CASE FILES | VALUE PROPOSITION – Hard Numbers for Hard Choices

Acquisitions are nothing new to the IT folks at Koch Industries. The Wichita, Kan.-based Koch?pronounced the same as coke?has been through the process of merging systems again and again, and today it runs dozens of subsidiaries worldwide.

On the subsidiary level, however, not all Koch executives are well versed in the rigors of acquisitions. In 1998, Koch Membrane Systems based in Wilmington, Mass., bought out Fluid Systems in San Diego. “With the acquisition, the business vision was to integrate the two organizations, standardizing on processes and systems,” says Lloyd Boyd, director of information technology at Koch Chemical Technology Group.

Executives at Koch Membrane called on Boyd and other IT leaders in their immediate business unit?Koch Chemical Technology Group?to handle the integration. Boyd and other executives at the business unit had successfully measured the value of integrations before, touting a proprietary, economics-based philosophy known as market-based management that combines more than 50 economic models and drives a two-pronged cost-benefit analysis process. Boyd applied that cost-benefit analysis to Koch Membrane, resulting in a new ERP system from Wilmington, Mass.-based vendor Visibility, increased efficiency and a net cost savings of approximately $430,000.

Before Koch Membrane got a new ERP system, Boyd and Project Manager Dan Murphy had to estimate alternatives and prove that opting for an ERP system was better than signing on with an ASP or selecting comparable client/server technology. They did that with methodology that incorporates research-based estimates and the assignment of risk.

The Cost

The first cost Boyd tackled was for software, which he estimated on a per-user-per-year basis. Koch Membrane had roughly 240 IT users, but factoring in staff scheduling, Boyd figured he wouldn’t need to account for more than 80 users at a time. With all options, Boyd knew Koch would need a database upgrade, at a cost of $300 per user per year, or $24,000 annually.

In researching software cost for the ASP option, Boyd consulted colleagues and websites to determine a rate of $300 per user per month, or $3,600 per year. For 80 users, an ASP would cost $288,000; he multiplied the figure by a risk factor of 1.5 because the ASP market was volatile. The final price tag: $456,000 including a database.

Boyd relied on the same research for the client/server option. Licensing fees would cost $2,500 to $3,500 per user per year. For 80 users, that would be $200,000 to $280,000. He then multiplied those figures by a risk factor of 1.15 to account for his own inexperience with client/server technology, for a range of $230,000 to $322,000. Boyd accounted for annual maintenance costs, adding a standard 10 percent fee to the lower figure ($20,000) and an 18 percent fee to the higher one ($50,400). The final calculation: $274,000 to $396,000 per year including a database.

Experience helped Boyd estimate the software cost associated with Visibility’s ERP; he knew he could get a licensing price of $1,500 to $1,800 per user per year because he’d overseen six similar implementations of the Visibility system at Koch subsidiaries. With 80 users, those fees would cost about $120,000 to $144,000. Boyd then factored in maintenance, adding 10 percent to the lower figure ($12,000) and 15 percent to the higher one ($21,600), for a range of $132,000 to $165,600. He multiplied those numbers by a risk factor of 1.05 to account for changes in the economy. The tally: $163,000 to $198,000 including a database.

For hardware costs, Boyd figured he’d have to upgrade technology for all 240 users. He broke down that cost into server, PC upgrades and network, and then estimated all of those areas for each option.

For the ASP option, costs for the server and network were nonexistent. Boyd asked his systems managers to estimate cost for PC upgrades; improvements could cost anywhere from $50 to $200 a machine. For 240 machines, that was $12,000 to $48,000.

Boyd hit the Web to research client/server hardware cost. He came up with a one-time annual cost of $8,000 to $30,000. He multiplied those figures by 1.25 to account for price fluctuations. The result: $10,000 to $37,500 per year. Since Koch had sufficient communications lines, network cost was not an issue, so Boyd factored in the same cost predictions from his systems people for PC upgrades: $12,000 to $48,000. The final estimate for client/server hardware was between $22,000 and $85,500.

With the Visibility ERP, additional memory was needed. Boyd estimated that cost between $1,500 and $15,000 depending on how much memory he’d need. He multiplied those figures by a risk factor of 1.05 to account for price fluctuations, for a cost between $1,575 and $15,750. Next, Boyd figured he’d need to install a VPN line to San Diego, and he estimated it at a one-time cost of $12,000. He multiplied that by 1.05, again to account for changes in the economy, for a total network estimate of $12,600. Finally, he factored in $50 for what his systems people deemed “minor” upgrades for every PC, for a total of $12,000. The final price tag was $14,175 to $40,350 per year.

No matter which option Boyd chose, he’d need to hire consultants. He researched ASP consulting projects online and determined that the project would likely take between 1,200 and 1,800 hours. He then averaged quotes for senior and junior consultants and arrived at a figure of $125 per hour. Boyd then calculated a range of $150,000 to $225,000 and multiplied those figures by 1.25 to account for his lack of experience with ASP consultants. The final range: $187,500 to $281,250.

After contacting practitioners, Boyd determined that client/server technology would require 1,600 to 2,400 hours of consultant work. He multiplied those figures by $125 for a range of $200,000 to $300,000. Boyd multiplied that spread by 1.25, again to account for his lack of experience with client/server technology. The end result: an estimate between $250,000 and $375,000.

Boyd could use the same Visibility consultants Koch had used in the past and could leverage five internal subject-matter experts. Therefore, he estimated the job taking between 800 and 1,200 hours, and figured it would cost him $100 per hour. He multiplied the resulting $80,000 to $120,000 range by 1.1 to account for project delays for a cost of $88,000 to $132,000.

Boyd knew that all options would put a financial strain on the organization internally, particularly in the areas of training and documentation. Basing estimates on previous experiences with similar projects, he figured internal cost would be $50 per hour.

