61FIN2FMO – FINANCIAL MODELING

FINANCIAL MODELING – TERM ASSIGNMENT (ASSIGNMENT #2)

This case is partially adapted from ERP decision case in the textbook (P.452-454)

I. THE ERP DECISION CASE

Background

During the 2000s, many large companies began to realize that lack of integration among their
information systems was leading to serious operational inefficiencies. Furthermore, these
inefficiencies were beginning to cause many companies to lose ground to other, better-organized
firms. At the same time, enterprise resource planning (ERP) software, especially SAP R/3
(http://www.sap.com/), was reaching a high state of maturity as its penetration rate among the
Fortune 1000 rose. The decision whether to convert to SAP (or a competing product) was a strategic
one for many companies at this time, both because of the high costs and risks of cost overruns (many
SAP implementations had failed or been far more costly than expected) and because of the high risks
of not implementing integrated software. This case will allow you to explore the analysis done by one
typical company for this decision.

What is ERP software? An ERP system is companywide software that links all operations to a central
database. ERP software is organized by module, one for each functional area such as Finance,
Accounting, Manufacturing, Payroll, Human Resources, and so on. Each of these modules has a
common software design, and it shares information as needed with the central database. While
converting old systems to ERP is a massive undertaking, once it is accomplished the firm has one
common database, one common definition of business concepts, one central warehouse in which all
information resides, and individual modules for each functional area that are compatible but can be
upgraded independently.

The Situation at Mega Corporation

Mega Corporation has for many years been a dominant manufacturer in its industry. As a worldwide
firm, it has four main manufacturing sites and sales offices spread across the world. Since most of the
growth in the firm occurred in the 1970s and 1980s, before integrated firmwide software was
available, few of the company’s information systems can communicate with each other. This lack of
information integration is becoming an increasing burden on the firm. Each of the manufacturing sites
has its own hardware and software, and none are linked electronically. As a consequence, much of
the sharing of information that goes on among the manufacturing sites is done by telephone, fax, or
memo. Each of the main sales offices has purchased and developed its own information systems, and
these do not communicate with each other or with manufacturing. Again, this forces the sales offices
to use telephone and faxes to share data. The accounting department is centralized at headquarters,
but its software system does not interface with the others. Much of their time is spent manually
transferring accounting data from the field into their central system. Purchasing is done by each of the
manufacturing sites independently, and since their systems do not communicate, the firm cannot keep
track of its purchases from single vendors and thus misses out on many discounts. This is just a sample
of the problems that Mega suffers due to a lack of information integration.

As these problems deepened, and the need for some centralized solution became more and more
apparent, a conflict arose between the chief information officer (CIO) and the chief financial officer
(CFO). The CIO wanted to install an integrated system immediately despite the costs and risks; the CFO
wanted to kill any attempt to install this software. Here is a summary of the pros and cons of this
decision, as expressed by the two executives

The Case for ERP

The CIO argued that partial fixes to the company’s current information systems were becoming more
expensive and less effective every year. The conversion to ERP was inevitable, so why not do it now?
Once the system was up and running, the firm could expect to see lower inventories both of finished
goods and raw materials. Finished goods inventories would be lower because Marketing and
Manufacturing would be able to share common forecasts; raw materials inventories would be lower
because Manufacturing would communicate its needs better to Purchasing, which would not have to
maintain large stocks of raw materials to cover unexpected orders. In addition, Purchasing would be
able to obtain quantity discounts from more vendors by pooling its orders from the various
manufacturing sites. Sales would increase because, with better communication between Marketing
and Manufacturing, there would be fewer canceled orders, fewer late shipments, and more satisfied
customers. Software maintenance costs would go down because the company would not have to
maintain the old, nonintegrated software, much of which existed simply to allow one system to
communicate with another. Decision making would also improve with the ERP system, because such
basic information as current production costs at the product level would be available for the first time.
Finally, once the basic ERP system was in place it would become possible to install more sophisticated
software such as a customer-relationship management or CRM system. A CRM system sits on top of
the ERP system, using its database to help answer questions such as ‘‘Are we making money selling
products to our customers in the Northeast?’’ and ‘‘Is our sales force in East Asia fully productive?’’.

