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 more effectively manage both types of spend, and uncover opportunities for cost savings.

Here’s what you need to know.

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.” They’re not as easy to predict or control, but they require less planning and tracking than direct spend. 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’ll 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 these supplies and materials are used 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 produce enough goods to meet projected demand.

With indirect spend, there’s no product inventory involved. Purchases are generally made on demand, 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, both 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 simplify and centralize the procurement process.

Optimize Direct & 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 and start streamlining how you plan and track your company’s spend. Proper management of your direct and indirect spend helps not only optimize your business’s efficiency but also has a direct impact on your bottom line.

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