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What is indirect spend? What are indirect spend items? August 6, 2010

Posted by HubTechInsider in Supply Chain Management.
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Since I started working at eSpendwise in Boxborough, many of my peers and people I meet at networking and technology business events in the Boston area ask me about what eSpendwise does.

I reply that eSpendwise provides SaaS (Software-as-a-Service) solutions to large enterprises (I reveal many of the different clients I have worked with over the course of my career to develop comprehensive indirect spend management solutions for at the bottom of this article, my Dear Reader) for indirect spend management and eProcurement.

Of course, my knowledge of indirect spend management and supply chain management predates my employment at eSpendwise.  In the 1990’s, I worked at Gulf States Paper Corporation, the second largest paper company in the United States. The company’s founder, Herbert Westervelt, entered the paper industry in 1884, founding the Westervelt Company, which later became the Prarie States Paper Company, then Gulf States Paper Corporation. Herbert Westervelt was the inventor of the machine that made possible the efficient production of the foldable paper grocery bag that every single person reading this article is familiar with, called the E-Z Opener grocery bag, open-able by the flick of a wrist.

My job at Gulf States was as an ecommerce advisor to Jack Warner, Herbert Westervelt’s grandson. Jack Warner’s mother, Mildred Westervelt Warner, served as the president of Gulf States Paper and was Herbert Westervelt’s daughter. This was very early in my career, and if you have ever been to the North River Yacht Club in Tuscaloosa (actually Northport), Alabama, you can understand why I was so impressed with the business end of indirect spend management and manufacturers of these materials. North River Yacht Club was the Disneyesque country club for the paper company’s executives, with one of the most extensive fine art collections in the entire country, including primitive artifacts from Africa and the South Pacific; Oriental art; and works by Georgia O’Keeffe, Mary Cassatt and James Whistler. The actual paper company HQ was styled in oriental fashion,  and the company’s sprawling Japanese gardens have captivated many a visitor. Jack Warner was a famous patron of the arts, and I spent many days and nights speaking with him and listening in as discussions and business debates with paper company executives raged over the future of the paper products industry, their Fortune 100 clients, and the role the Internet could play in making the distribution of the company’s products and services more efficient.

Paper companies are some of the prime players in indirect spend management, as they are the manufacturers of the types of materials and items that constitute corporate  indirect expenditures. My time at Gulf States Paper Corporation was my introduction to the world of Indirect Spend management.

OK, Dear Reader, I know you’re growing impatient with my reminiscences, and you are probably ready for me to cut to the chase: “What is indirect spend? What is indirect spend management, and why is it important for companies to worry about indirect spend items? What are indirect spend items?”

Direct vs. Indirect Spend

Direct spend refers to purchases of goods and services that are directly incorporated into a product being manufactured. Examples include raw materials, subcontracted manufacturing services, components, hardware, etc.

Indirect spend refers to purchases of goods and services that are not directly incorporated into a product being manufactured. Examples include computers, safety goggles, printed forms, office supplies, janitorial services, equipment, furniture, bags and packaging, wrapping supplies, store fixtures, receipt and point of sale supplies, floor cleaning products, building service and facilities maintenance supplies, etc.

Indirect spend includes all of the supplies that are necessary to run your organisation such as electricity, computers, furniture, capital expenditure, works and so on. The majority of indirect spend is common across all businesses but for some enterprises indirect spend expenditures can form a greater proportion of total expenditure than direct spend.  Internal services like catering, facilities management, legal or IT are often outsourced which has made the indirect spend budgets and indirect spend outlay of many organisations even larger. The breadth of enterprise indirect spend for many companies in diverse industries can be enormous, running the gamut from travel to staplers, and this often leads to corporate purchase ledgers with hundreds if not thousands of suppliers, dozens of which are frequnetly serving the same category of enterprise indirect spend requirement or capital expenditure.

Are shipping costs considered Indirect Spend?

This is a question that has been posed to me in several emails and conversations at Massachusetts technology networking events, usually just after I run through some of the above definitions for my questioner.

In general, shipping costs associated with Direct Spend items and finished goods are also considered Direct Spend, because they can be directly attributed to the costs of goods sold. However, freight costs for Indirect Spend items (supplies, consumables, etc.) would normally be treated as Indirect Spend items.

