The Logic of ERP Driven Improved Financial Performance

Executive Summary

  • ERP systems are justified on the basis of improved financial performance.
  • Learn the accuracy of this proposal regarding ROI.

Introduction

Our research into the studies of ERP ROI shows the following:

  1. ERP implementations show no positive business benefit, and often impose significant costs (e.g., missed orders due to lack of inventory, inability to ship orders that are received due to execution problems).
  2. The potential for ERP implementations to show a positive business benefit for up to a year after implementation is low, as the company is still adjusting to the radical changes that an ERP system imposes on a company. Once these problem projects are thrown into the mix, the average return for an ERP planning project is negative.

While there is no research into the ROI of ERP software, one would assume that ERP would generally have a poor ROI for the reasons listed above. Others, such as the Sloan Management Review, have noted this lack of ROI research:

“Given the high costs of the systems—around $15 million on average for a big company—it’s surprising…that despite such study, researchers have yet to demonstrate that ‘the benefits of ERP implementations outweigh the costs and risks.’ It seems that ERPs, which had looked like the true path to revolutionary business process reengineering, introduced so many complex, difficult technical and business issues that just making it to the finish line with one’s shirt on was considered a win.”

This begs the question as to why, as stated in the above quote, “ERPs…had looked like the true path to revolutionary business process reengineering.” The answer to this question is simple: a number of entities with a strong financial bias declared it to be so.

Negative ROI: The Missing Link of the ERP ROI Research

Every research study into the ROI of ERP systems that I reviewed (except for the research that attempts to find a correlation between ERP implementations and the financial performance of companies) contains several flaws. Some of this flaws have been stated previously in this book and relate to an underestimation of the TCO as described in the previous section. Obviously, if the TCO is not conclusive, then the ROI is inaccurate; the TCO is the base or the “I” in the ROI. Let’s review the issues with estimations of the TCO (issues that are usually overlooked) before moving on to examining the error from the return side.

  1. The TCO for ERP projects are not adjusted for risk.
  2. The total length of ERP projects is not included in the TCO calculation. The longer the project, the longer it takes for the project to pay back the investment. Furthermore, ERP projects are so problematic from the integration perspective that it can take up to five years for them to be fully integrated with other systems, and therefore fully operational.
  3. There is a 40 percent likelihood of a major operational disruption after an ERP project goes live. The costs of these major disruptions nor the costs of smaller disruptions are included in the ERP TCO calculations.
  4. ERP TCO estimations consistently underestimate the actual TCOs of projects. These estimations completely neglect or underestimate the costs of internal resources to adjust to and learn the ERP system. Actually, this issue is not specific to ERP software but is a feature of enterprise software generally. However, the large-scale nature of ERP software makes this issue worse.

The error on the return side of ROI is that ERP ROI studies look at the ERP system in isolation from the other software that the company implements. However, as will be explained in more detail in “Case Study #4 of ERP Misuse: Intercompany Transfer”, the transactional inflexibility of ERP systems—the fact that they have their modules so tightly integrated—restricts a company’s ability to fully leverage the functionalities in applications that are connected to ERP systems. As a result, a company with an ERP system will receive less value from other applications that they implement (unless the application is extremely simple) than a company that does not have an ERP system. Companies with ERP systems do not leverage the other applications that they purchase and implement, and this means the companies must use more of the mediocre functionality within the ERP system. I found this statement by Aberdeen very interesting:

“As ERP has become more pervasive, there is always a risk in perceiving it as necessary infrastructure. If viewed as a requirement for doing business, companies also run the risk of neglecting to measure the business benefi ts resulting from its implementation.”

I would say this statement is a bit late. The decision to purchase ERP was not based upon measurement of its business benefits, but was primarily based upon an idea that ERP systems were “necessary infrastructure.”

