Calculating ERP TCO

By Erik Kass

It's no secret that ERP is a major investment. ERP systems are company-wide and have long-term implications for the financial, human resources and information technology departments and various other aspects of the business as a whole - which is why careful upfront planning is so critical.

Total cost of ownership, or TCO, analysis can help business owners determine how much it will really take to make their ERP implementation projects a success.

Undertaking ERP implementation can be a risky decision, but TCO analysis is designed to help mitigate that risk by preparing a company for all the costs of ERP ownership - not just the obvious ones.

When done right, a good TCO analysis will help companies separate a good ERP investment from a bad one. However, a high TCO doesn't necessarily signal a poor investment if the corresponding returns on that investment are high enough to offset the expenses. The ratio between costs and rewards is more important than the numbers alone.

TCO begins with an estimate of all the direct and indirect costs associated with ERP implementation, including the cost of the software itself, maintenance costs, operational expenses, upgrades and eventual replacement. Naturally, this necessarily involves making some projections and assumptions about the future, so to achieve the most accurate predictions possible, TCO analysis includes several alternative scenarios.

One industry that is heavily invested in TCO analysis is the automotive and transportation industry. Owning a vehicle comes with a few obvious costs - the initial cost of purchasing the car, for example - and a whole lot of hidden costs that accrue over time. First, just driving the vehicle out of the dealership results in a significant loss of value, which means that even if a car owner sold his or her vehicle mere days after purchasing it, he or she would not be able to sell it for the same value the dealer did. Second, owning a car comes with a lot of responsibility. Car owners need to pay for maintenance and check-ups, buy new tires every few years and of course pay for gasoline. All of these factors combine to give an estimated TCO for the cost of owning a car - and that figure going to be significantly more than the car's MSRP on the lot. A similar line of thinking can be applied to determine the cost of a business to own a jet or a yacht, for example.

The same principle goes for ERP software. The cost of owning an ERP system is likely to end up being significantly more than the sticker price on the software, but companies that understand, prepare for and budget for these expenses will find that their ERP systems save them a lot more money than they cost.

The basic tenet of TCO is this: You cannot manage what you do not measure.
There are five major components of TCO analysis - acquisition, implementation, operations, maintenance and replacement. These five components represent the five life-cycle stages of an ERP system, and each one is associated with specific costs. Understanding all of these costs - in other words, planning beyond simply the initial ERP software costs - is one of the best ways that companies can prepare themselves for ERP and better their chances of becoming an ERP success story.

A graph of these expenses often resembles the Nike "swoosh" logo. There is an initial peak in costs when the software is first purchased and implemented, a dip as it begins running smoothly, and then a steady rise as the system becomes older, requires more maintenance and is eventually replaced. This is the natural cost cycle of an ERP system, and budgeting accordingly will help businesses steer clear of any unpleasant cost surprises.

A second critical part of TCO analysis is determining the direct and indirect costs and risks associated with ERP systems, and managing and controlling these costs and risks accordingly. Direct or budgeted costs include anything paid to clients, servers, peripherals and networks, along with capital, fees and labor in each area. Indirect costs are things like downtime and service to end users - costs that can be hidden and difficult to measure.

Once all these costs and risks are known, TCO analysis conducts a series of what-if scenarios to determine the best implementation strategy that will yield the lowest cost of ownership and offer the highest potential reward with the fewest risks.

Evaluating the TCO is the first step to understanding the potential return on investment, or ROI. Once a company is prepared for all the expenses of ERP - from the software to the maintenance to the upgrades - it can begin reaping the significant financial benefits without worrying about unexpected costs.

Erik Kaas is Director of Product Management for Mid Market ERP products at Sage. He is responsible for managing the product line life cycle from strategic planning to tactical activities. Erik manages a team of product managers responsible for specifying market requirements for current and future products.