Why is the difference between direct and indirect procurement important?

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EmanAbouzeid.jpgThe distinction between direct and indirect procurement was traditionally made in the context of manufacturing businesses. However, procurement disciplines have evolved more widely into the non-manufacturing sector and, accordingly, the distinction between direct and indirect procurement has broadened.

In this month's SmartProcurement, Eman Abouzeid (CSCP, CIPS), a procurement and supply chain professional with global experience, explores some of the supply chain practicalities that arise from the distinction between direct and indirect procurement.

The theory...

Direct procurement refers to a range of situations in which the items procured are either for resale (e.g. goods purchased by retailers) or for incorporation into goods for sale (e.g. raw materials and components purchased by manufacturers).

Indirect procurement refers to the purchase of any other, ancillary items, including maintenance, repair and operations (MRO) supplies, services and other operating expenses.

...and what it practically means

1. Quality perspective
The quality of direct procurement directly affects the quality of produced goods: poor quality will lead to increased quality costs, increased waste, scrap and rejects, and, possibly, reduced customer satisfaction.

By contrast, the quality of indirect procurement does not, generally, impact on the production process.

2. Stock and inventory perspective
Direct procurement frequently needs to be held in stock in order to maintain service levels. This ensures that there is no disruption to production operations or availability for resale.

By contrast, indirect procurement purchases are, usually, made as and when required, minimising the amount of stock held along with its associated costs.

3. Supplier relationship perspective
Direct procurement is more likely to be made via longer-term and more collaborative supplier relationships, since the priority will be the security and continuity of supply.

By contrast, indirect procurement frequently occurs on the basis of once-off, transactional relationships in order to take advantage of price competition, since the priority will be cost efficiency.

4. Functional perspective
Direct procurement is more likely to be performed by the procurement and supply chain function, because of its 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 procurement is more likely to be performed 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 procurement is included in an organisation's 'cost of goods sold': if this cost can be reduced, the company's gross profit (and, as a consequence, net profit) will increase.

By contrast, the cost of indirect procurement is included in an organisation's 'overheads' or 'indirect costs': if these can be reduced, net profit will increase, but there will not be any effect on gross profit.

6. Cost proportion of total spend
In many organisations, especially in the case of manufacturers, the cost of direct procurement is a very high proportion of total external spend. Therefore, opportunities for the procurement and supply chain function to improve the bottom-line profit of an 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 procurement, this would translate into a 1.2% increase in gross and net profit.

The same organisation might, typically, spend 10% of its revenue on indirect procurement, however, the opportunity to improve bottom-line profit is only one-sixth (10% vs. 60%) of what it is in the case of direct purchases.

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