FINDING THE BUSINESS VALUE AFTER SUCCESSFUL ERP IMPLEMENTATION: MAKING THE CASE FOR GROSS MARGIN Richard

J. Goeke, Ph.D. Widener University One University Place Chester, PA 19013 rgoeke@mail.widener.edu (610) 499-1141 Robert H. Faley, Ph.D. Kent State University PO Box 5190 Kent, OH 44242 rfaley@kent.edu (330) 672-1154 Kevin E. Dow, Ph.D. Kent State University PO Box 5190 Kent, OH 44242 kdow@kent.edu (330) 672-1109

ABSTRACT We make the case that ERP-related profitability improvements first manifest themselves in gross margin. Using regression discontinuity analysis, we compared SAP Successes with their matched competitors before and after their SAP implementation periods and found that the gross margin of SAP successes improved significantly but not their operating margin. These results proved robust across two different matching strategies, and the regression equations explained nearly all of the variance in gross margin. The strength of these results is likely due to the ideal position gross margin occupies along a firms value chain where productivity and profitability intersect. INTRODUCTION As managers increase their efforts to improve their organizations productivity and profitability [8], a common course of action has been the implementation of an Enterprise Resource Planning (ERP) system. Evidence of the business value of ERP investments has been mixed, with improvements in productivity rather than profitability much more likely [cf. 7,12,14,18]. These results are not unexpected, as leading business value models posit that improvements in profitability do not always accompany productivity improvements [10,15]. One of the more consistent findings reported in the ERP valuation literature has been the positive impact of ERP systems on the firms cost of goods sold (COGS) [cf. 17,18,19]. COGS is an important component of gross margin (gross margin = (net sales COGS) / net sales), and the managerial accounting field considers gross margin as a measure of both profitability (how many of a firms sales dollars are profit) and productivity (how efficiently a firms business processes convert inputs into outputs) [cf. 5,20]. However, we have found no research in the information systems (IS) field that makes use of gross margin when measuring the business value of an IS investment. We used regression discontinuity analysis to compare the gross and operating margins of SAP Successes verses their competitors before and after their SAP implementations. Our results indicated significant differential gains in gross margin, but not operating margin. Therefore, gross margin represents an important lens through which researchers and practitioners can view the business value of ERP investments.

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LITERATURE REVIEW The Business Value of ERP Implementation Researchers have generally found that ERP systems have a meaningful effect on firm productivity but not profitability. For example, Hunton et al. [12] reported that their sample firms significantly increased asset turnover compared to their competitors, but not profitability. Similar results were reported by Poston and Grabski [18], who found a significant drop in both COGS and number of employees three years after ERP implementation, but no significant improvement in residual income. Hitt et als [11] limited post-implementation data indicated that operating profitability of SAP adopters would deteriorate during the post-implementation period. Nicolaou [17] reported that the operating income of ERP adopters was significantly greater than their matched competitors during the third and fourth post-implementation years, but this improvement was primarily the result of a substantial drop in COGS. Hendricks et al. [9] found that only two of six profitability measures improved during the post-implementation period, and Matolcsy et al. [14] reported no significant improvement in net profit during the two years following ERP implementation, although they did show significant improvement in both inventory and fixed asset turnover. Finally, Vemuri and Palvia [19] found that only four of seventeen SAP implementations showed significant improvement in operating income as a percent of sales, while six showed a significant improvement in COGS. Gross Margin and ERP Implementation The positive impact of ERP implementations on COGS is especially relevant to the present study because of the relationship between gross margin and both productivity and profitability. We argue that gross margin acts as a bridge between the productivity and profitability of ERP systems; support for its use as a bridge between productivity and profitability can be found in the IT business value and managerial accounting literatures. IT business value researchers argue that there are two phases in the valuation of IT investments [2]. The first phase occurs early in the firms value chain at the operational level where measures of efficiency/productivity are more salient. The second phase occurs later in the value chain where measures of operating profitability are more salient. We propose that gross margin is a bridge between the two phases. Support for this proposal can be found in the financial indices used by business value researchers. For example, the process-oriented model proposed by Barua et al. [2] includes measures of productivity (such as capacity utilization and inventory turnover) that are closely related to gross margin. Managerial accounting theorists consider gross margin a measure of profitability and manufacturing efficiency [5]. Capacity utilization is commonly used to measure the efficiency of manufacturing operations, and also has a direct relationship with gross margin. Capacity utilization refers to how much of a firms available production capacity is actually being used, and is calculated (in dollars) as actual output divided by potential output [2]. As actual output increases (i.e., capacity utilization increases), the per unit COGS will decrease (through smaller overhead allocations), so gross margin should improve [6, p. 53]. Business value and managerial accounting researchers consider gross margin to be a reliable measure of the efficiency of a firms business operations as well as an early indicator of its

