What is Indirect Spend?
By Hugo Britt | September 8, 2020
To understand the difference between direct and indirect spend, let’s take the example of a toy manufacturer.
This particular toy company has built a reputation for producing the best teddy bears in the United States. They’re cute, they’re cuddly, and they’ve delighted thousands of children for the past decade.
The company depends on its well-established and efficient supply chain to procure wool and cotton fabric, silk ribbons for the bears’ bows, buttons for the bears’ noses and eyes, rattles, stuffing, fabric dyes, voice boxes, and yarn.
These components are categorized as direct spend, which means they are required to produce the company’s end-product – a teddy bear.
But these are by no means the only things that the company spends its money on.
The company’s indirect spend includes renting and operating its main office in New York, warehousing space across 12 states, the freight broker who fulfills all of the company’s shipping and transportation needs, and employee travel expenses when visiting factories in Mexico and China.
While these expenses don’t directly contribute to making the company’s final product, they are fundamental in keeping the day-to-day business alive.
In the past year, the company in this example has also invested in streamlining and fine-tuning their indirect spend. As a result, the organization has reduced its overall spend, consolidated its suppliers, and significantly increased supply-chain efficiency.
What is the difference between direct and indirect spend?
Direct materials are the things that go into the products (or services) a company creates, like the stuffing for the teddy bears in the example above. As such, direct spend is carefully controlled and inventory levels are closely monitored by procurement professionals to keep costs down while ensuring business continuity.
Accounting for 15% to 30% of an organization’s total expenses, indirect spend (sometimes referred to as Non-Production Procurement or MRO) describes the purchase of goods and services that do not become part of an organization’s final product or service.
This could be anything that contributes to the organization’s day-to-day operations and might include:
- Utilities, including gas, electric, and water
- Fulfillment centers, warehousing, or office space
- Office supplies such as laptops, computers, printers, desks, and stationery
- Marketing costs such as PR and creative agencies
- Outsourced services such as 3PLs, freight brokers, consultants, IT support, office security, and delivery drivers
- Legal and Human Resources
- Manufacturing expenses such as maintenance costs
- Employee training sessions
- IT software and support services
- Travel expenses including meeting with suppliers overseas
Historically, procurement teams have failed to give their indirect spend categories (and tail spend) sufficient attention, directing most of their time and expertise towards the optimization of direct procurement. However, it’s becoming increasingly clear that effective indirect procurement strategies can have a significant impact on an organization’s bottom line as it represents an ever-growing portion of its overall spend.
Four key challenges of indirect spend
Managers of indirect spend typically have to contend with the following four challenges.
1. Supplier Relationship Management
An organization’s indirect spend strategy is frequently limited to driving down costs. This means procurement professionals invest less time nurturing relationships with their indirect suppliers, negotiating favorable contractual terms, or developing a preferred supplier program.
This puts supply chains in a vulnerable position. The increased frequency of disruptive events mean it’s more important than ever to focus on SRM, even with indirect suppliers.
2. Sporadic purchasing
Indirect spend encompasses a vast and diverse range of materials and services that are procured through several channels and multiple locations across the business. Many purchases are one-off, with a supplier who will never be engaged with again.
Under these circumstances, it’s all the more challenging and complex to anticipate or predict spending needs and therefore monitor and identify opportunities for cost-saving.
3. Maverick spend
Spend mavericks drive up costs, damage supplier relationships, and increase risk for the organization by purchasing outside of approved channels. For example, the procurement team may have negotiated a discount with a hotel chain (Business Travel is almost always an indirect category), but a maverick might choose to use their favorite travel booking website instead.
Not only does this mean their purchase will not take advantage of any bulk discounts, but the supplier will not get as many bookings as promised in the contract. Additionally, the company will have no visibility of the quality (and safety) of the accommodation booked.
Indirect procurement is often considered less important than direct procurement, which results in a lack of funding and a lack of awareness across the organization.
According to Spend Matters, CFOs typically underestimate indirect expenditures, which means organizations allocate fewer resources and less investment to indirect procurement. This gap makes it more difficult for procurement to address challenges in this area.
In order for procurement to deliver on goals like driving supply chain efficiency, satisfying stakeholder expectations – and keeping the cost of teddy bears as low as possible – it’s crucial to optimize and streamline all spend.
Stay tuned for part 2 of this article for details on strategies for managing indirect spend. If you’re ready to take a closer look at your own indirect spend, Una can help. Contact us today.