Individual: Make-or-Buy Decision Paper
I WILL NEED TO EMAIL YOU THE SHORT STORY FOR THIS ASSIGNMENT.
Read Case Study III-2, “A Make-or-Buy Decision at Baxter Manufacturing Company,” in Managing Information Technology.
Write a 1,050- to 1,400-word (3- to 4-page) paper that addresses the following:
· Identify the business issues that are leading BMC to consider a new application.
· What are the key factors for Baxter in making the buy vs. build decision?
· What would you recommend Kyle Baxter do? Provide a rationale for your recommendation.
Provide research and references to support your recommendations.
CASE STUDY III-2 A Make-or-Buy Decision at Baxter Manufacturing Company
It is late Friday afternoon, and Kyle Baxter, president of Baxter Manufacturing Company, Inc., and his sister, Sue Barkley, vice president for customer relations, are discussing whether or not to purchase the Effective Management Systems manufacturing software package proposed by manufacturing Vice President Lucas Moore.
“I’m really fearful of buying such a large, complex software package given our past experience,” Baxter exclaims. “What do you think?”
“I really don’t know,” Barkley replies. “We do need manufacturing software, and there are some obvious advantages to purchasing this software. We have had bad experiences in past attempts to buy such software, but we have learned from some of our mistakes, so we might be successful this time. But I have been impressed by the success that MIS has had in building new systems for us, so I am in a quandry right now.”
“We’re going to have to decide before long,” Baxter notes, “but we need to talk with some of our people first.”
Baxter Manufacturing Company Background
Baxter Manufacturing Company (BMC), located in a small Midwestern town, is a leading manufacturer of deep-drawn stampings, particularly for electric motor housings. (Exhibit 1 shows a few of BMC’s products.) The company was founded in 1978 by its chairman, Walter R. Baxter, as a supplier of tools and dies, but it soon expanded into the stamping business. BMC is a closely held corporation, with the family of the founder holding most of the stock.
Some of BMC’s Stamped Parts
BMC’s engineers have implemented some of the most complex stamping concepts in the industry, as the company has established its niche as a quality supplier of deep-drawn stampings to the automotive (85 percent of sales) and appliance (15 percent of sales) industries. BMC’s major customers include Ford, General Motors, Honda of America, General Electric, Whirlpool, Amana, and Maytag. BMC puts great emphasis on quality and has achieved Q-1 status from Ford, a QSP Award from GM, and quality awards from Honda, and is recognized as a world-class supplier within its niche.none
none Copyright © 1997 by E. W. Martin. This case was prepared by Professor E. W. Martin as the basis for class discussion, rather than to illustrate either effective or ineffective handling of an administrative situation.
Producing a deep-drawn part is a complex process requiring repeated stampings, each with a different male/female die pair. This process is performed on a heavy press, using a very complex die that consists of perhaps 10 individual dies assembled together in a line. A coil of steel of the proper width and thickness is fed into one end of the press. After each stamping cycle a precision transport mechanism moves the material forward exactly the right distance so that a part that has completed one stage is positioned correctly at the next stage to be struck by the next die on the next cycle of the press. Thus each cycle of the press performs a different forming operation on each of 10 parts, and a finished part comes off the machine at the end of each cycle. (Exhibit 2 shows the different stages of a motor housing stamping.)
The Stages of a Motor Housing Stamping
BMC’s strength lies in its ability to produce efficiently large volumes of high-quality complex stampings. It may take 6 to 8 hours to install the dies and set up the huge stamping presses for a production run, so BMC cannot efficiently produce short runs and therefore does not serve the replacement market well.
BMC uses state-of-the-art equipment to develop and manufacture the necessary tooling for the needs of its customers. With the use of wire electrical discharge machines (EDM), computer numerical control (CNC) vertical machining centers, and CNC horizontal lathes, it is able to produce quality tooling efficiently. For the life of a part, BMC’s computerized equipment can reproduce identical die components for replacement of worn or damaged dies.
BMC’s 140,000-square-foot manufacturing facility is one of the best in the country, with 39 presses that range from 50-ton to 600-ton capacity. Every press is equipped with accessory items such as feeds, reels, and electronic detection systems. In addition to the presses, BMC has recently added the capacity to weld, drill, tap, and assemble stampings into more complex parts to suit the needs and desires of its customers.