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profitability. Based on previous research demonstrating the efficacy of ERP adoption on firm efficiency, we would expect ERP systems to positively impact gross margin as well. Hypothesis Because of the efficiencies that result from a successful ERP implementation, firms should experience a significant reduction in COGS, which will result in an increase in gross margin. Therefore, we hypothesize that: H1: The gross margin of SAP Successes will be significantly greater than their matched competitors. Although we would also like to make a directional hypothesis about differences in the operating margin of SAP Successes versus their matched competitors, we believe the vagaries associated with operating margin (e.g., swings in R&D, advertising and miscellaneous expenses, etc) make it very difficult to measure the effect of ERP systems on operating margin accurately. Thus, we would likely predict no difference between the operating margins of SAP Successes and their competitors but for the fact that it is impossible to accept the null hypothesis. Nonetheless, we include the operating margin results without a directional hypothesis for illustrative purposes.

METHODS Sample Selection We obtained the names of companies that were recognized as SAP Successes on the SAP website. The final list of companies included only publicly traded, U.S. based companies that were not divisions of other companies. We searched the Lexis/Nexis Academic Universes Wire Service Reports for the first announcement that each company would be purchasing SAPs ERP software. Once an announcement date was found, we allowed one year from that date as the time-period for the SAP implementation. With the company and year known, we then collected three years of pre-implementation and three years of post-implementation financial data from the Compustat database. This process resulted in a sample of thirty-six SAP successes. Matching Methods We used a matched-pair design to measure the gross margin and operating margin differential between each SAP success and its closest competitor over the same three-year pre- and postimplementation periods [1,9,13]. We matched the SAP successes to their competitors based on pre-event gross margin, pre-event operating margin and finally based on size (net sales). To create matches based on pre-event gross margin and pre-event operating margin, we used the matching procedure advocated by Barber & Lyon [1]. We used the matching procedure advocated by Bharadwaj [3] to create matches based on pre-event size. Analytical Method We examined the data using regression discontinuity analysis, which is especially useful when an event takes place that changes the intercept and/or slope of a regression line [16]. If we assume year 4 as the year of implementation, then we can compare three years of preimplementation results to three years of post-implementation results, as illustrated in Figure 1.

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Figure 1: Illustration of the regression discontinuity design

Slope (Post) = b1 + b2

b3

b0 0

Slope (Pre) = b1

Xi

To determine whether SAP Successes and their matched competitors differed significantly from one another on gross and/or operating margin, the slope and intercept of the gross and operating margin regression lines before and after the ERP implementation were compared [16]. A significant change in either the slope (b2) and/or intercept (b3) would indicate that the ERP implementation had the expected effect. RESULTS Results of our analyses are shown in Table 1. Table 1: Regression discontinuity results
Analysis 1 Matching Basis Pre-Implementation Operating Margin 2 Pre-Implementation Gross Margin 3 Pre-Implementation Size 4 Pre-Implementation Size * p<.05 ** p<.01 Dependent Variable Operating Margin Differential Gross Margin Differential Operating Margin Differential Gross Margin Differential B0 .052 .015 .006 .007 B1 -.018 -.006 -.002 .006* B2 -.001 .033* .010 .011* B3 .119 -.015 -.012 -.021*
Adj. R2

.347 .976 .681 .987

F 1.89 68.8* 4.55 130.2**

For matches based on pre-implementation performance (analyses 1 and 2 in Table 1), the regression discontinuity equation explained nearly all the variance in gross margin differential, and the adjusted R2 for the gross margin data was significantly larger than the adjusted R2 for the operating margin differential (F=34.93, p<.05) [4]. Moreover, the post-implementation slope

