Procurement can be divided into two separate disciplines: direct and indirect procurement
Indirect procurement refers to a disciplined process to buy services and products used in all company operations that are not directly incorporated into an end product. Indirect procurement is measured by how much money is used to acquire these products and services and that monetary quantity is referred to as indirect spend.
Direct procurement is a practice to source raw materials and goods for production. They are used to build, refine and/or manufacture end products of which are sold to customers. These purchases are made using ERP to place purchase orders and all materials have been coded with an item code. It’s possible to track and trace materials back to the supplier and in some cases even further to 2nd tier suppliers. Orders are followed and deliveries tracked to ensure a continuous production process. Supplier performance can be measured in multiple different ways, including ie. such as on-time delivery (OTD) or quality conformance.
Indirect spend is often categorized into multiple subcategories and is divided between multiple suppliers. In fact, indirect spend includes typically a much higher amount of suppliers than direct spend, it’s very distorted and the number of invoices is high. The monetary value of single order can be low making transactional costs significant.
Some indirect subcategories are mandatory and that justifies the claim, that all companies are practicing indirect procurement. However, not all distinguish it as a separate function or operation. Products and services bought under indirect spend are not incorporated into the end product, but they’re essential for companies to operate effectively and develop their processes in manufacturing as well as in support functions.
Indirect spend usually ranges from about 15% of the company’s total revenue up to 30% or more. The total indirect spend depends a lot on the line of the business the company operates in. Service or software companies usually have much higher indirect spend covering almost all procurement activities in the company, while manufacturing companies land somewhere in the range shown above. It occasionally also differs which categories are considered as indirect and which direct.
A typical way to start evaluating the size of indirect spend is to derive data from the ERP system and perform spend analysis. At this stage it’s very essential to include all company spend in the data, otherwise, exclusions are already taking place before the work has even begun.
Extensive spend analysis builds the baseline for any further steps on indirect spend. Results can be used for gaining quick wins through opportunity assessment, supplier base evaluation, and building procurement strategies.
Spend data collected from invoices and ERP systems are generally relatively difficult to get or at least it calls for a significant amount of manual work. And finally, when you have the data, you’ll notice that the level of details is not sufficient enough to define correct measures for proper spend management or deriving conclusions for procurement strategy. The reason for this is the lack of a transactional level. Orders are placed via e-mails and phone calls and they leave no trace in the system. Supplier quality, on-time delivery, and order process efficiency remain unknown.
Quality, long-term efficiency, and securing material supply in direct categories tend to lead to longer-term collaborative relationships with the suppliers. Indirect procurement is traditionally more focused on spend itself and finding cost reduction opportunities. Some general leverages to be used here are control of use, consolidating or dividing spend – depending on the supply market, or utilizing competition through the tender process.
Modern value-based procurement discipline, however, is aiming to bring balance between cost and benefits into indirect procurement. It means, that the overall value received through the indirect procurement process is the benefit received from the products or services divided by their cost of purchase.