BMC employs about 420 people and is nonunion. Management believes that these employees are BMC’s greatest asset. According to Chairman Walter Baxter:
We have a great group of people! We are fortunate to be located in a farming area where the people have a strong work ethic and a “do whatever it takes” attitude. We started out as a family company and we have a lot of families—husbands and wives, their children, aunts and uncles—working here. My son, Kyle, is now President, and my daughter Sue is Vice President for Customer Relations. We cherish our family atmosphere.
Over its 19-year history, BMC has grown at about 20 percent a year. The last five years of sales have been as follows:
This rapid growth has caused problems at times. For example, in 1990 its sales were so close to BMC’s production capacity that, even when running its production 24 hours a day 7 days a week, it became almost impossible to meet promised delivery schedules. According to Sue Barkley:
In 1991 we had to turn down business from existing customers who wanted to give us new parts to make. For almost a year we did not accept any new business. That was the most difficult thing we ever did because we were fearful that customers who had to go to our competitors might never come back. We told our customers that we hated to refuse their business, but we had to because if we took more business we couldn’t handle it—we would be late and couldn’t provide the level of service that we are committed to providing. Most of our customers understood. They were not happy about it, but they respected us for being up front about it. We did lose some good orders because we weren’t accepting business when they came out, but I don’t think that there are any customers who haven’t come back to us with more business.
By 1992 BMC had made the large investment necessary to significantly increase capacity and was back on its historical growth track.
In the late 1980s BMC’s automotive customers started to go to a just-in-time (JIT) philosophy in which they carried minimal inventories of raw materials and parts. Rather than sending an order for a month’s parts at a time as they had in the past, the customers began telling BMC one day what to ship on the next. BMC was provided with a blanket order for planning, but the customers reserved the right to change the amounts at the last minute.
Including the time to procure the raw materials, run them through the presses to make the parts, clean and pack them, and ship them out, BMC’s production process requires at least two weeks if things go well. Thus the automotive companies are forcing their suppliers to maintain their inventories for them, which places great pressure on BMC to reduce its cycle times. Because of its two-week production cycle and long setup times, BMC is often forced to maintain a finished goods inventory that is substantially above its target of a three-day supply.
About five years ago its automotive customers began to pressure BMC to convert to electronic data interchange (EDI), where all paper document flows between customer and supplier are replaced by electronic flows directly between the customer’s computer and BMC’s computer. Thus BMC receives all purchase orders and shipping schedules electronically and sends out electronic shipping notices and bills. EDI has the potential to be quicker and more efficient for both parties, but BMC’s factory computer systems were incomplete and fragmented, so for several years BMC accepted the data electronically, printed it out, and then rekeyed the data into those relevant systems that existed. The IS department is now building interfaces to enter the EDI data directly into some of BMC’s systems. One reason for this delay was that their automobile customers use one EDI standard while their appliance customers use another, and each customer has its own variation on the standard it uses. BMC has had to build a separate subsystem to handle each of its customers.
Information Systems at BMC
BMC’s managers have been very receptive to the introduction of new technology. They were early adopters of CAD/CAM, and are at the forefront of stamping technology. However, they have had little experience with the use of computers in business applications and have limited understanding of what the technology can do for them.
BMC got its first PCs in 1987, and a few managers started experimenting with Lotus spreadsheets. One of the first applications they set up was a spreadsheet for generating customer quotes by calculating what price to charge for a part based on estimates of raw material cost, tooling costs, the costs of stamping, and the expected quantity to be produced. Another early use of the PC was a scheduling spreadsheet developed by the company president, Kyle Baxter, when serving as vice president for manufacturing. This spreadsheet, which is still used today, contains data for each part, including the machine used, the number produced per hour, and the setup time. The quantity required and the delivery date are entered, and the spreadsheet determines when each part should be started into production and generates a schedule of what should be run when on each machine group. If the schedule is not feasible (e.g., some parts must be started last week), the scheduler can make manual adjustments in due date, quantity required, overtime, and other factors to produce a feasible schedule.
