Direct vs. Indirect Spend: Notable Differences (With Examples)

Direct and indirect spend are both critical elements of your business operations, but there are important differences between them. Understanding these differences will help you improve your company’s performance through better spend management. With the right approaches and tools, you can effectively manage both types of spend and find opportunities for savings.

Definitions & Examples

Direct and indirect spend are broad terms used to categorize spending based on its impact on the company’s bottom line. Each of them requires a different management strategy.

Direct Spend

Direct spend refers to any spending on raw materials or other goods and services used to create a product that’s sold to a customer. It often appears on financial reports as “cost of goods sold” (COGS) and directly affects the bottom line.

Businesses that sell physical products usually have higher direct spend. These expenses are easier to predict and control than indirect spend, but they require more planning, tracking, and management. Examples include:

• Lumber for use in construction
• Microchips for various electronics
• Cotton or wool to create clothing
• Plastics used in toy manufacturing
• Subcontracted design services

Indirect Spend

Indirect spend includes all other expenses that are not directly related to the creation of a product, but are essential to the daily operations of the business. Indirect costs generally support internal operations, and often appear on income statements as “operating expenses.”

These expenses aren’t as easy to predict or control as direct spend, but they require less planning and tracking. Indirect spend could include:

• Rent or lease payments for a warehouse
• Tools and equipment for manufacturing
• SaaS tools for the accounting department
• Travel expenses for sales representatives
• Computers and hardware for employees

Key Differences

There are some essential differences when it comes to managing direct and indirect spend. Each requires a unique approach, tools, and skills.

Organizational Setup

Most companies manage direct spend through a procurement department. This team has expertise in supply chain management, overseeing the purchasing process from end to end. They’re responsible for negotiating and communicating with suppliers, ordering supplies, and tracking shipments.

Indirect spend is not usually centrally managed. There may be a few leaders or department heads with their own budgets and spending policies. When an employee needs a new monitor or a department wants to order pizza for lunch, they submit a request to the appropriate person. Without strict spend management policies in place, this can lead to overspending.

Relationship Management

With direct spend, procurement spends a great deal of time building and maintaining supplier relationships to negotiate pricing, quality of materials, and delivery schedules. The goal is to generate long-lasting relationships built on trust and consistency.

Indirect spend focuses more on cost than relationships. Because this kind of spending doesn’t directly contribute to increased sales, the goal is to minimize negative effects on the bottom line. Supplier relationships aren’t as important here, but it’s still necessary to maintain good relationships with all involved stakeholders.

Inventory Management

If your company sells a physical product, managing your direct spend requires effective inventory management, as you need these supplies and materials to create the product you’re selling to customers. You need to know how much you have of each item to procure the right materials at the right time. Otherwise, inadequate stock will make it impossible to meet demand.

With indirect spend, there’s no product inventory involved. Purchases are generally made as needed, especially for things like office supplies or business travel. Indirect purchases are not usually stocked in the same way as direct purchases.

Performance Tracking

Direct spend performance is based on the company’s success in meeting customer orders on time and in full. KPIs like PO cycle time, PO and invoice accuracy, supplier defect rate, and rate of emergency purchases can be used to assess the performance of the procurement department.

Indirect spend performance is usually measured by cost savings. Budget variances, cost reduction, cost avoidance, total spend under management, and maverick spend ratios can be used to track performance related to indirect spend.

Use of Technology

Because planning, tracking, and managing direct spend requires immense effort, many companies are turning to automation to optimize the procurement process. Using procurement systems that integrate with the company’s ERP system can streamline the process even further by automatically notifying users when supplies are needed.

When it comes to indirect spend, automated solutions can also simplify and centralize the procurement process.

Common Challenges of Direct vs. Indirect Spend Management

Along with the differences mentioned above, there are unique challenges involved with managing direct and indirect spend. Of course there’s also some overlap between them, but in order to manage both effectively, you have to be aware of these differences.

Main Challenges of Direct Spend

• Industry-Specific Variables: When it comes to direct spend, each industry will have its own specific challenges to overcome; there’s no one-size-fits-all approach to management.
• Business Silos: When the human resources within a business are separated, it can create a lack of transparency. Procurement processes rely on several variables, and in order to manage them all, information has to be freely shared throughout the company.
• Suppliers and Trading Partners: Another challenge is managing the external suppliers and trading partners involved in procurement. In addition to differences in payment and cost management, each outside source will have its own set of issues at any given time. If not managed properly, these issues can have a domino effect across the supply chain.
• Financial Obligations: In order to keep things moving, the supply chain has to be well funded. The company must have enough capital on hand to make necessary purchases.
• Inventory Management: It’s essential to carefully track your inventory so that you always know exactly what you have and what you need. This helps to avoid both overstocking and understocking, which can be equally detrimental.

Main Challenges of Indirect Spend

• Lack of Visibility and Accuracy: Managing indirect spend that’s fragmented throughout your organization can lead to blind spots and inaccurate data.
• Weak Policy Adoption: Few will actually follow spending policies if there’s not enough support, training, or enforcement to encourage their adoption.
• Misalignment With Business Categories: If spend is miscategorized, the data won’t be useful to anyone.
• Lots of Vendors, Suppliers, or Stakeholders: Too many hands in the pot can lead to overspending and missed savings opportunities, especially when it comes to one-off purchases.
• Maverick Spending: Transactions made without regard to the company’s purchasing policies—like purchases from unauthorized vendors—increase risk and negatively impact your budget.

How to Improve Your Direct and Indirect Spend Management

Recognizing the differences between direct and indirect spend management is the first step toward addressing their unique challenges and improving the way you handle each. Here are some simple steps to help you optimize both types of spend management.

Improving Direct Spend Management

• Change Supply Chain Behavior: Implement a system that allows for regular and consistent negotiation of prices. Planning for this helps to ensure that the best quality and cost options aren’t sacrificed in favor of time.
• Fix Inefficient Procurement Processes: Eliminate problems that are causing inefficiency. This means creating systems that facilitate information sharing between teams, as well as revamping tracking systems to ensure accuracy.
• Focus on Long-Term Planning: Make sure you’re always looking toward the future. This will help you to secure capital before it’s needed and take advantage of discounts whenever possible.
• Recognize the Value of Procurement: Although some of these changes may seem tedious or appear to offer little benefit for front-end costs, improving the efficiency of procurement systems will pay off in the long run.

Improving Indirect Spend Management

• Focus on Transparency and Visibility: Indirect costs can be hard to grasp, but making sure they’re seen and understood can go a long way. You should be consistently reviewing these costs in detail.
• Develop a Strategic Plan: Create a plan for cost reduction, including specific KPIs and measurable goals to mark progress toward your overall objective.
• Refine Spend Categories: Take a close look at your spend categories and adjust them as needed. Are they coherent and aligned with your overall plan and goals? If not, don’t be afraid to change them.
• Invest in Automated Solutions: Once processes are in place to help you meet your objectives, invest in automation. It will help you stay on track, reduce the likelihood of errors, and avoid wasting time and energy on manual processes.

It’s Time to Optimize Direct and Indirect Spend

Now that you’re familiar with the key distinctions between direct and indirect spend, you can take on the challenges of managing them. Now is the time to start streamlining how you plan and track your company’s spend. Proper management of your direct and indirect spend will not only optimize efficiency, but also have a direct impact on your company’s bottom line.

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Mesh Content Team