As procurement teams manage and analyze costs to maximize profit, understanding the purpose of each purchase is crucial. To achieve this, organizational spend is often broken down into two categories: direct and indirect spend. Outside of procurement, these terms aren’t widely known or understood.
In this blog, we’ll explore these two categories. We’ll define direct and indirect spend as well as examples of each. Then, we’ll compare the two types of costs as well as the strategies and considerations required to manage them.
Broadly, the term spend refers to purchases made by an organization. Regardless of business size or annual budget, procurement managers must be able to understand their spend to thrive. To do that, it’s helpful to identify, categorize and analyze purchases individually and collectively.
Using direct and indirect categories enables procurement teams to control costs while ensuring the business can still effectively deliver the products and services they sell.
Direct spend, sometimes called direct cost, is the purchase of the materials and goods used to create the physical product a business sells.
For example, consider the direct costs for the company that makes the computer, mobile phone or tablet that you’re reading this blog on. Direct spend for an electronics company would include metal, plastic, screws, processing chips, wires, glass and so on. Essentially, any tangible object is created from purchases categorized as direct spend.
Indirect spend is the purchase of any good or service that isn’t a part of the end product that an organization offers. Instead, the business incurs these expenses to operate the business.
Using the example from above, think about all of the expenses an electronics company has that aren’t part of the products they sell. For instance, marketing software, office furniture, janitorial services and data storage are all considered indirect costs.
To explore more procurement terms, download this A-Z glossary.
Naturally, approaches to direct and indirect spend vary from one business to another. Some businesses, like financial services firms, only have indirect costs because they provide a service but no tangible products. On the other hand, businesses that manufacture goods traditionally want to reduce or eliminate as many indirect costs as possible because they do not generate revenue.
As you can see, the complexities and specifics of managing spend depend entirely on your business. Regardless, it’s important to categorize your costs and understand the differences between direct vs indirect spend.
The nature of supplier relationships is one big difference between direct and indirect spend. With direct spend, vendor relationships are long-term and recurring. In addition, disruptions to these relationships result in lost revenue. Because the goods they provide are mission critical, consistent and ongoing collaboration with direct-spend vendors is essential. Accordingly, procurement teams dedicate a lot of time developing mutually-beneficial relationships with these suppliers.
While building supplier relationships is still important when managing indirect costs, the focus is more on controlling costs and maximizing value. Interaction after an indirect purchase may only occur periodically during vendor performance evaluations.
Because of the products and services provided, vendor performance evaluations must consider direct vs indirect spend. For example, vendors that provide goods essential to product manufacturing will be reviewed by quality, on-time delivery and invoice accuracy. Conversely, procurement measures indirect-spend vendors by metrics like user adoption, efficiency improvement, customer success responsiveness and solution ROI.
Generally, direct procurement needs are well known. Indeed, direct spend is usually predictable and determined by customer demand. Alternatively, indirect spend is a response to a problem, challenge or need. As such, it depends on many internal and external circumstances.
When it comes to technology, there are solutions for managing both direct and indirect spend. For direct spend, procurement teams leverage data from a combination of ERP, P2P and inventory management systems. This type of procurement technology focuses heavily on managing logistics, purchase orders, invoices, accounts payable and so on.
However, indirect purchases are best managed using a system that centralizes the request for proposal (RFP) process. Because indirect spend is often less straightforward than comparing cost per unit, a strategic sourcing approach is helpful. Indeed, RFP management software automates much of the RFP process and makes it easy to score and compare complex RFP responses.
Explore the RFP process in detail with this guide: RFP process ebook.
In most businesses, both types of spend are crucial. Understanding the differences between direct and indirect costs helps to uncover insights and opportunities to optimize overall spend. Ultimately, every procurement team must determine the right balance of control and visibility for both.