Realizing that they needed someone to lead and educate them in the use of computers, in 1989 BMC management set up an MIS department and hired an MIS manager, Nancy Shaw. BMC installed a Data General MV minicomputer, and the first application was interoffice e-mail. This was a great way to start because it demonstrated how helpful the computer could be in sharing information. According to Sue Barkley:
E-mail was very well received because we were growing so rapidly and the need to communicate within the plant was so important. It wasn’t until we got on e-mail that we realized how much time we had been spending running around the plant trying to find somebody and leaving little notes on their desk. We really became dependent on our e-mail system.
During the next two years Shaw led the purchase and successful installation of a package of financial applications, including payroll, accounts payable and receivable, and general ledger. Also, in 1989 BMC was beginning to encounter problems in production because of its growing capacity problems and its customers’ switch to JIT. When customers changed their requirements, the production schedule had to be changed, which forced changes in the schedules of other parts, and production people seemed to be spending all their time rescheduling things. Because demand was so near to capacity, it was difficult to get all the orders done on time, and there was a lot of expediting going on, which again led to the need to reschedule. Although there was no computer support for manufacturing other than the spreadsheet used for scheduling, BMC’s management decided that if scheduling could be speeded up, the problems would be alleviated. Consequently, the decision was made to purchase a software package for scheduling.
As mentioned previously, by 1991 the problems in meeting shipping schedules had gotten so bad that BMC began to have to turn down new business. Management again decided that they had to do something about machine scheduling, so again they decided to purchase a scheduling package.
The Present MIS Department
In 1994 Shaw left and BMC hired Don Collins to replace her as MIS manager. Collins had 20 years of experience as a lead systems analyst with a large manufacturer and broad experience with manufacturing systems. In 1996, Collins has a programming staff of four. The 1996 capital budget for hardware, software, and other information technology items was about $200,000. The MIS expense budget for payroll, supplies, and education was about $350,000.
The MIS department is using a development tool called Cyber Query Cyber Screen (CQCS) from Cyber Science, but Collins is giving some thought to what BMC’s development environment of the future should be. The Data General MV computer is becoming obsolete and is reaching capacity, so BMC will have to obtain additional capacity soon.
In order to plan a production schedule you need to know what you have in inventory, so the MIS group has created systems to track raw-material, in-process, and finished-goods inventories. MIS has also developed a minicomputer system that accepts EDI orders from customers and allows the customer service group to create a shipping schedule on the computer. Collins believes that within 2 more years the MIS group can build and install a set of manufacturing systems that will satisfy BMC’s basic needs and provide quite satisfactory EDI service to customers.
This success in building new systems opened BMC managers’ eyes to the possibilities for using the computer, and they have generated so many requests for new systems that an MIS steering committee has been established to approve projects and set systems development priorities. The members of the MIS steering committee are President Kyle Baxter, Controller Lou Wilcox, Sue Barkley, and Don Collins.
The New Proposal
In late 1996 Lucas Moore, vice president of manufacturing, suggested that BMC purchase and install an integrated package of manufacturing software sold by Effective Management Systems, Inc. (EMS). Moore had worked as an engineer with the company for 7 years and then took a leave for 2 years to get an MBA. The vice president of manufacturing retired soon after Moore returned, and Moore was promoted to that management position.
Moore supports the proposal that BMC install the EMS Time Critical Manufacturing package consisting of eight modules: shop floor control, EDI integration, inventory management, factory data collection, standard routings, labor collection, engineered product configurator, and general ledger. The purchase price of this software package is $220,000, including documentation, training by EMS, and consulting help during installation of the software. The cost of a software maintenance contract is $55,000 a year, and EMS will make limited changes requested by BMC at a cost of $60 per hour.
The EMS software will run on several minicomputers, including BMC’s Data General MV. However, additional computer capacity will be needed whether BMC purchases the EMS package or builds its own manufacturing systems.
Moore is relatively new to the manufacturing area, having taken over that area about a year ago, and was not involved in the past attempts to purchase scheduling software.
