured

This book combines a meta-analysis of all of the academic research on the benefits of ERP, coupled with on project experience.

ERP has had a remarkable impact on most companies that implemented it. Unplanned expenses for customization, failed implementations, integration, and applications to meet the business requirements that ERP could not–have added up to a higher Total Cost of Ownership for ERP were all unexpected, and account control, on the part of ERP vendors — is now a significant issue affecting IT performance.

Break the Bank for ERP?

Many companies that have broken the bank to implement ERP projects have seen their KPIs go down— but the question is why this is the case. Major consulting companies are some of the largest promoters of ERP systems, but given the massive profits they make on ERP implementations — can they be trusted to provide the real story on ERP? Probably not, however, written by the Managing Editor of SCM Focus, Shaun Snapp — an author with many years of experience with ERP system. A supply chain software expert and well known for providing authentic information on the topics he covers, you can trust this book to provide all the detail that no consulting firm will.

By reading this book you will:

  • Examine the high failure rates of ERP implementations.
  • Demystify the convincing arguments ERP vendors use to sell ERP.
  • See how ERP vendors take control of client accounts with ERP.
  • Understand why single-instance ERP is not typically feasible.
  • Calculate the total cost of ownership and return on investment for your ERP implementation.
  • Understand the alternatives to ERP.

Chapters

  • Chapter 1: Introduction to ERP Software
  • Chapter 2: The History of ERP
  • Chapter 3: Logical Fallacies and the Logics Used to Sell ERP
  • Chapter 4: The Best Practice Logic for ERP
  • Chapter 5: The Integration Benefits Logic for ERP
  • Chapter 6: Analyzing The Logic Used to Sell ERP
  • Chapter 7: The High TCO and Low ROI of ERP
  • Chapter 8: ERP and the Problem with Institutional Decision Making
  • Chapter 9: How ERP Creates Redundant Systems
  • Chapter 10: How ERP Distracts Companies from Implementing Better Functionality
  • Chapter 11: Alternatives to ERP or Adjusting the Current ERP System
  • Chapter 12: Conclusion