Direct vs. Indirect Procurement
Last updated: November 7, 2018
Procurement is the process of obtaining or acquiring services and products that allow a company to do business. Procurement is more than purchasing those products and services. It involves planning and strategy, reviewing a budget as well as determining a cost model and how the items or services will be paid for. How well a company manages procurement can have a significant effect on the business' profitability.
Procurement can be classified as either direct spend or indirect spend. Direct procurement typically refers to the purchase or acquisition of items or services that the company uses to create its own products. Indirect spend refers to the purchase or acquisition of items or services that a business will use internally.
Understanding the difference between the two allows a company to decide best where to allocate its spending and to identify ways to save money.
Usually, direct spend procurement is focused on the purchase or acquisition of tangible items. It can also be focused on the services that produce the items in question, such as manufacturing.
There are several different types of direct spend purchases. These are some of the most common direct procurement goods and products:
Raw materials are the items that ultimately get transformed into the product a company sells. They can include metals, plastics, fabrics and materials such as leather, depending on what types of products a company produces. Often, direct spend management focuses on finding companies that can produce or provide raw materials to a business for the lowest possible price.
Not every company that produces tangible products manufacturers those products on-site. Part or all of the manufacturing process might be contracted out to another company. Since the cost of contract manufacturing is directly connected to the product a company sells, it is direct spend.
A company does not need to test its products in-house. Any fees associated with testing services are classified as direct spend. The cost of shipping a product to an outside lab for testing is also direct spend.
Print Materials include instruction manuals, warning labels or a description of the product itself. The cost of print Materials can include the cost of designing the materials, translating information into multiple languages and fabricating the material itself.
Equipment costs fall under the direct spend category if the equipment is used to produce the service or product a company sells. Examples include sewing machines owned by a clothing manufacturer, power tools owned by a construction company and printers owned by publishing companies.
Direct spend procurement isn't limited to companies that produce their own products. Items purchased by a business for resale, such as clothing meant to be sold at retail, also fall under the direct spend umbrella.
The cost of transporting items to their destination, whether that destination is a store or warehouse, can fall under the direct spend category. Transportation can also be an example of indirect spend — more on that below.
Why should a business concern itself with direct spend procurement? For many companies, without direct spend procurement, there would be no company. A fashion brand cannot produce clothing without the raw materials — such as fabric and thread — or the equipment — sewing machines — to do so. A retailer that sells clothing can't exist without clothing to resell.
Direct spend procurement also affects the overall quality of the goods sold or the services offered by a business. If a company decides to purchase low-quality materials to produce its products, it is likely to end up with a final product that isn't the best. On the other hand, a business that decides to procure more expensive, higher quality materials will produce a high-quality finished product.
The lower quality product is likely to command a lower price while the company with the higher quality product can ask for and receive a higher price since they made the item from top-quality materials.
Direct spend also affects the experience enjoyed by the company's customers. How much a company spends on the materials used to produce its products influences the price paid by the consumer. More expensive materials often mean a higher consumer price point while companies that use inexpensive materials can pass on along their savings to the consumer, in the form of a lower price.
For some businesses, direct spend is all about finding the balance between affordably priced materials and most significant quality materials. A low-quality, low-priced item might make a consumer happy initially. But if that item doesn't last for very long, the customer is not likely to be satisfied. On the other hand, a high-quality, high-priced item might not appeal to customers who are value-focused. But if a company can convince a consumer that they are making an investment and that the item will last longer than comparable products at lower price points, the consumer is more likely to feel confident in paying the higher price.
Direct spend procurement can also influence how efficient a company is at producing the goods it sells or in offering its services. A company that uses a considerable number of subcontractors or intermediaries along the way might be spending more than a company that uses one manufacturer or that sells its goods direct to the consumer.
The goals of direct spend procurement can be many and varied. For some businesses, a primary goal is to reduce costs. A company might wonder how it can find the same materials it has been using for a lower price, for example. One option might be to purchase larger quantities at once so that the company receives a volume discount. Other ways of reducing costs include reducing the price of labor, either by outsourcing or by working with a lean team, and reducing the cost of equipment, such as renting instead of purchasing.
Other common goals of direct spend procurement include:
- Reducing waste: In some ways, reducing waste can help a company also reduce costs. Reducing waste can include streamlining manufacturing processes or finding ways to produce the same products using fewer materials.
- Managing inventory: Purchasing more than a company can comfortably sell within a set period can cause several problems. the unsold inventory can prevent the company from purchasing more timely products to offer. Unsold goods also end up being sold at a reduced price, which can cause a business to lose money in the long run.
- Reducing lead times: How fast a company can get a product to market can affect its profitability.
- Reducing risk: A business might decide to work with multiple vendors as a way to reduce or manage its direct spend risks. If a company works with multiple vendors and one of those vendors faces a shortage or needs to discontinue operations suddenly, the company isn't left scrambling to find a replacement.
- Increasing sustainability: Companies that are interested in being more environmentally conscious and sustainable are likely to pay attention to how their direct spend procurement helps or hinders their sustainability efforts. For example, a green-minded business might prefer to partner with a vendor that puts environmental efforts at the forefront.
