Calculating Total Cost of Ownership: an Important Measurement of ROI

By Guest Blogger Chuck Langenhop

While many enterprise resource planning (ERP) system buyers know what TCO (or total cost of ownership) stands for, they may not understand the nuances of how to calculate it. Unlike the cost of tangible capital purchases like a production line, a truck or a copier, ERP systems have many hidden costs. Calculating TCO is essential for making a fair comparison of different proposals, for negotiating with vendors more effectively and for planning cash expenditures.

TCO is the denominator in the calculation of return on investment (ROI). While ERP marketing literature often describes ROI benefits that can be realized by purchasing a new system, from a practical standpoint, ROI is difficult to calculate in advance. In fact, as companies adopt more formal, complex processes with their new ERP systems, it is not uncommon for them to add additional staff having specialized skills in areas like system administration, purchasing, production planning and financial analysis.

While it is possible to achieve short-term savings with an ERP system, for the most part, the savings are actually realized over the long-term. As a result, companies should look to ERP software as a strategic investment for growth and not one with a short-term payback. TCO should, therefore, be a principal financial consideration when measuring your company’s ROI.

Now, let’s look at the ERP factors that contribute to the calculation of TCO.

Special Cost Considerations
Although TCO should include all anticipated costs in the first three years of ownership, there should be a distinction between Phase I (go-live) and Phase II (post go-live) requirements. For example, if a company does not plan to implement the ERP system’s integrated customer relationship management (CRM) functionality in Phase I, it should be excluded from TCO. It is important, however, to receive quotes for additional modules that may be desired in Phase II in order to make a fair comparison – and to verify that each vendor can meet those future needs.

While the Software-as-a-Service (SaaS) subscription model has become popular, it is subject to perpetual monthly charges based on the number of users. In comparing SaaS and licensing proposals, the three-year horizon is less meaningful. In this case, a discounted cash flow comparison should be made instead of using ROI.

Primary ERP Software
Under ERP licensing, there are generally certain base modules that are proposed, such as financials, customer service and operations. Optional modules may also be proposed, including configure-to-order, CRM, capacity requirements planning, engineering change management and a payroll interface.

The ERP vendor also quotes user licenses. Concurrency refers to the maximum number of users that can be logged in at a given time. Under a named licensing convention, however, each user must have a unique user name. Named users cost less than concurrent users. Separate user licenses may also be quoted for automated data collection, CRM and service management.

The primary manufacturing software will often be proposed with a discount from list price. Some vendors will continue to honor the discount for additional modules or users purchased within a specified time period following the contract date.

Maintenance
Maintenance is charged on a yearly basis as a percentage of either the gross or net ERP software license. Often it is due on the date of the contract. But in some cases it is deferred until go-live.

Third Party Software
In calculating TCO, decision-makers should have a clear understanding of third party software that will be required for Phase I. Report writers, business intelligence (BI), auto-FAX, CAD, advanced warehousing, project management and field service are just some examples.

Infrastructure
The vendor should provide hardware and networking requirements and then advise the prospect on the incremental cost. While many prospects prefer to stay on their existing platform, the ERP system that is identified as the “best fit” may require a migration, such as from IBM to Microsoft Windows or Windows to UNIX.

If a company prefers to avoid the costs of hiring system/database administrators and acquiring servers and network OS/VPN, outsourced hosting may be a viable solution. In that case, both the monthly costs of hosting and the costs of new client workstations, data collection devices and printers need to be assessed.

Implementation Support
Professional services include software installation and configuration, design workshops, training, piloting, conversion and go-live support. As much as possible, estimates should be provided upfront for modifications and custom report writing. To the extent that your company has its own IT analysts that can customize screens or write reports, outside development costs will obviously be lower.

The general rule is that the ratio of services to software costs is in a range of 1:1 to 1.5:1 for a “consultant light” implementation and 2:1 to 4:1 for “consultant heavy.” It is important to focus on the time quoted and not the rate. Most vendors will not quote a fixed fee so it is important to calculate TCO based on a realistic scope of services. For example, if three vendors quote 200 days, whereas another vendor quotes 175 days (due to a factor such as an aggressive “train the trainer” assumption), the fourth vendor has probably underbid.

Aside from making a vendor’s TCO unrealistic, a low level of services may be a sign that the vendor lacks sufficient resources to manage the size of your company’s implementation, especially if will be across multiple sites.

One final note when it comes to implementation support is this: It is better to pay more to secure sufficient resources from a qualified vendor than to pay less initially and incur greater costs later for a less successful conversion. Remember the old saying, “Pay me now or pay me later.”

The TCO Bottom Line
While the most expensive ERP system will probably meet all or most of your company’s requirements, the TCO may far exceed the corporate budget. On the other hand, there can be both functionality and implementation risks associated with selecting the least expensive ERP solution. By effectively negotiating price and carefully considering how much of the investment can be deferred to Phase II, buyers who have insight into TCO can, in fact, have it both ways.

About CTS Guides
This article is presented by CTS Guides, a leading publisher of independent software reviews, ratings and evaluation tools. Since 1983, we have helped over 23,000 companies evaluate and select new software. Get your free Manufacturing Software Selection Kit and Smart Shortlist™ Consult at www.ctsguides.com/manufacturing.asp.

About the Author
Chuck Langenhop, CMA, is an ERP selection and implementation consultant with CFO Advisory Services, LP in Dallas, TX. He has over twenty years of experience in financial management, budgeting, business planning, diagnostic reviews, process reengineering, e-Commerce and systems selection and implementation. Chuck is the developer of the CFO Advisory Services’ proprietary Six-Blade Approach for Cutting through ERP Transition Risk™, and holds a Master of Business and Public Management degree from Rice University and a Bachelor of Science degree in Accounting from the University of Delaware. For more information, Chuck can be reached at clangenhop@cfo-advisory.com.

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