How to calculate the return on investment in an ERP software? (part 1)

Enterprise resource planning (ERP) systems add value to companies by automating and optimising core business processes, such as finance, inventory management, manufacturing, sales, project management, and human resources, in a single, unified platform. It provides centralised access to key business data. With greater transparency of these functions, business leaders can increase efficiency, reduce costs and open up new growth opportunities.

Quantifying the return on investment (ROI) in an ERP softaware is crucial for preparing a business analysis that justifies the implementation of such software.

In addition, analysing the ROI of ERP helps businesses assess and predict the impact of the software on their organisation and refine their overall approach to ERP over time, ensuring its value to the company continues to grow.

However, because ERP solutions have the potential to encompass a wide range of business aspects, quantifying their impact—and, therefore, ROI—can be challenging. This is especially true for companies migrating to cloud ERP softwares, which deliver intangible benefits whose ROI is more difficult to measure in monetary terms.

In this article, we look at the many benefits of ERP solutions, how to accurately calculate their ROI, and tips to help your company get the most value from its investment in this type of software.

Advantages of an ERP software

Before calculating the return on investment, it is essential to determine the reasons why your company should invest in an ERP software.

Centralised database

ERP software collect information from across the business and store it in a common database.

This enables employees, in general, and key business leaders, in particular, to monitor the ‘pulse’ of their business using a unified, accurate, and integrated view of business operations, from back-end financial processes and warehouse operations to lead generation and sales success.

The big picture

Working with a single version of the organisation’s activities eliminates data silos and saves a lot of time when making informed business decisions. For example, real-time information on supply chains, warehouse capacity and forecasted customer demand can help a manufacturer maximise production without overstretching its teams.

Enables companies to grow quickly

Cloud ERP software offer a compelling platform for growth, particularly for companies that need to expand rapidly to manage the increasing complexity of their operations.

Minimises human error

ERP solutions help businesses improve order and payment timeliness through optimised invoicing. In contrast, manual accounting is slow and prone to human error, which can lead to unnecessary costs and delays.

As the saying goes, time is money. The faster a business can process, ship, and invoice an order, the sooner it reaches the customer and the sooner the business receives payment.

Many of the benefits that companies derive from ERP software stem from the way ERP software integrates processes involving multiple departments.

Imagine a standard order-to-payment process involving multiple teams and points of contact, including sales, fulfilment, invoicing, and payment registration.

With ERP software, stakeholders across the entire chain can track and manage the whole process through a single system.

For example, a salesperson who has just closed a deal with a large customer can check the order status at any time and keep the customer informed without relying on anyone else. This process increases efficiency and saves money, helping to build stronger customer relationships based on accountability, trust and on-time delivery.

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How to calculate the return on investment in an ERP software?

The benefits of ERP systems are well documented, but calculating the return on investment in one is a complex process. Before looking at a sample calculation, let’s consider three important factors:

· On-premise and cloud deployment models

· Hard and soft returns

· Initial implementation and ongoing use

The choice of deployment method is key to calculating the return on investment in ERP.

ROI for a cloud ERP software

Technically speaking, the term ‘return on investment’ (ROI) does not fully apply to cloud systems, as they are typically paid for through monthly or annual subscription fees, which are treated as operating expenses for accounting purposes rather than capital expenditures.

The ‘investment’ in the ROI acronym refers to capital investment, and capital expenditures require more complex accounting treatment.

ROI refers to locally installed (on-premises) softwares, which typically require upfront capital expenditures to purchase the licences, hardware, and infrastructure necessary to run the software.

However, organisations implementing a cloud ERP solution can use ROI calculation principles to understand the value that ERP software bring to them.

There is also a helpful distinction between ‘hard’ and ‘soft’ ROI. Hard ROI refers to the traditional return that can be easily attributed to a quantifiable financial value, such as additional revenue or reduced costs.

On the other hand, soft ROI refers to intangible gains such as increased employee morale or improved company image. Both benefits can have a significant impact on the bottom line, but the exact financial value of their contribution is more difficult to calculate.

