Direct vs Indirect Procurement - How are they different?
Procurement makes the world go round – said no one ever. But in a deep way, it really does. Every product or service was essentially made possible by procurement.
Procurement is just a technical way of saying what goods and services a company purchases to produce its end product (you can read more about the differences between Procurement vs Purchasing here). For example, a bakery is an enterprise. The flour and sugar the company buys go into producing cupcakes. In technical terms, we say the bakery procured flour and sugar.
Without a doubt, procurement is not only a core business process but also lies at the heart of supply chain management. Lest you be misconstrued, procurement isn’t as simple. What’s described above is just the crux of it.
In the following sections, we’ll delve into the nitty-gritty details. Procurement can be direct or indirect. We’ll discuss both at length and identify key differences between the two.
Suppose a person owns a bakery that sells cupcakes. What are the different products or services they’ll need to purchase to produce cupcakes? We identified two of them before – flour and sugar. These are items that if the owner doesn’t procure, their bakery will go out of business very soon.
Direct procurement is when an enterprise purchases materials without which the business can’t run. These materials are essential for a business’s core activity.
So, for example, a steel manufacturing plant can’t function without purchasing iron and carbon. It also can’t function without building a blast furnace. Whatever resources the plant buys to make the production process happen is called direct procurement.
Now that we’ve covered that bit, let’s talk a bit about how it all works. Often, an enterprise procures essential materials in large quantities. This helps them get a good discount on a lumpsum basis.
So, a bakery owner might procure, let’s say a month’s worth stock of flour and sugar. The supplier might offer a discount because the bakery is purchasing a large quantity of materials.
Before they finalize the deal, they would probably take biddings from different suppliers in hopes that they get a greater discount from some other supplier? Discounts are always good for business, right?
As a rule of thumb, we suggest that procurement professionals should receive bids from at least three different suppliers and go for the one that offers the best price.
Sure, a company has to have essential material to produce its product but what about the little things that make this possible? Ever wondered where the coffee we have at work comes from?
That was a rhetorical question. Of course, it comes from the supermarket. What we really meant to ask was where does it fit in the production process? Such items fall under the umbrella of indirect procurement.
These products and services are not directly related to a company’s production process but rather facilitate it. So, indirect procurement includes office supplies, decorations, training manuals… you know, the little stuff that keeps your day-to-day business alive.
Let’s consider that bakery again. Does it only need flour and sugar to commercialize its cupcakes? Well… no, in fact, it also needs utilities, kitchen appliances, marketing materials, computers, furniture! There’s a lot that goes on beyond direct purchases that make the production process possible. All of those indirect expenses, are in fact, Indirect purchases. These items support day-to-day production and aren’t directly tied to the company’s earnings.
Differences Between Direct vs Indirect Procurement
A finance and procurement professional must understand the difference between indirect and direct purchases. For the former, it helps with the cost-center analysis and for the latter, it’s what they do for a living!
First off, direct procurement is when a company purchases essential materials (direct spend) without which they can neither produce the end product nor raise any revenue. Meanwhile, indirect procurement is when a company purchases non-essential materials (indirect spend) that support the production process.
Secondly, direct procurement relies on a customer-vendor relationship. What a company purchases essentially is what they’ll offer their customers. In other words, the quality of the flour purchased determines the quality of the cupcakes produced.
On the contrary, indirect procurement does not have anything to do with the customer-vendor relationship. For example, the coffee the bakery staff drinks at work will not determine the quality of the end product – the cupcake.
Thirdly, direct procurement is planned. For example, if the bakery sells an average of 1,000 cupcakes in a month, it’ll procure exactly 1 month’s worth of flour and sugar, based on the sales forecasts.
Meanwhile, it can’t exactly plan in advance how much coffee and other office supplies it would need for the month. So, the bakery will purchase such items on a need-basis. Therefore, indirect procurement is spontaneous spending.
Summing it up
Direct Procurement: When a company buys direct materials essential to its production process and revenue. This is also called direct purchases.
Indirect Procurement: When a company buys indirect materials that are not directly related to the production process but only facilitate it. These are called indirect purchases.
Examples of Direct Procurement
- A bakery buys flour and sugar to produce cupcakes using direct sourcing
- A construction company buys concrete, cement, and subcontracted labor to construct a building
- A steel mill buys raw materials (iron) and equipment (a blast furnace) to produce steel
Direct procurement relies on a customer-vendor relationship – the materials a company procures directly impact their end product.
- If a bakery procures high-quality flour and sugar, it will produce high-quality cupcakes. This is called material sourcing, where the procurement team finds the right balance between the quality of raw materials and the price it can pay
- If a construction company buys poor quality cement, it will build a weak structure and foundation of a building
- If a steel mill does not procure chromium, carbon, and other alloys in the right amounts, it cannot produce stainless steel
An enterprise will buy essential materials according to its budget and will plan it based on demand planning projections.
- A bakery will forecast expected sales this month based on past records. Based on the number of sales, it will procure essential materials like flour and sugar. This could be biweekly or monthly
- A construction company will order concrete and cement for a project based on its project timeline and procurement budget
- A steel mill will order necessary materials like iron, chromium, carbon based on expected project forecasts
Examples of Indirect Procurement
When a company buys indirect materials that are not directly related to the production process but only facilitate it. These are called indirect purchases.
- A bakery buys drinking water for its staff
- A construction company pays rent and utility bills
- A steel mill pays for fuel for transporting raw materials
Indirect procurement does not rely on the customer-vendor relationship – the materials a company procures do not impact the end product.
- A bakery whose staff drink any brand’s coffee daily has nothing to do with the cupcakes’ quality that the bakery produces.
- A construction company’s service quality does not depend on which brand printer it uses
- The quality of steel a steel mill produces doesn’t depend on whether the mill uses Toyota trailers or Mercedes trailers for transport
An enterprise buys essential items like office supplies only on a need basis (spontaneous spending).
- A bakery may not keep a month’s stock of coffee because the item isn’t directly related to the production process. It will order coffee whenever it runs out
- A construction company will not have a concrete plan when and how much office stationery it needs to purchase. It’ll buy the items only when there’s a need for it
- A steel mill won’t have a budget on rent and utilities. It’ll have to pay off its liabilities whenever they are due. Of course, it’s the management’s responsibility to make sure the expenses do not exceed the revenues
P2P process: Making your Life Easier
Both direct and indirect procurement follows the Procure to Pay (P2P) process. What’s P2P one might ask? Simply put, it’s the procurement process in its entirety. Sending inquiries, receiving quotations, finalizing orders, receiving the material, and paying off the invoice.
However, it’s not as simple as it sounds. First, operating teams identify their requirements, generate purchase requests, and get them approved.
Once the purchase request has been approved, Purchase Orders (POs) should be generated, and transmitted either electronically or manually (think email or fax) to suppliers. (Read here more about what is a Purchase Order).
When materials/services are delivered, it’s best practice to record that the items were Received (you don’t want your accounting person to pay an invoice for something that did not arrive!). Having this information properly recorded makes it really simple to then do a 3-way match when you receive the invoice.
If all this sounds stressful, ControlHub is a one-stop integrated procurement solution that tracks every request, PO and payment in the blink of an eye. It simplifies your procurement process so there are no more complicated spreadsheets to manage, endless back-n-forth emails, and needless workplace misunderstandings to resolve. It’s just easy-peasy purchasing workflows.