“Given that our MIS group is doing a good job developing new systems,” Baxter asked, “why should we purchase the EMS package rather than build manufacturing systems in-house?” Moore’s reply was:
The time and cost differences between purchasing and building are too significant to ignore: 6 months to install this advanced system versus 2 years to build our own basic system, and a firm $220,000 to purchase this system versus over $400,000 to build our own.
“We have not been successful in two tries to use purchased software packages in the manufacturing area,” Baxter noted. “What makes you think that we would be successful this time?” Moore replied:
Baxter also talked with Collins, who argued that BMC should continue its process of building the manufacturing systems that it needed. He estimated that the needed systems could be completed in about two years at a cost of around $420,000—$220,000 for outside help (including training his people in new development tools) and $200,000 in internal costs.
When Baxter asked Collins why BMC should not purchase the EMS software, Collins replied:
First, the EMS software is far more complicated than we need. For most general manufacturers each part may require six operations on six different types of machines, and each part has a routing that is different than other parts. Then several parts may be assembled into a subassembly, so you have two- or three-level bills of material. We typically take a coil of steel, stamp out the part, clean it, box it, and ship it out, so both our routings and our bills of material are very simple, as is our production process. The EMS system is designed for much more complex manufacturing.
Second, we have had little or no experience with computerized production systems. Does it make sense for us to try to jump to a very complex and sophisticated system like the EMS proposal? Lucas has a very superficial understanding of this software package, and he doesn’t know any of the details of how it will work. Therefore, he has no idea of the difficulties that his people will run into in adapting to this complex package. It will require them to do many tasks that they have never done, or even considered doing. And they don’t need this complexity. Wouldn’t it be better to build our own systems that correspond to where we are on the learning curve and plan to upgrade them as we progress in our understanding of our systems needs?
Third, it is likely that the system does not fit the way we are running the business. Do we change the system or do we change how we run our business? We probably can’t change a purchased system, so we would have to change the way we run the business. Do we really want to do this?
Fourth, we are constantly changing our manufacturing facilities and processes, and they may be unique to our business. If you purchase a package, you are at the mercy of the vendor to make changes in it. He may or may not make the changes that you want, and in fact he may make some changes that you do not want. If you do not expect the system to change and it is a common system, you probably should purchase it. For example, one general ledger system is just like any other, and they haven’t changed in 20 years, so you should purchase this application. But we are continually changing things out in the shop, and if we build our own systems, we can change them when we need to.
Finally, we have demonstrated that we can build and successfully install our own systems, but our record with purchasing and installing manufacturing systems is dismal. The EMS proposal may fulfill our needs, but then again it may not. We failed twice in the past because the system we purchased did not fit our needs. Why take that chance again?
After his discussions with Moore and Collins, Baxter sat down with his sister, Sue Barkley, to discuss what to do about Moore’s proposal. “Sue,” Baxter began, “you were able to get the second manufacturing software system we bought up and running, but conditions in the shop were so chaotic that we abandoned trying to use it. Why don’t we go back and try it again?” Sue replied:
CASE STUDY III-3 ERP Purchase Decision at Benton Manufacturing Company, Inc.
Benton Manufacturing Company, Inc., is a U.S. manufacturer of a varied line of consumer durables. Although its stock is publicly traded, a single family holds a controlling interest in the company. In 1998 Benton had net sales of almost $1 billion and an operating profit of about $180 million.
Benton’s 5,200 employees operate seven factories and 57 distribution centers located throughout North America. In the past few years Benton has acquired several companies, and two of Benton’s factories have been added as the result of acquisitions that broadened Benton’s product line. Benton’s products are sold through thousands of independent dealers who may sell both Benton’s and competitors’ products.
Benton is the leader in its industry with its products claiming some 40 percent of the market. However, industry demand is growing very slowly while the structure of the industry is undergoing rapid change as formerly independent dealerships are being acquired by large chains. This consolidation is changing the power relationships between Benton and its dealers and causing Benton’s traditional profit margins to erode.1 Benton has responded to this pressure by pursuing a Continuous-Improvement strategy that so far has increased productivity more than 25 percent, reduced in-process inventory 30 percent, freed up thousands of square feet of factory space, and reduced new product development cycle times.
