8 min read
Direct vs. Indirect Procurement: Key Differences Explained
Learn key differences between direct and indirect spend, how their strategies differ, and procurement best practices.
Can a bakery produce bread without flour and sugar? Or without kitchen appliances, utilities, and furniture?
Of course not! In order to run a successful business, you need a dedicated procurement team to obtain these essential goods and services, ensure timely delivery, and nurture good relationships with your vendors.
Paying for offices, utilities, technology subscriptions, and cleaning services is also part of the procurement team's responsibility. However, these items fall under a different category, and today we're going to learn which is which.
Keep reading to find out the key differences between direct and indirect procurement, how their strategies differ, and how to control spending for both.
What is Direct Procurement?
Continuing in the line of food establishment examples, let's consider a local family pizzeria that you visit after a long day at work.
What different products or services does the staff need to purchase in order to produce pizza? Do they need flour and sugar for the dough? What about tomatoes to make a sauce and different toppings, such as cheese and pepperoni?
All these items are critical to run a pizzeria, and without them, the final product simply wouldn't exist and a pizzeria would go out of business very soon.
Thus, these materials would be categorized under direct procurement.
Direct procurement, or direct spend, is the purchase of goods and services directly associated with the manufacturing of the company's final product. Take these examples:
- A factory purchasing raw uncut steel to manufacture vehicle parts;
- A plumbing company buying new fittings to be installed;
- A restaurant purchasing raw food items;
- A bakery buying flour to make bread;
- A fashion brand sourcing fabrics.
Typically, direct purchases are made in large quantities to get a bulk discount.
If we consider the above-mentioned pizzeria, the owner (or a procurement team for a larger chain) would probably purchase a month's worth of flour, sugar, and pizza toppings.
Before finalizing the deal, they would likely take bids from different suppliers, hoping to get a bigger discount.
For direct procurement, driving the best value from sourcing materials, minimizing risk, and fostering long-term relationships with trusted suppliers will bring the most revenue and value to your company.
What is Indirect Procurement?
This is where the other little things that support the business come in: electricity, transportation, and office supplies are all necessary for a business to run.
Some employers even provide coffee, drinking water, and cookies. Such items fall under the umbrella of indirect procurement.
These products and services are not directly related to the company's production process but rather facilitate it.
Here are some other common examples:
- Outsourced services: security guards, janitorial services, IT, and any other services the company handles externally.
- Office supplies: laptops, coffee, toilet paper, pens, and paper clips.
- Travel and transportation: meeting and business trip expenses.
- Technology: computers, software subscriptions, telephony.
- Professional services: consultancies and advisors.
- Utilities: water, electricity, and maintenance.
- Marketing: advertising and social media.
- HR functions: recruitment and training.
- Facilities: offices and laboratories.
As you can see, there's much more beyond direct purchases that facilitates day-to-day business operations.
In fact, indirect spend equals up to 50% of all company purchases, and if addressed properly, companies can reduce indirect costs by 25%.
Check out our new article on SpendMatters to learn six successful tactics for efficient indirect spend control.
Direct vs. Indirect Procurement: How Their Strategies Differ
The key difference between direct and indirect spending is how they are managed and what functions they address.
Direct procurement focuses on securing core supplies meant to be processed and delivered to customers, and indirect procurement deals with purchasing spontaneous goods.
And since the functions of direct and indirect procurement differ, the way they operate is different too.
Let's look closely at how they work in different categories.
Direct costs are typically managed by centralized supply chain and procurement teams that have a strict budget and are focused on specific areas of spend.
On the other hand, indirect costs are often decentralized and are handled by multiple internal stakeholders with less rigid and more independent budgets and spend protocols. Indirect costs also include small parts of the business with their own unique needs.
Nevertheless, having indirect expenses scattered across the business is not ideal. Creating a centralized structure along with spend categories for indirect procurement helps ensure compliance and reduce costs, especially in service-oriented businesses where indirect costs are high.
Supplier Relationship Management
Since direct procurement teams deal with suppliers whose materials directly impact the quality of the end product and, thus, the company's reputation and credibility, supplier relationship management is their top priority.
That's why a lot of time and effort is invested in building long-term, sustainable, and collaborative relationships to ensure a steady supply chain, drive quality, and improve efficiency.
By contrast, indirect procurement teams focus more on spend management and reducing company expenditure, so their relationship with suppliers is more transactional.
But don't be mistaken that indirect spending has no use at all for vendor management.
For example, a software company with little to no need for direct procurement can, with strategic vendor management, reduce its overhead costs and negotiate the best prices for related services.
Let's get back to our local pizzeria.
Suppose it has been open for 2 years now. Surely, the owner already knows how many pizzas they sell per month.
For instance, if they know that they sell about 300 pizzas monthly, they'll calculate how much flour will be needed and purchase enough for the month.
Effective inventory management and direct procurement are interlinked. If a business runs out of raw materials, it can significantly hurt the supply chain and have devastating consequences for a company's bottom line.
Meanwhile, indirect spend operates on an as-needed basis, as monthly costs of coffee for staff, office equipment, and utilities can't be precisely predicted in advance. Therefore there's little opportunity for planning or budgeting for indirect spend.
Since procurement activities for direct and indirect spend are not the same, measuring their success is also different.