The Case against ERP

The case against ERP was made forcefully by the CFO. ERP hardware and software costs are high and
must be paid in full before any benefits come in. ERP systems change almost everyone’s job, so the
retraining costs are enormous. Some people will even leave the company rather than retrain on the
new systems. No one within the company has any experience with ERP, so an expensive group of
consultants must be hired over many years. Even after the consultants are gone, the company will
have to hire a substantial number of highly trained and highly paid systems people to maintain the
ERP system. Improved decision making sounds valuable, but it is hard to quantify, and besides, if the
company has as much difficulty as some firms have had implementing ERP, the ‘‘benefits’’ may well
be negative!

The only rational way to develop an understanding of the likely costs and benefits of implementing
ERP, and perhaps to settle this argument, is to develop a model. You have been asked by the Board to
do just that. Your model should be complete in that it accounts for all the possible costs and benefits
from both an ERP system and from installing a CRM system on top of the ERP system. The model
should be flexible, so that alternative assumptions can easily be tested. It should be robust, in that
nonsensical inputs should be rejected. It should also provide insights, so that the Board can use it
effectively to decide under what circumstances the ERP/CRM project would make sense. Some of the
initial assumptions on which the Board would like the model to be built are described next.

Assumptions & Data

First, the model should cover 20 years, from 2019 – 2038.

Second, it should account for changes in sales (and revenues) from the ERP and CRM systems, as well
as changes in inventories.
Finally, it should include the costs of hardware, software, consultants, permanent employees, training
of nonprogramming staff, and maintenance of old systems.

Specific numerical assumptions follow:

 Without ERP, sales are expected to hold steady at about $30 million per year over the next 15
years.
 Sales can be expected to grow about 1 percent/year once an ERP system is fully operational,
which will take two years.
 If a CRM system is installed, sales growth will become 2 percent/year. (The CRM system would
be installed in year 4 and become operational beginning in year 5.)
 The company currently spends $5 million per year maintaining its old systems, and this cost
will grow by $100,000 per year. All of this maintenance cost will be avoided if an ERP system
is installed.
 ERP hardware will cost $6 million in the first year of installation (ignore depreciation).
 ERP software will cost $11 million in the first year of installation (ignore amortization).
 CRM hardware and software will each cost $2 million in the year of installation (year 4). The
CRM installation cannot occur before three years after the ERP installation is begun. (ignore
depreciation and amortization)
 Consultants work 200 days per year.
 The number of ERP and CRM consultants required from 2019 to 2023, the daily rate starts at
$1,500. The daily rate will be adjusted yearly and indexed by the expected inflation of 1%
(constant).
 The company will have to recruit additional programmers each year from 2019 to 2023. The
starting yearly wage for each programmer is currently $100,000. This payment is expected to
increase 0.5% per annum. Please note that programmers are needed until 2038.

Year Number of ERP Number of CRM Additional Number

consultants consultants of programmers

2019 10 0 10
2020 8 0 8
2021 7 0 7
2022 6 2 6
2023 1 1 6
2024 0 1 0

 The costs of training nonprogramming staff starts at $3 million in 2019, $2 million in 2020, $1
million in 2021 and then $100,000 in 2022.
 Without ERP, inventory turns over 11 times per year. Thus, the average level of inventory (in
dollars) is annual sales divided by 11. With the ERP system, turnovers are expected to increase
to 14. To hold a dollar of finished goods inventory for one-year costs $0.50. Lower inventory
increases profitability.
 Cost of goods sold (excluding the costs of inventory) are 75 percent of sales revenues.
 The hurdle rates normally used in the company to evaluate capital investments range from 10
to 15 percent. However, an argument has been made that a significantly higher rate should
be used given the risks of this project.
 Efficiency gains from ERP systems have varied widely from firm to firm. Some managers within
this firm are optimistic and would estimate these gains at $7 million per year. Others are
 pessimistic and would see a loss of $5 million per year due to cost overruns and unexpected
retraining expenses. Finally, there is a neutral camp that would prefer to assume no efficiency
gains or losses from ERP.