1 This is a disguised case. Because of confidentiality issues, further details about Benton’s products or its industry cannot be disclosed.
Benton has a history of continuous growth in sales and profits. In order to continue this growth in today’s increasingly competitive environment, Benton management has focused on growth through the following strategies: (1) customer-driven new product development, (2) the acquisition of new businesses that complement existing ones, (3) international expansion, and (4) emphasis on the Continuous-Improvement approach.none
none Copyright © 2000 by E. W. Martin. No part of this case study may be reproduced, stored in a retrieval system, or transmitted in any form or by any means without the permission of the author.
Enterprise Resource Planning Systems
As one response to growing competitive pressure, Benton management is considering acquiring an Enterprise Resource Planning (ERP) system. An ERP system is a comprehensive set of software modules that integrate a company’s financial, human resources, operations and logistics, and sales and marketing information systems, storing the data for all these systems in a central database so that data are entered only once and the results of each transaction flow through the system without human intervention. An ERP system can replace many separate poorly integrated computer applications systems that a company has purchased or developed over the years. During the 1990s the use of purchased ERP packages exploded among Fortune 500 companies, making the leading vendor, Germany’s SAP, the fastest-growing software company in the world.
Thomas H. Davenport2 explains why ERP systems—sometimes called Enterprise Systems (ES)—are so popular:
2 Thomas H. Davenport, ”Putting the enterprise into the enterprise system,” Harvard Business Review, July–August, 1998, pp. 123–4.
An ES streamlines a company’s data flows and provides management with direct access to a wealth of real-time operating information. For many companies, these benefits have translated into dramatic gains in productivity and speed.
Autodesk, a leading maker of computer-aided design software, used to take an average of two weeks to deliver an order to a customer. Now, having installed an ES, it ships 98 percent of its orders within 24 hours. IBM’s Storage Systems division reduced the time required to reprice all of its products from 5 days to 5 minutes, the time to ship a replacement part from 22 days to 3 days, and the time to complete a credit check from 20 minutes to 3 seconds. Fujitsu Microelectronics reduced the cycle time for filling orders from 18 days to a day and a half and cut the time required to close its financial books from 8 days to 4 days.
Along with the successes, however, there have been a number of resounding failures in attempts to utilize ERP systems. Davenport3 reports on problems with enterprise systems:
3 Ibid., pp. 122–3.
The growing number of horror stories about failed or out-of-control projects should certainly give managers pause. FoxMeyer Drug argues that its system helped drive it into bankruptcy. Mobile Europe spent hundreds of millions of dollars on its system only to abandon it when its merger partner objected. Dell Computer found that its system would not fit its new, decentralized management model. Applied Materials gave up on its system when it found itself overwhelmed by the organizational changes involved. Dow Chemical spent 7 years and close to half a billion dollars implementing a mainframe-based enterprise system; now it has decided to start over again on a client/server version.
Some of the blame for such debacles lies with the enormous technical challenges of rolling out enterprise systems–these systems are profoundly complex pieces of software, and installing them requires large investments of money, time, and expertise. But the technical challenges, however great, are not the main reason enterprise systems fail. The biggest problems are business problems. Companies fail to reconcile the technological imperatives of the enterprise system with the business needs of the enterprise itself.
An enterprise system, by its very nature, imposes its own logic on a company’s strategy, organization, and culture. It pushes a company toward full integration even when a certain degree of business-unit segregation may be in its best interests. And it pushes a company toward generic processes even when customized processes may be a source of competitive advantage. If a company rushes to install an enterprise system without first having a clear understanding of the business implications, the dream of integration can quickly turn into a nightmare.
The ERP Study
Aware of the growing use of ERP systems and concerned that Benton might be missing an important development, Benton President and CEO Walter S. McHenry has formed a two-person team, composed of Adam T. Meyer and Jerry L. Cook, to investigate whether or not Benton should purchase such a system. Meyer is a senior systems analyst who has been a star with the Benton IS department for 15 years and has led many successful projects. Starting in engineering 12 years ago, Cook has worked in several areas throughout the company, including production, finance, and market research. Although not an IT professional, Cook is quite comfortable with computer technology and has led the introduction of CAD and LANs into engineering. McHenry told Cook and Meyer:
ERP seems to be the direction that our industry is going, and we probably need one too. However, I don’t know the specifics of what an ERP system involves or what it might bring to the company, so I want you to do a quick study and determine whether ERP is for us, and if so how we should approach it.