Indirect procurement teams focus mainly on keeping expenses under control, ensuring that there's no redundant spend, and making sure the company doesn't waste money on costs that aren't actively supporting business growth.
That's why they typically measure their success by using cost-saving KPIs, e.g., cost avoidance and cost reduction.
On the other hand, the main task of direct spend teams is to fulfill customer orders on time and in full. Cost savings are as important as inventory management and delivery KPIs.
For example, unused inventory leads to ongoing unnecessary costs by taking up storage space and tying up cash flow. Meanwhile, delays in delivery and poor supplier performance lead to an inability to satisfy the customer's order and, as a result, can seriously damage your company's bottom line.
Thus, ensuring that the company has the right materials at the right time is a priority.
Read more about how to choose and measure procurement KPIs for both direct and indirect spending in our latest blog post.
Impact on Industries
We shouldn't underestimate either indirect or direct procurement impact on overall business success.
Naturally, as processes and needs differ by industry, so will the amount spent on direct vs. indirect costs.
For example, direct spending far outweighs indirect spending in industries where the materials businesses procure directly impact their end product, e.g., manufacturing, construction, and retail.
Meanwhile, IT companies, recruitment agencies, and businesses that provide professional services prioritize indirect spend.
Tips to Better Control Direct and Indirect Procurement
It's clear by now that indirect and direct procurement involve different processes, stakeholders, functions, goals, and strategies depending on which one you are dealing with.
It's better to develop separate approaches and strategies for these two types of spending.
Still, here are some great tips to increase the value of procurement processes within your organization when it comes to both direct and indirect spend:
- Use spend data and analytics to understand trends, identify opportunities, and develop category management strategies.
- Regularly look into your contracts to find savings opportunities or restrictions that drive up costs or limit services, such as termination charges, automatic price increases, or contract renewals.
- Work closely with the finance department. Cooperation between the two will improve financial reporting, demand planning, and decision-making; it will also help increase savings and build stronger supplier relationships. Our article on SaasHub is a great guide on procurement-finance collaboration.
- Monitor and measure KPIs to improve decision-making and align the procurement process with business objectives, goals, and strategies.
- Embrace technology to achieve sustainable procurement and responsible sourcing.
Is a Procurement Solution Really Worth the Investment?
Procurement automation provides direct and indirect procurement teams with the full visibility needed to maintain supplier relationships, manage inventory, and identify opportunities to improve sourcing and reduce costs.
- No more manual and repetitive tasks. Replace tedious work with customizable process automation.
- Forget about Excel or PDF orders. Precoro generates POs instantly and automatically sends them to suppliers.
- Procure materials with limitless product catalogs for easy ordering.
- Achieve 90% faster approvals with approval thresholds, smart reminders, the ability to reject or approve from anywhere by email or Slack, and the option to assign backup approvers.
- Gain valuable insights about your performance with dashboards and custom reports so you can identify opportunities to cut down costs, forecast expenses better, and keep up with inventory needs.
- Manage suppliers, budgets, and inventory easily in one place.
- Automatic 3-way matching with customizable exceptions and supplier invoice tolerance rates to recognize and eliminate discrepancies.
- Integrate your Precoro workflow with any accounting or ERP system, such as QuickBooks, Xero, or NetSuite, and synchronize all documents and supplier data.
Taking all of this into account, is procurement software worth it?
It's up to you to decide what's right for your business. But if you have any questions or doubts, don't hesitate to contact us or use a free 14-day trial and see for yourself how Precoro helps more than 1000 organizations procure faster and spend smarter.
Is indirect procurement as valuable as direct procurement?
Some industries, like manufacturing, construction, and retail, value direct spend more.
Meanwhile, technology, recruitment agencies, and businesses that provide professional services may prioritize indirect procurement.
Why is indirect spend important?
While it may not seem like it, indirect spending accounts for a substantial portion of any company's budget, so it has a significant impact on an organization's long-term success.
It's especially critical for fast-growing companies, which have more vendor contracts, data, and purchases – these costs can quickly spiral out of control as the company expands.
With a proper strategy and precise monitoring of products and services that fall under indirect purchases, you can:
- Eliminate maverick spending;
- Cut costs and increase savings;
- Strengthen business operations;
- Develop mutually beneficial relationships with your suppliers.
What are the challenges of indirect procurement?
Regardless of what industry your organization is in, some of the common challenges you may encounter when managing indirect spend, especially if there are no procurement tools to help, include:
- Working with a large pool of vendors;
- Poor process visibility;
- Maverick spending;
- Lack of control;
The main difference between direct and indirect spend lies in the functions they perform and the goals they try to achieve.
Direct spend refers to procuring raw materials that directly impact the company's revenue and production process, e.g., a pizzeria buying flour to produce pizza. It focuses on maintaining relationships with key suppliers, inventory, and supply chain management. Basically, you want your suppliers to provide you with the best-quality goods on time so that your customers get the best possible service.
On the other hand, indirect spending means buying materials that facilitate the production process and aren't directly related to it, e.g., paying for utilities, offices, or transportation. When it comes to indirect spend, many companies try to – and need to – cut costs as much as possible.
Direct spend is more end-customer-oriented, while indirect procurement is business-oriented. For both, evaluating and optimizing procurement processes can result in better spending and an improved bottom line.