Support Costs of ERP

The maintenance costs of Tier 1 ERP (and possibly other tiers as well) are likely headed upward. ERP software is stabilizing; it is falling further and further behind the other applications connected to it and that can replace much of ERP’s functionality. Instead, SAP moves almost all of their newer functionality to their non-ERP modules, as they can charge new license fees for the modules. Analysts are not picking up on this, but investment in ERP has wilted, and ERP systems are unable to meet requirements without further customization. Your ERP vendor already has your ERP business; now they want to nudge up the ERP support costs and they have some other software they would like to sell you. The High

Opportunity Cost of ERP

The opportunity costs of ERP are underemphasized (or ignored altogether). The term “opportunity cost” is used infrequently, so let’s define it before we explain how it should be used in making decisions:

“In microeconomic theory, the opportunity cost of a choice is the value of the best alternative forgone, in a situation in which a choice needs to be made between several mutually exclusive alternatives given limited resources. Assuming the best choice is made, it is the ‘cost’ incurred by not enjoying the benefit that would be had by taking the second best choice available.” — Wikipedia

In general parlance, costs are often described as the amount that we pay for things. Economists look at costs quite a bit differently. Opportunity cost is one cost category, and sunk cost.

Promoters of ERP tend to present any benefits of ERP without acknowledging that the time and effort spent on ERP could have gone into other initiatives. However, the gain from those systems should be compared against the gain from ERP systems.

Let’s take a simple example. Imagine that I have no car. I have a hard time getting around town because I lack transportation. To improve my condition, I buy a Hummer. After a week, I report that I am able to get around town much more efficiently, and compared to walking, I am now much more mobile. Have I established that the Hummer was the best possible alternative? Obviously, I have not proved this. I could have purchased any car—almost any of them with lower operating costs than a Hummer. Therefore, the question is not whether the purchase of the Hummer improved my condition compared to the other alternatives (these alternatives could have included any other car of equivalent or lower cost, public transit, bicycle, etc.). Does my analogy that a Hummer is the best automobile one can buy sound silly? Well, it should, but it is no sillier, no less evidence-based, than the evidence presented for why ERP has helped companies. The comparison can never be between “something” and “nothing,” but between two “somethings.” People that compare something to nothing are stacking the deck in favor of the “something” and are not promoting research or a logical and serious framework.

The Logic of ERP Driven Improved Financial Performance

Enterprise software implementations should have a positive ROI. This is why they are purchased. In this section I will provide a synopsis of the research findings.

“The results are based on a sample of one hundred eighty-six announcements of ERP implementations; one hundred forty SCM implementations; and eighty CRM implementations. Our analysis of the fi nancial benefits of these implementations yields mixed results. In the case of ERP systems, we observed some evidence of improvements in profitability but not in stock returns. “The results for improvements in profi tability are stronger in the case of early adopters of ERP systems. On average, adopters of SCM system experience positive stock returns as well as improvements in profi tability.” — The Impact of Enterprise Systems on Corporate Performance

This makes sense because ERP functionality was more advanced in the past. Now the technology of almost any on-premises ERP system will be quite dated. Secondly, at one time an announcement that a company was going to implement an ERP system would have had an effect on stock prices because the system was considered leading edge. However, ERP systems are so common now that a bump in stock price can no longer be expected. Interestingly, the improvement in financial performance for ERP lagged SCM implementations. When ERP is compared to other types of implementations, it consistently lags other enterprise software categories.

The Stock Price of Firms that Invest in ERP

“The evidence suggests that over the five-year period, the stock price performance of firms that invest in ERP systems is no different from that of their benchmark portfolios.”The Impact of Enterprise Systems on Corporate Performance

This means that investing in an ERP system did not impact the stock price of the companies in the study.

“The positive changes in ROA (Return on Assets) during the implementation period are statistically signifi cant at the 5 percent level. Although the changes in ROA during the post implementation period are positive, none of the changes are statistically signifi cant. Overall the evidence suggests that although fi rms that invest in ERP systems do not experience a statistically significant increase in stock returns, there is some evidence to suggest that profi tability improves over the combined implementation and post-implementation periods.” — The Impact of Enterprise Systems on Corporate Performance

ERP Versus SCM ROI?