The study team found that there are four major ERP software vendors they might consider: SAP, J.D. Edwards, Oracle, and PeopleSoft. Each of these vendors is financially stable, supports global companies, has a full line of highly integrated modules, and is a leader in R & D. There are a number of “Tier 2” vendors, but Cook and Meyer believe that none of them is suitable for a long-term partnership.
After a great deal of study, attending a number of conferences, and talking with several people from companies that are using ERP systems, the study team is convinced that Benton should replace its legacy “back office” systems with an ERP system. Meyer explains:
We believe that information technology is crucial to survival in today’s competitive environment. Our present systems are growing old and hard to maintain, and will have to be replaced in the next few years. ERP systems have much more functionality and much better integration than our internal IT staff can possibly provide, so we have to use them just to keep up with our competitors who are starting to install them.
Furthermore, Benton management has established strategic business plans that cannot be realized without an ERP system. These plans include the following emphases that cannot be fully supported by our present information systems:
· International expansion
· Mergers and acquisitions
· Use of IT as a strategic weapon
· Integration with suppliers and customers
· Reduction of operational costs
· Product line expansion
· Process standardization across different units of the company
Adopting an ERP system will be a monumental undertaking for Benton. According to Cook:
An ERP system is not just a huge infusion of software and technology. We have learned that this is not just an IT project. Rather, it will require wholehearted commitment from all departments. They have to be willing to change their work processes to conform to those dictated by the ERP–the software is almost an afterthought. Benton has never faced change of this magnitude!
Reactions to the ERP Proposal
Cook and Meyer know that there is strong support for an ERP system from IT management, and they are confident that, although President McHenry does not seem to want to get personally involved, he is supportive of an ERP system. To make sure that McHenry understands the issues involved in adopting an ERP, Cook and Meyer have urged him to visit with a friend of his who is the CEO of a company that installed an ERP two years ago and is reported to be very pleased with the results.
There is also a great deal of support for an ERP system from operating-level management. But the reaction of VP-level management (see the partial organization chart in Exhibit 1) is mixed. According to Cook:
Partial Benton Organization Chart
Contrary to what Benton management believed in past years, we’re going to have to change. Although the structure of our industry is changing, our dealers are changing, and the economy is changing, the need for us to change is not universally recognized in the company management. We have some managers whose view is more defensive and who are less willing to embrace change.
Benton’s present human resources information systems are old and inadequate. Susan R. Hamilton, human resources vice president, is an enthusiastic supporter of an ERP system. Hamilton says:
I have talked with human resources managers who have ERP systems from several different vendors, and they are all enthusiastic about their systems. I know that an ERP system will enable us to increase productivity, serve the needs of our employees much better, and significantly improve the management of our human resources at Benton. Although I realize that converting to such a system will be a long and difficult process, I can’t wait to get started.
Tracy C. Scott, vice president for distribution, has seven years’ experience with Benton and is one of the few top managers that have management experience outside the company. Scott advocates an ERP system:
Our present computer systems work well at the distribution centers, but they only provide local information–I can’t get a quick picture of the entire distribution system. Better information would enable us to significantly reduce our finished goods inventory and at the same time provide better service to our customers. The integration of sales, production, and inventory information that an ERP system provides would enable me to do a much better job of managing my department.
Pat L. Miller, vice president for manufacturing, joined Benton as an engineer 20 years ago and worked in many positions in the manufacturing area prior to becoming a vice president four years ago. Miller is concerned about the possible impact of an ERP system on the manufacturing area:
For the past several years we have been concentrating on lean manufacturing through the Continuous-Improvement approach, and have increased productivity over 25 percent and reduced inventory by 30 percent in our factories. The Continuous-Improvement approach avoids going for the “home run.” Rather, it concentrates on producing many relatively small improvements, each of which can be quickly and easily implemented. It seems to me that an ERP project costing over $30 million is the antithesis of our Continuous-Improvement approach that has been so successful. First, it is one huge step, not a progression of small improvements. Also, in the ERP approach you must use the process dictated by the designer of the ERP system, and that is inflexible. How can you do Continuous Improvement?
