In many businesses, the differences between direct spending and indirect spending are subtle. In either case, the name of the game is simply to keep spending as low as possible, bolstering the company’s profit as a result.
But manufacturers, distributors, and direct-to-consumer retailers know better than anyone how different these two types of spending can be.
In the simplest terms, direct spend and indirect spend are both considered procurement functions, with direct spend focusing on materials that will eventually be sold to customers and indirect spend focusing on expenses like office supplies or rent that keep the business running behind the scenes.
Yet, knowing the differences between these two goes beyond simply classifying them correctly in your business’ financial statements. It also allows you to improve your business’ performance, whether you work in supply chain management, finance, procurement, or the executive team.
What Is Direct Spend, or Direct Procurement?
Direct procurement refers to the money that goes into the raw materials and goods used to create a product. Those familiar with the income statement will recognize this as part of cost of goods sold, or COGS.
As an example, consider a company that builds bikes. In order to make a bike, they’ll need to purchase metal frames, tires, brakes, and (who could forget?) bells to go on the handle bars. Without these parts, a sale can’t happen. They’re directly responsible for the company’s revenue.
Similarly, a beauty brand may source tubes of lipstick from one supplier and mascara from another, both of which would be considered direct costs.
No matter which stage of the supply chain your business lies in, any costs that are directly tied to future sales are considered direct spending.
What Is Indirect Spend, or Indirect Procurement?
Indirect procurement refers simply to money that’s spent on most everything else. If it doesn’t have a direct link to revenue, it’s indirect. On the income statement, these would typically fall under operating expenses.
The bike manufacturer, for example, might have some indirect costs for things like coffee in the break room, computer monitors for new employees, and travel. They’re important in helping the company drive revenue, but it’s impossible to trace a dollar spent on a new monitor to a dollar earned on a sale. For that reason, it’s classified as indirect.
Direct vs. Indirect Spend
So they’re two different kinds of spending. What’s the big deal, right?
The biggest difference between these two types of spending is how they are managed. With indirect procurement, the name of the game is cost savings. With direct procurement, on the other hand, it’s supplier management and change management.
Let’s start by looking at where each of these costs originate.
1. ERP vs. Employee-Driven Spend
Manufacturers, distributors, and retail brands rely heavily on the help of an ERP, or enterprise resource planning system, to analyze demand for their products and place orders for the appropriate amount of direct materials to fulfill them.
Once the ERP recognizes the need for a purchase to be made, a buyer will typically step in to manage the purchase order process, communicating with key suppliers and ensuring those parts arrive on time. What makes this so challenging is the back-and-forth negotiations with suppliers. SourceDay has found that 40% of PO lines will change on average, meaning either the ship date, quantity, price—or some combination of the three—will shift between the time an order is placed and when it’s received. This makes keeping track of orders and managing all that change a real challenge for direct procurement teams.
Procurement professionals focused on indirect spend, on the other hand, mostly oversee employee-driven spend. If an employee’s headset breaks, they can request a new one. If a team member needs to travel to visit a customer, they’ll need to book a flight and hotel. These are all indirect expenses that can get wildly out of hand if a company doesn’t have strict policies in place to guard against overspending.
In other words, where the spend originates has a big impact on how it’s managed.
2. Supplier Relationship Management
As we mentioned above, direct spending focuses more on managing supplier relationships. But what does that look like? And why is it so important?
In many businesses, supplier communication runs through channels like email and phone calls and changes are tracked in spreadsheets and PDFs. While a large number have made the switch to modern software solutions, the pressure placed on buyers to properly manage these relationships remains.
If parts arrive late, these companies might have to stop production lines, pay their customers late fees, or pay extra to expedite the late parts. Worst of all, they might break the trust of their customers. To help maintain accountability, buyers will often specialize in certain areas of direct spending, becoming category managers.
Indirect procurement teams, on the other hand, primarily manage internal stakeholders, though they may cultivate closer relationships with some vendors.
Procurement professionals at large corporations may look out for savings opportunities through strategic sourcing partnerships. If all computer monitors were purchased from one company, for example, they might get a discount and be able to cut some costs.
3. Spend Management
Spend management is all about the impact to the bottom line, and both direct and indirect spending play an important role here. The less a business spends, the more revenue they retain and the higher profit they report.
Indirect spending focuses heavily on spend management because it can be a source of waste within an organization. Keeping spend under control is, by and large, the only way they can impact the bottom line.
But while indirect spending really only impacts profit, direct spend can also have huge impacts on the top line, or a company’s ability to generate and recognize revenue. Put simply, when materials are late, companies can’t ship their products. And if they can’t ship those products, they can’t bill their customers and recognize that revenue. The longer inventory sits there, the higher the risk that customers cancel orders or demand changes.
At the same time, late orders or incorrect orders put important customer relationships (and the consistent revenue they provide) in jeopardy.
So while indirect spending can boost the bottom line, direct spending can impact both the top and bottom line.
4. Measuring Performance
Because the processes for these procurement activities are so different, the way their success is measured is also different.
Indirect procurement is most commonly measured by cost savings.
Direct procurement, meanwhile, is judged, first and foremost, by their ability to meet customer orders on time and in full. Laddering up to this KPI are several other important metrics, like work-in-process (WIP) inventory, production line capacities, and more. In this world, inventory management is equally as important as spend management because unused inventory incurs carrying costs, takes up space in a warehouse, and ties up cash flow.
With direct spending, success comes down to having the right materials in the building at the right time so that operations don’t have to skip a beat.
5. Business Impact
In many industries, direct and indirect spending may have roughly the same impact on a business’ success. However, in industries like manufacturing, distribution, and straight-to-consumer retail, businesses revolve around direct spend and its financial impact far outweighs that of indirect spending.
For example, Napoleon, an outdoor grills manufacturer, shared with us that millions of dollars were on the line when the COVID-19 pandemic struck. If they weren’t able to make real-time adjustments to their direct materials purchases, the impact could have been massive.
6. Technology & Software Solutions
In manufacturing, distribution, and retail, reliance on an ERP system to help with demand planning and the sheer amount of change they have to manage means that an out-of-the-box “procurement software” likely won’t meet their needs.
In most cases, e-procurement solutions or procurement software is tailored to industries with a bigger emphasis on indirect spend than direct spend. These solutions often aggregate approved vendors in one location and allow users to log in and purchase what they need to. Administrators can also set strict limits and rules about what employees can (and cannot) purchase.
Those product companies with large direct spend needs have long relied on spreadsheets and email to communicate with suppliers because a software tailored to their specific needs was hard to come by. Of course, this is what SourceDay set out to change.
As we built a solution with these companies in mind, we knew that any technology seeking to replace email and spreadsheets had to connect directly to the ERP and that it had to be easy for suppliers to adopt. It also had to make it easy for these companies to put a spotlight on change, highlighting where suppliers couldn’t meet ship dates or quantity requirements and relying on automation for business-as-usual transactions.
The Bottom Line
While there are several differences between direct vs. indirect spend, the key point to take away is that some industries (namely manufacturing, distribution, and direct-to-consumer retail) care a whole lot more about direct spend, and their procurement strategies dictate that the two cannot be treated the same. In other industries, the shades of difference may be more subtle and a one-size-fits-all solution may be just right.
To learn more about how SourceDay can help your business manage direct spend, talk with a member of our team today!