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Why is it important to estimate ROI before making an investment?
Many small companies constantly postpone deciding whether to invest into MRP or not as they are straggling to estimate Return on Investment. There is a widely spread opinion, that RoI cannot be estimated for an investment when it comes to digital solutions, which is not true. Another common mistake, often made by companies, is the belief that positive results are granted regardless of which digital solution you implement. There are high risks to invest into the wrong features, overinvest or invest too little, which leads to an exceptionally long return on Investment or even to reduced productivity. Similar trends, where not all investments gave positive results, were observed in the 70s and 80s of the previous century at the peak on automation of production process, when in many cases the raise of productivity was far below expected. Dr. Armand Feigenbaum, an American quality control expert described this phenomenon in his interview to Industry Week by saying “After 10 or 15 years of automation-computerization - if anything, we have increased the hidden factory.” Hidden Factory is a term coined by Armand Feigenbaum. It refers to the activities in a manufacturing process that decrease the quality and efficiency of an operation. Thus, it is essential to thoroughly study the potential gains before making an investment decision.
How to calculate ROI of the MRP system.
How to calculate the effect of MRP on productivity and EBITA? Firstly, let us shift the paradigm. The MRP and all other digital solutions cannot have any direct influence on profitability or productivity without changing the processes at the same time. Higher productivity can be achieved by streamlining the production process and reducing ‘Hidden Factory’, where MRP plays a crucial role in creating a condition that enables the streamlining of a process. In this article, I will give you a simple, yet powerful 8-step process that allows you to estimate the gains that you can achieve with the implementation of MRP.
Before getting started, you should set metrics to monitor your company’s performance. Making a profit is often used as one of the metrics, which is not necessarily wrong. However, consider that: Profit = Price – Costs. The selling price is largely influenced by a degree of competition and the customer’s willingness to pay for a specific product, whereas cost is fully under the company’s control. There are three universal metrics which apply to enterprises, regardless of the size or sector they are working in. The first metric is cost. If the competition becomes much fiercer and you are forced to go along with the market’s overall price competition, reducing the cost allows you to maintain the profit. The second metric is the rate of defects. Defects create the ‘Hidden Factory’ consume your resources and reduce productivity. The third metric is lead time. Lead time, in my opinion, is the most underestimated metric. Lead time has influence on both components of profit - price and cost. The longer the products spend in your production, the more non-value-added tasks are needed and the higher the cost. At the same time, shortening the lead time will not only reduce costs, but will also create a competitive advantage and as a result will give you an opportunity to increase the price.
Thus, the idea behind calculating the ROI of MRP is for estimating how well MRP is capable to empower necessary process enhancements by increasing effectiveness and efficiency of the processes. Effectiveness measures how much of all activities are necessary to achieve the end-result. These necessary activities are called value-added activities. Efficiency measures how well the task is being performed.
8-step process to calculate ROI of MRP.
Step 1. Map your current process. To streamline your process, you need to get a full understanding of your current process. Often, managers know exactly what the necessary value-added steps are to get a product from raw material to finished goods, but at the same time, they lack knowledge of non-value-added tasks hidden in between. A mapping process helps to reveal the non-value-added tasks or waste.
Step 2. Identify the non-value-added tasks and the non-efficiencies of your process. According to the Lean Operational Excellence Strategy, any work or task performed can be classified into one of three categories: Value-Added Work, Non-Value-Added Work and pure waste. For a task to be referred as Value-Added, it must meet three criteria:
Firstly, the task shall create value for the customer, or put into other words – the customer must be willing to pay for it.
Secondly, the task shall change the form, fit or function of the product.
Thirdly, the task must be completed right the first time.
Thus, your goal is to identify non-value-added activities and waste, and to eliminate them from the process.
Some of the non-value-added tasks are required to support the execution of value-added tasks. These supporting tasks are often referred to as auxiliary tasks. Look at the possibilities to execute these auxiliary tasks in the way that they would have minimal effect on the performance and cycle time of the value-added task. A well-known example comes from Toyota, where changing dies at the die press used to take up to 3,5 hours. Over time, engineers managed to reduce the time required for changing the dies to just 3 minutes. Here is the quick introduction how to reduce impact of auxiliary tasks on effectiveness of operation.