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was significant for the gross margin differential. No significant results were found in the regression discontinuity equation for operating margin differential. Similar results were found when matches were based on pre-implementation size (analyses 3 and 4 in Table 1); the regression discontinuity equation explained nearly all the variance in gross margin differential, and the adjusted R2 for the gross margin data was significantly larger than the adjusted R2 for the operating margin differential (F=31.88, p<.05) [4]. Moreover, the postimplementation slope and intercept were significant for the gross margin differential. No significant results were found in the regression discontinuity equation for operating margin differential. DISCUSSION We make the case for considering gross margin as an alternative measure of the impact of ERP systems on firm profitability. As we hypothesized, the gross margin of SAP Successes was significantly greater than the gross margin of their matched competitors. This was not the case for operating margin. These results maintained using two very different matching strategies and the regression discontinuity equations explained nearly all the variance in gross margin. The fact that the results were both significant and very similar across the two matching strategies is indicative of their robustness. The fact that SAP Successes had a significant advantage in gross margin compared to their competitors is a meaningful finding in itself. Research has shown that ERP systems improve the firms efficiency, but finding profitability improvement has been elusive. We suggest that researchers, by focusing on operating margin to measure firm profitability, may have been looking in the wrong place. First, operating margin can be affected by a myriad of factors that lie beyond the scope of an ERP implementation. Second, gross margin is ideally situated along most firms value chains and measures both efficiency and profitability. It is a relatively clean measure of profitability, especially when compared to traditional profitability measures such as operating margin. Therefore, we urge IS researchers to consider using gross margin as a measure of ERP profitability. This is especially the case for large-scale IT implementations such as ERP systems where it is particularly difficult to measure accurately important components of operating margin. References [1] Barber, B.M. & Lyon, J.D. Detecting abnormal operating performance: The empirical power and specification of statistics. Journal of Financial Economics, 1996, 41(3), 359-399. [2] Barua, A., Kriebel, C.H. & Mukhopadhyay, T. Information technologies and business value: An analytic and empirical investigation. Information Systems Research, 1995, 6(1), 3-23. [3] Bharadwaj, A.S. A resource-based perspective on the information technology capability and firm performance: An empirical investigation. MIS Quarterly, 2000, 24(1), 169-196. [4] Carte, T.A. & Russell, C.J. In pursuit of moderation: Nine common errors and their solutions. MIS Quarterly, 2003, 27(3), 479-501. [5] Fields, E. Essentials of Finance and Accounting for non Financial Managers. New York: Amacom Books, 2002.

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[6] Fridson, M.S. & Alvarez, F. Financial Statement Analysis. 3rd ed. Wiley Finance Series. New York: John Wiley & Sons, 2002. [7] Goeke, R.J. & Faley, R.H. Do SAP successes outperform themselves and their competitors. Communications of the ACM, Forthcoming, [8] Griffell-Tatje, E. & Lovell, C.A.K. Profits and productivity. Management Science, 1999, 45(9), 1177-1193. [9] Hendricks, K.B., Singhal, V.R. & Stratman, J.K. The impact of enterprise systems on corporate performance: A study of ERP, SCM, and CRM system implementations. Journal of Operations Management, 2007, 25(1), 65-82. [10] Hitt, L.M. & Brynjolfsson, E. Productivity, business profitability and consumer surplus: three different measures of information technology value. MIS Quarterly, 1996, 20(2), 121-142. [11] Hitt, L.M., Wu, D.J. & Zhou, X. Investment in enterprise resource planning: Business impact and productivity measures. Journal of Management Information Systems, 2002, 19(1), 71-98. [12] Hunton, J.E., Lippincott, B. & Reck, J.L. Enterprise resource planning systems: comparing firm performance of adopters and nonadopters. International Journal of Accounting Information Systems, 2003, 4(3), 165-184. [13] Kerlinger, F.N. & Lee, H.B. Foundations of Behavioral Research. 4th ed. Fort Worth, TX: Harcourt College Publishers, 2000. [14] Matolcsy, Z.P., Booth, P. & Wider, B. Economic benefits of enterprise resource planning systems: some empirical evidence. Accounting and Finance, 2005, 45(3), 439-456. [15] Melville, N., Kraemer, K. & Gurbaxani, V. Review: Information technology and organizational performance: An integrative model of IT business value. MIS Quarterly, 2004, 28(2), 283-322. [16] Neter, J., et al. Applied Linear Statistical Models. Boston, MA: McGraw-Hill, 1996. [17] Nicolaou, A.I. Firm performance effects in relation to the implementation and use of enterprise resource planning systems. Journal of Information Systems, 2004, 18(2), 79-105. [18] Poston, R. & Grabski, S. Financial impacts of enterprise resource planning implementations. International Journal of Accounting Information Systems, 2001, 2(4), 271-294. [19] Vemuri, V.K. & Palvia, S.C. Improvement in operational efficiency due to ERP systems implementation: Truth or myth? Information Resources Management Journal, 2006, 19(2), 1836. [20] Webster, W.H. Accounting for Managers. New York: McGraw-Hill, 2004.

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