ERP implementation consists of two main phases: initial installation and subsequent use by employees who aim to maximise the benefits of the new technology. During these phases, companies often rely on their ERP vendors for implementation assistance and, in most cases, for migrating data from the previous software to the new one.

Employee training and how they work with the system are essential to maximising the return on investment in a new ERP system. This is why most successful implementations are accompanied by introductory training for employees, where they learn the ins and outs of the latest software and how it meets and exceeds their needs.

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Below, we present the basic formula for return on investment in ERP and look at an illustrative example:

ROI = (total investment value – total investment value) / total investment value x 100%

The interpretation of the formula indicates that it represents the ratio between the profit realised from the investment in ERP (expressed in financial value) and the total value of the asset.

This ratio is expressed as a percentage. The total value of the investment in ERP encompasses the initial cost of the solution and all anticipated costs throughout its lifecycle.

Traditionally, this formula is only applied to on-premises ERP systems, as it refers, by definition, to the capital expenditure for the purchased asset plus the associated ongoing operating costs. In the case of a cloud software, the equivalent costs would include monthly or annual licence fees for using the ERP software.

The higher the ratio between profits and the total value of the investment (or its equivalent in the cloud), the higher the return on investment (ROI).

Read more: How ERP software is revolutionising pig farming at Boni Holding

Let’s examine an example of a consumer goods manufacturer that has implemented a cloud-based ERP system, paid for through an annual subscription. The company needs to calculate the ROI of its new solution three years after it goes live based on initial implementation costs of $50 000 and yearly fees of $100 000. This yields a total investment value of $350 000 over three years, equivalent to the cloud investment. Of course, this example is simplified; the manufacturer’s total costs may also include employee training costs for using the new ERP solution, implementation partner fees and others, in addition to the initial installation costs and annual licence fees, depending on the specific use case and ERP implementation model.

In terms of return on investment, the manufacturer has chosen to focus on fixed costs, so it has calculated the sales growth, higher margins and lower production costs that it can attribute to its ERP software, as shown in this table:

Benefit	Year 0	Year 1	Year 2	Year 3	Total
Sales growth	$0	$50 000	$80 000	$100 000	$230 000
Productivity gains	$0	$30 000	$40 000	$90 000	$160 000
Cost savings	$0	$60 000	$100 000	$115 000	$275 000
Total					$665 000

The value provided by the software over the past three years (excluding inflation) is $665 000.

When we substitute the total value of the benefits achieved from ERP and the manufacturer’s simplified total costs into the ROI calculation formula, we get:

($665 000 – $350 000) / $350 000 x 100, which equals a 90% return on investment.

It is important to emphasise that the benefits achieved in this example are also simplified.

The total value that a company can attribute to ERP will depend on the nature of its business and may include improvements in product quality, reduced transport and inventory storage costs, increased order volume, reduced headcount, and lower administrative costs. In addition to these hard, measurable benefits, a company may also derive intangible benefits from implementing ERP, such as increased employee morale, which should also be taken into account when calculating the return on investment.

One final caveat to note is that some organisations prefer to measure the return on investment in ERP on a year-over-year basis rather than over the entire software life cycle. One approach to this is to use the formula described above and apply only the revenues and/or savings for the year in question. However, this is not always ideal, as a significant portion of the initial costs will not recur in subsequent years. For example, employee training is most intensive in the first few months after software implementation and less so in subsequent years.

Similarly, the return on ERP tends to increase in the first few years after implementation, as this is the period when new efficiency opportunities are unlocked, and better returns are achieved before the situation stabilises.

At Balkan Services, we have expert knowledge of business, technology and legislation and speak all three languages. We will listen carefully and advise you on choosing the right business system for your needs

Balkan Services has implemented business software solutions since 2006 and has completed over 750 projects for over 400 clients. We follow a proven implementation methodology with clear steps and best practice know-how.

Stay tuned for part 2 of the article, where we will look at five tips: How to increase the return on your investment in an ERP system?

Source: The ROI of ERP Systems