Direct Procurement vs Indirect Procurement: The 6 Key DifferencesBusiness | July 07, 2022 | By
Procurement process is categorized into Indirect and Direct Procurement. It comprises Request for Purchase (RFP), Request for Quotation (RFQ), Quotation negotiation & selection, Purchase Order (POs) release, Material tracking, Goods Receipt, and Invoice payments.
What is Direct Procurement?
Direct procurement is the sourcing and procurement of goods that go directly into a product. For instance, in an automotive plant the chassis, tires, alloy wheels, seats, instrument cluster, etc., are the direct materials that go into the production of a car. Direct material procurement accounts for about 65-80% of the Cost of Goods Sold (COGS).
What is Indirect Procurement?
Indirect procurement is related to operating processes and maintenance in an organization. For example, purchasing office supplies or printing materials are indirect procurement or spending as they are not directly associated with manufacturing. It is widely categorized as follows: Utilities, Facilities, Marketing, Office supplies, Technology Purchases, Human Resources, Travel, Outsourced Services.
While both are essential to the functioning of the business, it is important to understand the differences between them. So that teams can take necessary action and allocate resources accordingly.
Here are the 6 key differences between Direct and Indirect Material Procurement.
Supplier Relationship Management
Building and maintaining relationships with suppliers takes a lot of time, effort, and energy for direct procurement teams. Production schedules and continuity are directly influenced by raw material availability and quality, which impacts the reputation and credibility of the company. There is usually a long-term collaborative relationship with suppliers here. The chosen supplier should be capable of handling the production volume in proto, pilot, and production orders. Upon completion of the proto and pilot phases, the demand for the parts will increase based on market needs. So to handle such volumes, supplier selection and management will be crucial factors to stabilize production. This process is very cumbersome.
Let us consider a company that is manufacturing SUVs. If any of the components, say a bonnet’s design is new, RFPs are raised and RFQs are sent to potential suppliers. After the cost is negotiated, the production part approval process (PPAP) is performed to ensure that suppliers meet the standards and are capable of manufacturing the desired component for the duration of the production phase. And the same process is repeated for all outsourced components.
In indirect procurement, managing suppliers is simple. The focus in indirect procurement is on spend management rather than supplier collaboration. The supplier relationship is transactional with a key focus on competitive costs.
When it comes to cost management, both direct and indirect procurement are worlds apart. While both teams initially start by preparing a budget, the way it is done is totally different. The direct procurement teams mostly go with “should-cost analysis” which is conducted by the buyer organization to determine the cost incurred by the supplier to develop and deliver the product. Whereas, for indirect procurement the “zero-based costing” method is used. It is calculated/allocated by reviewing the activity or expenditure at the beginning of each budget cycle and not based on the previous spending history. But for some cases like travel and human resources, previous budget history is considered since it is the easier way.
Hence, cost management in direct procurement is much more complex than indirect procurement, since many factors need to be considered.
Let us consider the same bonnet example. The first step in the development process is cost analysis, after which the RFQs are sent to potential suppliers. Then, once the buyers receive the quotes from the suppliers, cost is negotiated considering various factors. For example excess quantities should not be purchased based on prices breaks keeping in mind the inventory carrying costs. The need to find a middle ground between the quantity and cost is crucial here. The same negotiation process happens with multiple suppliers. Finally, one or more suppliers are chosen based on the need. And, if there is an increase in the price of a single component more than the estimated budget, then the impact in cost will create a cascading effect on the whole BOM, thus affecting the project cost.
Managing inventory is a different ball game in direct procurement compared to indirect procurement. Let us take an automotive manufacturer. The company works with four semiconductor suppliers with each of them supplying 50,000 units per month. If the company’s plant has a car manufacturing capacity of 70,000 units per month, the number of semiconductors required will be 70,000 or more depending on the car configuration. So imagine the volume of semiconductors that needs to be stocked. This is just a small component. A typical midsize SUV may contain 2000 to 3000 components in the BOM and every component needs to be stocked on time so that the production line flows seamlessly without any delay.
Taking the same example, the tool management that falls under indirect procurement is straightforward. One, the tools are managed by the suppliers. Two, knowing the tool life, material finish, and the number of components to be delivered to the customer within a specific period is enough in most cases to determine the number of tools and types of machinery needed. However, managing the tool inventory does not enable production directly. So is managing any other item in the indirect procurement.
Impact on the Bottom Line
Having a good control or grip on managing direct procurement has a huge impact on the bottom line. It starts with choosing the right suppliers based on the company strategy (strategic sourcing), cost negotiation, and arriving at the right cost. The next is the availability of the materials at the right time, place, and quality. Items arriving late or any delay, mishaps in the logistics, or damaged components, dent a huge blow to product delivery and thereby sales and profit margins. The next factor is managing the inventory with minimal inventory carrying cost. Any increase in inventory carrying cost will also directly affect the bottom line.
Indirect procurement has an impact on the bottom line too. But not to the extent of direct procurement. Any indirect expenditure once finalized is sanctioned by the management. And changes or increases in the price are either approved or rejected based on the necessity of the requirement which does not directly impact the bottom line.
For indirect procurement, it is a spend management software that gives an uncomplicated buying experience and a set process workflow. When it comes to direct procurement what is needed is a software that’s developed to handle the depth and complexity of the direct procurement process and that is also easy to use. And infact having the right procurement software is only the first step. Thanks to the disruptions of the past couple of years, product manufacturing companies are beginning to realize the need for direct procurement software. However, many direct procurement teams get constrained by unwieldy systems that are feature-rich but have non-intuitive user interfaces linked to their legacy ERP systems. And productivity and compliance are negatively impacted by such cumbersome processes.
Complexity Involved in Direct and Indirect Procurement
Direct procurement is a complex and extensive process compared to indirect material procurement. It requires stakeholders from across the enterprise/company to gather the data for sourcing and procurement. The data usually comes from the design teams who share the BOM after they finalize the design. Once data is available, companies decide whether to manufacture the item/part in-house or use the services of a supplier – Make or Buy decision making. Following the outsourcing of production, the buyers track the progress of the items and coordinate delivery. Each of these processes is repeated and requires competent management and strategy.
Indirect procurement is a simple spend management process that is performed for the efficient running of an enterprise. Unpredictability in the indirect procurement process is manageable and can be negated. While it is possible and easy for many people to relate to Business Spend Management, it is not easy for anyone outside the product manufacturing enterprise to understand the complexities, decision making, and tools involved in direct material procurement.
Use Zumen for Procurement
Understanding the differences between direct and indirect procurement processes helps in strategizing and allocating the resources. It also helps in mitigating the challenges faced during the procurement lifecycle.
Managing direct procurement is no child’s play. Product manufacturing companies need competent and user-intuitive procurement software to handle the breadth and depth of direct material procurement. While it is imperative to spend time and effort managing direct procurement processes, a successful business will also consider its indirect procurement processes and adopt user-friendly procurement software technologies. Zumen’s Source-to-contract software is built to handle the complexities of direct material procurement with a simplified user-intuitive workflow and at the same time handle indirect procurement with ease. To know more about how Zumen does it, schedule a free demo or reach out to [email protected].