If direct spend has to do with the purchase and procurement of items that have some tangible connection to the production of items or services, then indirect spend procurement refers to the purchase or acquisition of goods and services that aren't directly connected to a product or service. Another way to look at indirect spend is as the procurement of goods and services that are necessary for a business to function. Indirect spend is often responsible for half of a company's purchases.
As with direct spend, there are different kinds of indirect spend categories. A list of common indirect procurement examples and spend categories includes:
Facilities management involves the maintenance of a business' office space and other property. It typically includes custodial and housekeeping services, pest control, HVAC maintenance and maintenance of alarm and security systems.
Marketing and advertising services can include purchasing print or on-air ads, digital and social media marketing and hiring PR or advertising firms.
The cost of hiring an outside consultant typically falls into the indirect spend category.
Companies in a variety of industries, such as higher education and healthcare, often need lab supplies and specialized equipment.
Technology spend can include anything from the purchase of computer equipment and software to hiring an IT firm and managing data.
The cost of utilities can include electricity at a building or buildings and telephone and Internet service.
Pens, sticky notes, paper and envelopes are just a few of the items that fall into the office supplies category. Office supply spending might not seem like much of an issue at first but can really add up, as it's very easy to over-purchase or to miss out on the best prices from certain suppliers.
MRO procurement refers to any purchase made to help repair or maintain equipment and supplies. MRO purchases might not directly influence the products that a company produces, but they are an essential part of a business' operation. Since the MRO category is so broad, it can be difficult for businesses to track and compare prices on their own.
Although transportation can be an example of direct spend, it also sometimes falls into the indirect spend category. Examples of indirect spend transportation costs include traveling from a workspace to a client's office or traveling by plane to visit a factory or manufacturing plant in another part of the world.
Document management includes storing files, shredding paperwork that contains confidential information and data management. Print services include the costs of producing printed materials, such as pamphlets and books.
As noted above, indirect spend can often be responsible for up to half of a company's costs. Although the products and services associated with indirect spend aren't directly connected to the products or services offered by a business, businesses often can't function without them. Finding a way to reduce indirect spend costs can often save companies a significant amount of money.
Indirect spend procurement can also influence how successful a business is overall. For example, if a company doesn't find the right PR agency or advertising firm to represent it, it might struggle to attract customers, making it a challenge to get ahead or grow. Ensuring that the people who work for a company are well-trained and that they are happy and engaged with their work is also essential for a business' success. Companies without sufficient human resources are more likely to spend more time searching for employees and might struggle with employee retention. A revolving door of staff harms company culture, which can ultimately hurt a business' bottom line.
A solid indirect procurement strategy has the goal of saving one of two things — money or time.
Cost reduction is a common goal. A company might look for vendors or agencies that offer their services at a price that is considerably less than the other firms.
Some businesses hope to save time rather than money when it comes to indirect spend procurement. They might choose a more expensive agency or a pricier service if it promises to solve a problem more quickly than a lower-cost option.
Depending on the size of a company, it is not uncommon for different departments to work with different vendors to provide the same service. For example, one department might work with Tech Company A while another department works with Tech Company B, instead of every department at the company using the same tech company. Finding a way to align each department and consolidate indirect spend can lead to considerable savings.
The most significant difference between indirect and direct procurement is how a business uses the items or services purchased. Direct spend items go right into the products or services a company produces or offers. Indirect spend items are more "behind the scenes." Indirect spend refers to the purchase or acquisition of items or services that a business will use internally. You could say that direct spend is the cost of being in business while indirect spend is the cost of doing business.
Some argue that indirect spend is considerably more nuanced than direct spend. If your business produces smartphones, then you need to purchase items such as glass screens and Lithium-ion batteries to put the phones together. Typically, only one department needs to make direct spend purchases. Indirect spend is often spread across a company. If different departments aren't in communication with each other, it is likely that a business is spending more than it needs to on indirect spend. Marketing, consulting and IT services are all areas where there might be overlap across different departments.
Although direct spend and indirect spend are different, they have one thing in common — businesses need both of them. If there's an issue with a company's direct spend procurement, such as a sudden jump in the increase of a raw material or a shipment that goes missing, then the company can risk missing production or delivery deadlines or might fail to create and send out new product completely.
If there's a problem with indirect spend procurement, such as difficulty hiring an advertising agency or storing documents and data in multiple locations, a company is likely to struggle to operate efficiently and can notice a drop in productivity and revenue.
Your business can use a variety of strategies to improve indirect spend procurement and save time and money. The strategy that will work best for your company will be one that is aligned with your goals. If you intend to reduce costs, a strategy that involves compiling spend data for the company as a whole, then looking for places of overlap can be effective. Look for opportunities to merge two separate cases of indirect spend, such as consolidating your business' IT services into a single provider.
You aren't on your own when it comes to determining which indirect spend procurement strategies will best help your business. Dryden Group has a comprehensive database of indirect category pricing data that can help you expedite the process of analysis and projections. We specialize in helping businesses manage and make the most of their indirect spend procurement, as indirect spend tends to be more complicated than direct spend when it comes to pricing methodologies and contracts. Contact us today to learn more about our indirect sourcing consulting and procurement auditing services.