Some businesses focus a significant amount of effort maximising their direct purchasing, while indirect can often be overlooked. But what is direct and indirect procurement and what are the differences between the two?
A manufacturing business generates a constant requirement for production materials. These may take various forms: raw materials, parts and components, subassemblies and so on. Without adequate supplies of these materials when they are needed, production operations may be disrupted with expensive consequences. The procurement of such items – direct inputs to the production process – is often referred to as “Direct Procurement”.
Manufacturing businesses also require consumable supplies, sometimes referred to as maintenance, repair and operating (MRO) supplies, and all businesses spend money on general ‘running expenses’: travel, stationary, telecommunications and so on. The procurement of such items – indirectly supporting the production process – is often referred to as “Indirect Procurement”.
In the procurement literature, this distinction is often made in the context of manufacturing businesses merely. However, procurement disciplines have been developed more widely in the non-manufacturing sector, and accordingly the distinction between direct and indirect procurement has broadened to be:
Direct Procurement: refers to a range of situations when the items procured are either for resale (e.g. the goods purchased by a retailer), or for incorporation in goods for sale (e.g. raw materials and components purchased by a manufacturer).
Indirect Procurement: refers to the purchase of any other, ancillary items (including MRO supplies, services, and other operating expenses).
What difference does the distinction between direct and indirect procurement make?
A number of practical implications arise from the distinction between direct and indirect procurement:
1. “Quality Perspective”:
The quality of direct procurements has a direct impact on the quality of goods produced: as poor quality will lead to increased quality costs, increased waste, scrap and rejects, and possibly reduced customer satisfaction.
By contrast, the quality of indirect procurements does not generally impact on the production process.
2. “Stock / Inventory Perspective”:
Direct procurements frequently need to be held in stock, in order to maintain service levels: to ensure that there is no disruption to production operations or availability for re-sale.
By contrast, indirect procurements are usually made as and when required, minimising the amount of stock held, with its associated costs.
3. “Supplier Relationship Perspective”:
Direct procurements are more likely to be made via longer-term, more collaborative supplier relationships, since the priority will be the security and continuity of supply.
By contrast, indirect procurements are frequently made on the basis of one-off, transactional relationships, in order to take advantage of price competition, since the priority will be cost efficiency.
4. “Functional Perspective”:
Direct procurements are more likely to be carried out by the procurement and supply chain function, because of their specialised nature, the need for complex contract and supplier management, and the potential impact of supply disruptions or quality problems on production operations.
By contrast, indirect procurements are more likely to be carried out by end users, as they represent relatively straightforward ‘re-buys’ of standard supplies, often supported by approved supplier lists or framework agreements for supply (against which orders can be ‘called off’ as required).
5. “Accounting Perspective”:
The cost of direct procurements is included in the organisation’s ‘cost of goods sold’: if this cost can be reduced, the company’s gross profit (and as a consequence, net profit) will be improved.
By contrast, the cost of indirect procurements is included in the organisation’s ‘overheads’ or ‘indirect costs’: if these can be reduced, net profit will be improved, but there will not be any effect on gross profit.
6. “Cost Proportion of Total Spend”:
In many organisations, especially manufacturers, the cost of direct procurement is a very high proportion of total external spends. Therefore, opportunities for the procurement and supply chain function to improve the bottom-line profit of the organisation are much greater.
For example, if a manufacturing company’s cost of sales is 60% of its sales revenue (i.e. it makes a gross profit of 40%), and 2% can be trimmed from the cost of direct procurements, this translates into a 1.2% increase in gross and net profit.
The same organisation might typically spend 10% of its revenue on indirect procurements; however, the opportunity to improve bottom-line profit is only “one-sixth” of what it is in the case of direct purchases.
Direct procurement refers to the procurement of inputs and consumables for the primary revenue-earning activities of the enterprise.
Indirect procurement refers to the procurement of inputs and consumables for the support activities.
I hope this has been of interest to you and furnished you with some knowledge to consider.
References: CIPS Studies, Purchasing and Supply Chain Management (Lysons & Farrington)
ABOUT THE Guest Author:
Eman is a global procurement & supply chain professional and former Procurement and Sourcing manager at the British Council. With over 14 years of extensive experience in global procurement and supply chain operations.