While the financial benefits of ERP investments are either nonexistent or barely perceptible, the results of SCM software investments were positive; while investments in CRM software were the same as ERP, they did not show gains. Furthermore, clients that were early adopters of ERP achieved better returns, which means that returns of companies that have recently implemented ERP are even worse.

“The results for the accounting metrics provide strong support that fi rms that invest in SCM systems show improvements in ROA and ROS (Return on Sales). Improvements are observed in both the implementation and post-implementation periods, with mean and median changes in ROA and ROS generally positive and most are statistically signifi cant at the 2.5 percent level or better.”The Impact of Enterprise Systems on Corporate Performance

ERP Versus CRM ROI?

CRM on the other hand scores very similarly to ERP implementations: no relationship to financial performance improvement can be found.

“Over the full four-year period, the mean (median) abnormal return is –15.22 percent (–12.41 percent), and nearly 53 percent of the sample firms do better than the median return of the firms that belong to their assigned portfolio. However, none of these performance changes are statistically significant. Basically, investments in CRM systems have had little effect on the stock returns of investing firms. These results are consistent with that of Nucleus Research (2002), who report that 61 percent of the twenty-three Siebel customers that they surveyed did not believe they had achieved a positive ROI.” The Impact of Enterprise Systems on Corporate Performance

Overall ROI of ERP

“Despite the generally positive acceptance of ERP systems in practice and the academic literature, other studies have not found overwhelming evidence of strong positive performance effects from investments in ERP systems. Our results are generally consistent with these findings.”The Impact of Enterprise Systems on Corporate Performance

“For example, although Peerstone Research (Zaino [2004]) found that 63 percent of two hundred fifteen fi rms gained ‘real benefi ts’ from adopting ERP, they also report that only 40 percent could claim a hard return on investment (ROI). Other ROI results are reported by Cooke and Peterson (1998) in a survey of sixty-three companies that found an average ROI for ERP adoption of negative $1.5 million.”The Impact of Enterprise Systems on Corporate Performance

“Overall we find that, controlling for industry, ERP adopters show greater performance in terms of sales per employee, profit margins, return on assets, inventory turnover (lower inventory/sales), asset utilization (sales/assets), and accounts receivable turnover.”ERP Investment: Business Impact and Productivity Measures

This last quote sounds convincing, although no numbers are listed and there is no comparison of the financial benefit versus the implementation of another type of system. Furthermore, it is no longer possible to be an earlier adopter of ERP software; at this point one can only be a late adopter, meaning that the benefits to adopting ERP are lower. The data for this report was taken from companies before or during the implementation (prior to the system being live) and prior to when the system is operational and providing benefits to the company. This same report stated that the benefits of the ERP implementations began to reverse after the system was live. Here are the productivity gains from the same study.

“There is a productivity gain during the implementation period, followed by a partial loss thereafter. When value added is used as the dependent variable, the gains are 3.6 percent during implementation with a loss of 4.7 percent for a net gain of –1.1 percent (t=.8, not significant).”ERP Investment: Business Impact and Productivity Measures

Conclusion

Did the information in this article shock you?

When I first began researching these topics, I was also unaware that every one of the proposed rationales for the purchase and implementation of ERP systems would prove to not only be wrong but spectacularly wrong. I found myself quite surprised that these false predictions had not been reported in some published form. A multitude of entities has misled readers as to the benefi ts of ERP systems. I don’t necessarily assign a nefarious motive to all the people who have written about ERP vendors over the years. Certainly, vendors and software companies write marketing literature and have no interest in the truth. However, many journalists lack research skills and simply repeat what they have heard about ERP. Perhaps readers do not demand more, and if the journalists were to do the research, they might find things that would be unappealing and could cause blowback from their editors and advertisers.

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