Analysis and requirement

1. Using the assumptions and data already given and whatever additional assumptions you feel
are warranted, build a model to project the Net Present Value of the gains from the ERP and
CRM decisions. Remember that your model will be complete, flexible, robust, and capable of
providing insight if it follows the 05 principles of modeling with spreadsheet. Please ignore
any effects of taxes and depreciation and amortization.
2. Establish a base case. Perform what-if analysis. Over what ranges for critical parameters does
the project look attractive?
3. Which assumptions appear to be especially critical in determining the gains from ERP?
4. Where are the breakeven values for critical parameters at which the project changes from
attractive to unattractive?

II. DELIVERABLES

Each group must submit three files:

1. An excel model built to project the NPV of the gains from the ERP and CRM decisions. The first
sheet contains information of the group members.
2. A PowerPoint slides or a WORD document to summarize the analysis of the case. The
presentation should use graphical illustration wherever possible to convey your insights. Do
not repeat anything the Board already knows—get right to the point.
 The length for a PowerPoint presentation is 5-7 slides.
 The length for a WORD document is 2-4 pages.
3. A video that walks through the model and explains how the model adheres to the 05 principles
of modelling with spreadsheet (the range name and protection are not required). The video
should be under 7 minutes (expected length is under 5 minutes)
 The video can be a screen recording of a walkthrough of the Excel model.
 The video can be a recording of in-person presentation.
 If you want, you can create a PowerPoint presentation and record the screen of the slideshow.
 The best practice is that you upload the video to the Youtube.com (made it private so that
only person who has the link can access your video) and insert a link to the video in the
PowerPoint slide (first slides). If you do not want to upload your video to the Youtube.com,
send your video in MP4 format.
III. MARKING CRITERIA

The maximum mark is 150 and the details of the marking is provided in the below table.

Criteria Maximum Notes

marks
Investment rationale 10 1. Clear investment rationale for the ERP
project is provided.
2. A recommendation is provided.

Parameters and 10 1. Critical parameters are identified and

assumptions analyzed properly.

Excel model 80 1. The model follows the 05 principles of

modeling and capable of providing
insights.
2. Both the excel file and the video are
used to assess the model.
3. The format of the model is assessed.
Sensitivity analysis 30 1. Base case and what-if analysis are
performed correctly and appropriately.
2. Break-even analysis is provided.

Quality of video and 20 1. Clear sound and images for the video.
formatting of the report 2. Standard formatting for the PPT or
(PPT or WORD) Word document.
3. Acceptable length.
4. Presentation skills

IV. ASSISTANCE
1. If you have any questions, please email me or arrange a meeting with me at 801C on 11/11 or
the faculty office on 25/11/2020 from 9:30-11:10.
2. You can seek help from your tutor by sending her or him an email.
3. Below are some suggestions to make and upload the video. Please note that you can create a
video using a cell phone, a camera, a laptop, or a desktop.

Follow this link to download a free screen recorder (windows)

https://www.flashbackrecorder.com/express/

Follow this link to learn how to record screen with PowerPoint presentation:
https://support.microsoft.com/en-us/office/record-your-screen-in-powerpoint-0b4c3f65-
534c-4cf1-9c59-402b6e9d79d0#OfficeVersion=Office_2013

Follow this link to learn how to upload video on YouTube

https://support.google.com/youtube/answer/57407?co=GENIE.Platform%3DDesktop&hl=en

Follow this link to learn how to record screen online:

https://www.apowersoft.com/free-online-screen-recorder
 You can use ZOOM or GOOGLE MEET to record your videos.
https://support.zoom.us/hc/en-us/articles/201362473-Local-recording
https://support.google.com/meet/answer/9308681?hl=en

V. SUBMISSION

Before you submit, please zip your files https://www.winzip.com/win/en/downwz.html and name it
as

“GROUP NAME_ASSIGNMENT2_DATE”

For example: “MARVEL_ASSIGNMENT2_11.09.2020”

Drop your file to:

https://www.dropbox.com/request/o68CMqLE0nrkGYnmXbBo

Due date: 30 NOVEMBER 2020.