I have another concern. We have a unique culture here at Benton that, in my opinion, is responsible for the success we have enjoyed. I have read that installing an ERP system may well force you to change your culture to be more compatible with the ERP system. That sends shivers down my back!
Lee L. Gibson has been vice president for finance for 10 years. Until about three years ago the information systems department reported to Gibson. Gibson, who is responsible for financial analysis of Benton’s investments, asserts:
The IS department has developed excellent financial systems for me that are quite adequate for our needs, so I see no major need for an ERP system as far as the finance department is concerned.
Also, I am very concerned about the high cost of an ERP implementation and about whether the bottom-line return from such a system would justify this huge expense. We have always subjected our IT investments to a rigorous cost/benefit analysis, and I don’t see any reason why we should treat an ERP system any differently. In my view, the larger the investment, the more important it is that it be carefully justified, and an ERP system would cost many times as much as the largest IT system we have ever developed.
Meyer shudders at the thought of trying to use cost/benefit analysis to justify an ERP system:
The costs of an ERP system are readily apparent up front, but many of the benefits are results of more complete and timely information that enable you to better manage the enterprise. These intangible benefits do occur, but they are not easy to identify and quantify beforehand.
At conferences we talked with a number of people that are delighted with the results of their ERP systems, and we always asked how the cost justified the system. We got a lot of strange looks and blank stares. The identifiable cost reductions will seldom justify the cost of an ERP system, but people are installing them because they realize that they have to in order to compete in the future. And many companies are beginning to get bottom line results that they ascribe to their ERP investments.
Gibson’s concern prompted Cook and Meyer to develop the analysis presented in Exhibits 2 and 3 This analysis is based on a study they obtained that reported the experience of over 60 firms that have successfully installed ERP systems and used them for at least three years. Using the figures from this study, the team estimates that it will cost Benton some $34 million to install an ERP system and $750,000 a year for a maintenance contract. The benefits are estimated to be about $11.593 million a year after installation is complete. Over a seven-year period this produces an Internal Rate of Return of 20 percent and a Net Present Value (at a 20 percent discount rate) of just over $156,000, which just barely meets Benton’s criteria for such investments.
Industry-Based Annual Benefits of Benton’s ERP
Cost/Benefit Analysis for Benton ERP
Cook explains how the yearly benefits were developed, as shown in Exhibit 2:
In each area of benefits (inventory, centralized operations, etc.), the table shows the industry low and high as a percent of the Base Amount column, which contains the current cost to Benton of the category in each line, except for the last line where it contains Benton’s total revenue. The three Estimated Benefits columns are calculated as follows: The Low $ column is the Base Cost times the Low percent; the High $ is the Base Cost times the High percent; and, the Medium $ is the average of the High $ and Low $ columns.
For each row we considered Benton’s situation and chose a Low $ or Medium $ figure depending on our judgement, trying to be conservative. In the Inventory row we chose the Low $ column because we had already reduced inventory by 30 percent. In the Centralized Operations row we chose the Low $ figure because we think we are already pretty lean. And in the Incremental Revenue row we chose the Low $ figure because we are already growing revenues by 6 to 7 percent, and doubt that we will be able to do much better than that given the industry conditions. Incidentally, in that line we took only 50 percent of the increased revenue as the benefit because labor and materials cost is half the revenue. We think that the $11,593,000 estimate of total yearly benefits is conservative.
Meyer explains Exhibit 3:
We based our estimate of total cost of converting to an ERP on the concept of “cost per seat.” The industry “cost per seat” ranges from $15,000 to $35,000, which includes hardware, networks, software, consulting, conversion, customization, and the cost of our people who work on the project. Because we expect to have to do a good amount of reengineering and will need a lot of help from outside consultants, we took $25,000 per seat and multiplied by the number of PCs we expect to have on the system (1360) to get the $34 million cost estimate. We also included $750,000 a year for a maintenance contract. We used judgement to spread both the costs and the benefits over the 7 years.
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