How to Guide for Calculating ROI on Quality Management Software
Return on Investment (ROI) is a common metric used in finance today for evaluating, approving, and measuring the success of investments or projects. Typical situations for using the metric could include: purchasing a new piece of equipment, opening a new facility, or developing a new product. To use this metric effectively it is important to understand the overall formula, the definition of each of the terms in the equation, and the steps to take for using it in the decision making processes.
In general, the formula would look something like this:
Simple ROI = (Gain from Investment – Cost of Investment) / (Cost of Investment)
Although, each company may have a different flavor of the ROI metric, meaning differences in the formula could include:
- Evaluating ROI over different time periods
- Using Rate of Return instead of ROI, where Rate of Return puts the return in terms of Compound Annual Growth Rate (CAGR)
- Using different Hurdle Rates (minimum ROI or Rate of Return required by a company to make an investment)
To help understand these differences and get a better idea of how to use ROI let’s look at how ROI applies to Quality Management Software.
Using ROI for Software Buying Decisions
The ROI calculation is a good tool for evaluating investment decisions and it is only natural to try and apply this tool to purchasing software. In fact, using ROI to purchase software is nothing new at all. Companies have been using ROI to validate purchasing decisions of ERP Software, Engineering Software, CRM Software, and more for many years.
Interestingly, using ROI as a tool to predict and then review actual results has also been a topic of extensive research in the market place. Although there have been some differences in these findings, the major takeaway has been that those firms calculating ROI both before and after software implementations end up with more successful implementations.
There are different theories on why simply measuring ROI improves ROI but it probably goes back to the old adage “if you don’t measure it you don’t manage it”.
Calculating ROI for Quality Management Software
One area where ROI for software investments has not been used effectively has been the Quality Management Software space. Often when companies invest in a Quality Management Software it is because they feel they are out of compliance, producing low quality products, overwhelmed with the inefficiencies of paper based documentation, are trying to manage many disparate systems, or face any number of other quality related issues. In these situations, companies simply purchase the software to alleviate the pain and don’t necessarily look to see what real Returns on the Investment can be made.
This approach is not necessarily “wrong” but in general the implementation will go smoother and the benefits will be further reaching if ROI is considered in the process. Which lends the question, how should ROI be calculated for Quality Management Software?
This question is really two questions in one: what will my real costs be and what are the total savings I can expect? To better answer these questions we have created a step by step guide to help guide you through the process.
The Steps to take for Measuring ROI on Quality Management Software
To best illustrate the steps that can be taken in determining the ROI, we’ll use an example to help walk us through the process. We’ll use “Company Y” as our target. Company Y is a midsized manufacturer with $100MM in revenue and has been struggling with quality and compliance issues for several years now. It has been an issue of increasing importance and is now on the CEO’s radar. Last year, before looking at directly investing in software, Company Y first wanted to better understand their business and quality processes.
Step 1 – Benchmark Performance: Company Y decided to go through a benchmarking process, documenting their internal business processes, performance in metrics like Cost of Quality, and use of technology. Through this benchmarking process they discovered:
- They have many disparate systems for managing their quality system
- Many of the processes to manage the quality, safety and environmental systems are manual
- Many of the processes are managed through access databases or third party software
Step 2 – Estimate Savings: Through a detailed analysis (QAD CEBOS’ ROI calculator is coming in the next posting) Company Y estimates that by adopting Quality Management Software they will be able to lower their costs through efficiencies and reduction in Cost of Quality by $100,000 per year.
Step 3 – Estimate Costs: In regards to the software costs, Company Y estimates they will spend $150,000 in software and services fees in year 1 and an additional $20,000 per year for maintenance and support beginning in year two.
Step 4 – Use ROI Formula: Plugging these numbers into the ROI formula, we find that over the next 5 years:
Simple ROI = (Savings over 5 years: $500,000 – Cost of Investment over 5 years: $250,000) / (Cost of investment over 5 years: $250,000) = 100% over 5 years or 20% per year.
Step 5 – Make Your Decision: At this point Company Y has good visibility into what savings can be expected over the next 5 years from the adoption of Quality Management Software. Company Y also understands how this will impact the broader company and their competitive positioning. With all this information in tow, Company Y is able to make an educated decision on whether they believe an approximate return of 20% per year over the next 5 years is good value when compared to other investment options Company Y may have.
Quality is more than compliance or cost avoidance, it is about making quality a way of life and infusing it through the organization. This means when buying Quality Management Software it should be about more than the cost of compliance it should be about ROI and specifically reductions in the Total Cost of Quality.
The above example is fictional but is very real to the situations we encounter day in and day out in the marketplace as a Quality Management Software provider. For these companies implementing Quality Management Software ends up driving considerable reductions in the Cost of Quality and the staff required to manage the systems who can now put time on higher value added activities. Unfortunately, for those companies that don’t measure ROI these savings are never documented. To address this issue, companies should measure the Cost of Quality as well as ROI for Quality Management Software, which will help your company make better technology decisions and take the credit where credit is due for improved operations.