A cursory look at industry reports led Boyd to believe that an ASP implementation would require between 6,000 and 7,825 hours of internal time for all 240 Koch Membrane employees. At $50 an hour, he estimated that cost between $300,000 to $391,250. He multiplied those figures by a risk factor of 1.25 to account for a general unfamiliarity with projects of this nature and arrived at a final estimate of $375,000 to $489,000. The ASP option had relatively the same time and price estimates for training and documentation as the client/server option. Boyd read reports that documented how the client/server option was slightly more complicated than the ASP model, so he set the low-end of the time range a bit higher at 6,500 hours instead of 6,000. With the same estimated hourly rate and the same risk factor of 1.25, that brought the overall estimate for internal cost on the client/server option to between $406,250 and $489,000.

For the Visibility system, Boyd factored in the same amount of time for training and documentation but added extra time to account for training the five internal subject-matter experts to oversee the project after implementation. As a result, his estimate ranged from 7,000 to 8,325 hours, for a cost of between $350,000 and $416,250. Because of Koch’s familiarity with Visibility, he applied a risk factor of 1.1, for an estimate between $385,000 and $458,000.

Koch Membrane was spread between Boston, San Diego and Europe, so Boyd had to account for travel expenses. He figured each trip would cost from $1,000 to $1,200.

To implement an ASP, Boyd figured on between 50 and 80 trips to and from Wichita, for a cost of $50,000 to $96,000. Boyd then multiplied that range by 1.15, to account for changes in price as well as a number of emergency and unscheduled trips. The end result: a range of $57,500 to $110,400. Boyd used the same data to estimate travel cost for the client/server option.

For the Visibility option, Boyd figured that the local subject-matter experts would reduce the number of trips from 80 to 70, for a cost between $50,000 and $84,000. Since his staff is familiar with Visibility, Boyd assumed there would be fewer emergency trips. He multiplied those figures by 1.1 to come up with a range of $55,000 to $92,400.

The Benefit

To calculate the cost benefit of improving processes, Boyd met with representatives from Koch Membrane’s four major departments?accounting, engineering, manufacturing and sales. He asked them what improvements they expect of a new system, how they use the current systems and how they expect to use a new system differently to improve efficiency. Finally, the team, working with the department reps, established an average hourly rate to help quantify an estimate. For accounting and sales, the rate was set at $50 per hour. Because most of the efficiencies would be saved on shop floors, the manufacturing rate was set at $30 an hour.

Next, Boyd worked with team leaders in the departments to come up with time range estimates. In accounting, a new system would save between 5,000 and 8,000 hours of work, or $250,000 to $400,000. In sales, between 1,000 and 3,000 hours would be saved, or $50,000 to $150,000. In manufacturing, he set the range from 1,650 to 2,500 hours, or $49,500 to $75,000. The figures did not differ across options because department representatives didn’t care which option helped them achieve efficiencies. To address differences among options and tie savings more closely to the realities of each option, Boyd used different risk factors.

With an ASP, he multiplied the ranges by a risk factor of 0.75 to account for Koch’s inexperience with Web-based systems. Estimates for accounting savings dipped to a range of $187,500 to $300,000, sales estimates dropped to $37,500 to $112,500, and those for manufacturing fell between $37,125 and $56,250.

For the client/server option, Boyd multiplied the ranges by 0.8 to account for Koch’s lack of experience with the software. The estimates for accounting savings dipped to a range of $200,000 to $320,000, the sales savings dropped to between $40,000 and $120,000, and manufacturing savings slipped between $39,600 and $60,000.

To readjust estimates for the Visibility option, Boyd multiplied the ranges by 0.9 because he didn’t think training would go as smoothly as expected. The estimates for savings in accounting dipped to a range of $225,000 to $360,000, the sales estimates dropped to $45,000 to $135,000, and those estimates for manufacturing slipped down to a range of $44,550 to $67,500.

With any new system, Koch Membrane would save the cost of the old system being replaced. Boyd calculated that Koch Membrane would save $375,000 annually for replacing its preexistent mainframe computer, and $210,000 annually for ending its preexistent consulting contracts, adding up to a $585,000 benefit.

To calculate savings in inventory management, Boyd asked manufacturing representatives how they expected the new system to help them manage inventories. With better planning, the representatives figured they would save at least $625,000 in Boston and $25,000 in San Diego.

To readjust inventory management savings associated with an ASP, Boyd multiplied manufacturing estimates by 0.5, to account for a complete lack of experience with the technology. The end result was a $312,000 savings estimate for Boston and $12,500 estimate for San Diego. To recalculate inventory management savings brought about by the client/server option, Boyd multiplied manufacturing estimates by a risk factor of 0.75, to account for a lack of experience with new products in the niche. That re-adjustment resulted in a $468,750 estimate for Boston and an $18,750 estimate for San Diego. To get a more realistic view of inventory management savings brought about by improvements with the Visibility ERP system, Boyd multiplied the figures by 0.8 to account for concern about overestimating the impact of training on the new system. Boyd’s savings estimates were lower than those of the representatives?$500,000 for Boston and $20,000 for San Diego.

The Choice

Just about across the board, implementing the Visibility ERP system cost the least and saved the most. According to the initial estimates, the Visibility option would cost between $704,775 and $920,505 and save $1.4 million to $1.7 million; the ASP option would cost about $1 million to $1.4 million and save between $1.2 and $1.4 million; and the client/server option would cost about $1 million to $1.5 million and save $1.4 million to $1.6 million.

After its origination process, the choice was clear: Koch would replace the mainframe system with the Visibility ERP system. That decision was the first step on a rigorous value measurement time line, but it was a critical one.