What's the difference between direct and indirect procurement?

Effective procurement teams understand how to accurately categorize business expenditures to enhance reporting and improve the ability of leadership to make informed decisions.

One common categorization method is to mark all spending as either direct or indirect procurement.

Most spending falls clearly into one of these two categories, but some costs, like certain software expenses, are a little trickier to define.

Discover the difference between direct and indirect procurement and learn how to categorize software expenditure to drive more effective financial decision-making.

Direct vs. indirect procurement: The principle difference

The main difference between the direct and indirect procurement functions is whether or not the product or services you’re buying go directly into the production of the thing you sell.

If an item goes directly into production, it’s considered direct procurement. If not, then the purchase is regarded as indirect procurement.

Consider a clothing manufacturer.

Examples of purchases that relate directly to the production of the thing they sell (and thus are examples of direct procurement) include:

• Fabrics and materials
• Zippers and buttons
• Water for washing clothing
• Contractor fees for design consultancy

Examples of indirect procurement for the same company are:

• Rent for physical stores
• Ecommerce platform subscriptions
• Office supplies

The clothing manufacturer cannot produce garments without fabrics and buttons, but they can continue to do so even if they run out of paper in the office.

What is direct procurement?

Direct procurement is purchasing products or services (direct materials) that directly relate to the production of the thing your business creates and sells.

Most direct procurement falls into one of four categories:

1. Raw materials (such as the use of timber by a furniture builder)
2. Parts and components (such as the electronics used to build a smartphone)
3. Professional services that directly impact production (such as design consultancy for a property development company)
4. Certain software purchases that relate directly to production (such as Photoshop used by a graphic designer)

Without any of these inputs, the given business would not be able to create and sell its product or service (you can’t build a smartphone without glass for the screen, for instance).

Learn more about the importance of direct procurement in our guide, “What is direct procurement?”.

What is indirect procurement?

Indirect procurement encompasses all other spending—anything that doesn’t go directly into producing goods or services.

However, this distinction doesn't mean that any expenditures categorized as indirect procurement are unimportant.

Some essential examples of indirect procurement include:

• Project management software for internal initiatives
• Outsourced payroll and accounting services
• Office equipment like laptops and desks

Each of these expenses is important to business operations but supplementary to the actual production of goods or services. That’s what classifies these purchases as indirect spending.

Categorizing spending as direct or indirect procurement

The key to distinguishing whether a purchase is direct procurement is understanding whether that purchase is essential to producing your goods or services.

For example, a furniture builder can’t create a wooden table without timber, and a graphic designer can’t make images for their clients without a design tool.

This distinction is generally easier for those manufacturing a physical product, as it’s clear exactly what goes into the product you produce. Categorizing procurement activities as direct or indirect for service-based businesses takes a little more effort, but the principle is still the same.

Consider a marketing agency that builds new websites for small businesses.

No physical components go into making a website, but that doesn’t mean there aren’t elements crucial to its production.

For instance, without a website development platform, that agency couldn’t begin building the new site.

So, for this particular company, the website development platform is considered direct purchasing. However, other companies might categorize this type of spending as indirect procurement.

For instance, a clothing retailer might have an in-house web development team that uses the same software. In this case, the software would not be considered direct procurement, as its use does not relate directly to the production of the company’s clothing.

Direct vs. indirect procurement: Key differences

Accounting and spend management

Understanding whether a given expense is considered direct or indirect procurement helps buying teams implement appropriate spend management policies.

For instance, cost reduction might be your primary goal when sourcing new vendors for indirect procurement categories. When it comes to direct procurement suppliers, you might opt to maximize quality instead.

To narrow your focus, you could split the management of spend categories so that one procurement manager deals only with supply chain management and direct procurement spending, and the other handles indirect spending.

Improve your direct and indirect spend management practices with our guide: 5 steps to effective spend management.

Managing strategic supplier relationships

While strong relationships with all your vendor stakeholders are important, relationships with direct suppliers are most critical.

Remember, direct spending is vital to producing the thing you sell. Consider our previously mentioned clothing manufacturer.

The purchase of fabric to manufacture their garments is direct procurement, making the relationships with the vendor who supplies that fabric vital.

If, for any reason, that relationship should disappear (for instance, if the supplier closes their business), the clothing manufacturer will be unable to produce their items. They will likely have to halt the production process while they re-source the required items.

To help mitigate this risk, implement strategic sourcing and supplier relationship management practices, such as quarterly performance review meetings.

Learn more about the process in our guide: The complete guide to strategic sourcing in your vendor management process.

Monitoring and mitigating vendor risk

Any time you bring a third party on board as a supplier, you’re opening yourself up to potential risk.

The most common examples of vendor risk include:

• Financial risk (for example, if your vendor goes out of business)
• Reputational risk (for example, if your vendor has a PR issue that reflects poorly on your company)
• Security risk (for example, if your vendor has a data breach)
• Operational risk (for example, if your vendor experiences supply chain disruptions and can’t deliver the components you need)

It's particularly important to assess and monitor risk for direct suppliers, as these are the vendors who are most vital to your core business operations.

Suppose one of your vendors has a supply chain issue, which impacts their ability to deliver on a critical component order. You might have to reduce your production volume or arrange to source the components elsewhere, possibly at a higher price.

As such, your regular vendor relationship meetings should also include a conversation around these critical risks.

Learn more about this business process in our guide. Vendor risk management: What to watch for and best practices.

Using Vendr to simplify your procurement

Understanding the difference between direct and indirect procurement is the first step to accurately categorizing spending for thorough analysis and effective decision-making.

To make effective decisions that improve the bottom line, drive compliance with internal purchasing policies, and maximize value from your vendor relationships, you need a simple yet powerful way of categorizing and visualizing company spending.

Vendr is the SaaS buying platform designed to help finance and procurement professionals maximize their software spending ROI. Vendr helps you:

• Monitor vendor purchasing at a glance with intuitive spend analysis reports
• Identify cost savings opportunities with overlapping spend alerts
• Get in front of contract renewals with automated upcoming renewal notifications
• Negotiate better agreements with support from our team of SaaS buying experts
• Improve purchasing compliance by using automation to drive approval workflows

Find out exactly how much you could be saving on your SaaS stack today with our free savings analysis.

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