All tasks taken while performing an operation can be separated into ‘internal tasks’ and ‘external tasks’. An ‘internal task’ can only be done when a machine or automated process has been stopped. Whereas an ‘external task’ can be done at the time when the machine or automated task is running. For example, let’s think of a machining workstation of a made-to-order manufacturer, where the parts are worked on a CNC machine. To complete the operation, the operator must go through a series of tasks. Extract the completed part from the machine, place it on the chart and label it, identify a new task to be completed and locate the next part to be machined, place it into the CNC machine, load a cutting file for the next part, complete machining. While extracting the completed part and loading the next part into the machine – they are clearly ‘internal tasks’, as they can be performed only when the machine is stopped. All other tasks - place the completed part on the chart and label it, identify new task and locate the associating next part and load the cutting file for the next operation, might be currently ‘internal tasks’ as well, but many of them can be performed at the time the machine is working. Meaning some, if not most of today’s ‘internal tasks’ can be transformed into ‘external tasks’. Your goal is to identify options on how to move as many ‘internal tasks’ as possible into ‘external tasks’.
Step 3. Capture the current state of your performance metrics. Above we discussed the company-level metrics – cost, lead time and number of defects. At the workstation or on the operation level, appropriate metrics are – operation throughput time, effectiveness of operation (OEE) and number of defects. If you fail to capture these numbers before changing the process, you lose the opportunity to assess the result of made changes.
Step 4. Design a concept of ‘to-be’ process. Map the first version of your new ‘to-be’ process, where all or at least most of the waste has been eliminated and as many ‘internal tasks’ as possible have been moved into ‘external tasks’.
Step 5. Analyze which pre-conditions are required to implement the ‘to-be’ process. Some of the pre-conditions can be created by changes inside the organization. For example, changing factory layout makes it possible to reduce the time on transportation and required energy to move parts from one workstation to another. Some pre-conditions can be created by technology. For example, to speed up locating the next part to be machined from the WIP storage, it will require an MRP capable to track the location of the parts that are in the storage. To speed up the labelling of parts, it will require an MRP solution capable of printing barcode labels when completion of operations is reported, and it will require an investment into a label printer. To speed up reporting an operation, it might require an MRP that is capable to print barcodes on work order, thus the operator shall only scan the barcode to report operations.
Complete the analysis for all operations in your process. Next compile the list of solutions and their features that are required for creating ground for streamlining the process.
Step 6. Evaluate available solutions and to which degree are they capable to create required pre-conditions. Select the ones which have the highest impact on streamlining a process.
Step 7. Finalize the ‘to-be’ process. Knowing which processes can be streamlined and to which degree and given the features of the selected MRP, draw a final version of the ‘to-be’ process map. Calculate the new throughput rate.
Step 8. Calculate the effect and ROI. Let’s say your current throughput is 500 finished parts a month and your total production overhead cost (depreciation of equipment, salary and wages paid to factory personnel and electricity used to operate the equipment) is 100,000 $, which makes it 200 $ for a part. Say, after implementation of an MRP solution and applying required changes to your process, the estimated throughput will be 650 parts a month. For the sake of not overcomplicating our example, let’s say changing the process will not change the overhead costs. In this case, the overhead component in products cost structure will reduce from 200 $ per product to 153,85 $. That corresponds to 650 times 46,15 $ = 29 997 $ cost-saving a month from reduced overhead costs, when you reach expected throughput. Plus, you will have increased profit from revenue growth. In a similar way, calculate all benefits you will achieve, including reduction of costs related to fewer defects. In our example, see the table below – total results show 30% capacity increase, 30% increase of revenues and 54% increase of earnings.
Now calculate the total investment needed for the implementation of MRP, changing process and training employees. Calculate the monthly depreciation of investment for one produced product. If your select an MRP, where you have a monthly-payment plan, it should be a straightforward calculation. Let us take an example, where total project costs, including purchase of new devices, MRP software, cost of hiring the project manager for implementation project and costs of temporarily stoppages of production to apply changes, are 75,000 $. In this case, optimistic RoI of MRP solution would be just above 1 month. As getting used to the new procedures and new software will require some learning curve, the realistic result for first month usually falls somewhere in between 70% and 85% from optimistic estimation.
What benefits you will get following above-described process.
By following the above-described 8 steps, you will have facts to make decisions what feature in your ‘to-be’ process required for an MRP solution and the option to select a solution that fits your needs. You can make a data-driven decision based on which process changes are worth to apply given your current available options. You can prioritize changes that will have a higher pay-back.
As a cherry on top, you will discover many ‘low-hanging fruits’, changes in the process that can be achieved very easily and quickly, often requiring no investment at all.
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