In terms of freight and budgeting in large enterprises, I think a few other points are vital to understand:

  • Freight almost always has its own GL (General Ledger) code in corporate budgeting and accounting systems.

  • Freight for Indirect Spend items is captured in corporate accounting systems differently than freight for Direct Spend items.

Direct vs. Indirect Procurement

With the above information in mind, would procurement of items used in the delivery of a service constitute direct procurement? For example, corrugated boxes used for offsite document storage services…

Well, the answer is that If the boxes are specifically billed to the customer then, yes, it would be direct procurement. For example, if the customer gets billed for 500 boxes at $2 each, then it would be direct procurement.

If the boxes are simply factored into the overhead percentage that gets added to the direct cost, then I would consider the boxes to be indirect procurement.

Which categories you use depends on your own company needs. Many companies start with the UNSPSC. Some companies have their own internal set of codes or GL (General Ledger) or Oracle Financials “Cost Center” codes that they use as their internal indirect spend categories.

Indirect Spending in Retail Enterprises: GNFR, or Goods Not For Resale

In a retail company that sells rather than manufactures goods, what would the direct spend be?

The terms “direct spend” and “indirect spend” were at first commonly used in manufacturing enterprises, however retail enterprises, mail order companies, luxury retailers as well as ‘big box’ national retail chains all use indirect spend items in very heavy usage patterns. “Direct spend” may refer to what is spent on the actual items being resold. On retail company’s income statements, this is reflected in the “cost of goods sold.”, or COGS. Indirect spend, in the retail world as it is in manufacturing environments, refers to the spending on goods and services that are not sold, but rather purchased to support the operations of the company. Retail enterprises refer to this as “Goods Not For Resale”, or GNFR.

For retail enterprises, this can include store fixtures, bags and packaging, wrapping paper, cards, signage, catalogs, flyers and other point of sale and in-store marketing, fulfillment supplies, shipping supplies, point of sale recipt printer paper and price gun tape, point of sale and checkout equipment and other consumables, store lighting, mops, brushes, and cleaning supplies, and more.

The range and breadth of items that a typical retail or mail order enterprise will use to support their direct sales and product merchandising and sourcing operations, as well as their global fulfillment and shipping operations, is truly vast and can extend into product catalogs of indirect spend items in the tens of thousands of products.

Indirect Spend Management Challenges

Organizations face a number of issues while dealing with their indirect spend management. Procurement teams in most product-based companies have traditionally focused on reducing their direct spend, and therefore lack the experience and the art of indirect spend management. Further, indirect spend management is spread across a broad spectrum of commodities, thereby increasing the supplier base and the supply chain management complexities.

Different companies face different challenges while dealing with indirect spend management. Requirements for certain indirect spend management categories such as office supplies may be similar across companies; however, they may vary drastically for other categories such as transportation and utilities.

More importantly, what makes indirect spend management difficult is that most companies lack the leverage in negotiations with their vendors due to low volumes and thus, lose out on discounts. In most companies, low volumes may also lead to non-contractual spending (known in the spend management industry as “Maverick spend”) in certain product categories. In order to deal with all these challenges, companies need assistance and customized software from expert software provider partners whom specialize in indirect spend management solutions for enterprises of each of these varied industries.

In the current economic downturn, it is important for companies to control indirect spend management for efficiency. For companies in the services and supplies sector, it is even more critical, since optimizing their indirect spend may significantly affect their bottom lines.

The right software tools that are specialized to address and mitigate the challenges associated with enterprise indirect spend management can conduct in-depth analyses of an organization’s existing indirect spend processes (some enterprises may lack even a basic eProcurement solution for indirect spend), identify potential saving areas, patterns in requirement of indirect commodities, and shortcomings in the existing process. In addition, vendors of such software can work closely with client enterprises to help their clients create channels for bulk buying and negotiate discounts which would otherwise not be offered to these organizations. Using their software as a tool, they can then equip their companies with the leverage of volume. Further, they can help establish and standardize the purchasing process. This helps remove irregularities from the buying process, reduce overall cycle times, and help corporate controllers and finance, purchasing departments keep a check on the non-contractual spend.

The five major differences between direct and indirect procurement

Although it has been true that in many industries, until the relatively recent past, indirect procurement has been a low priority for organizations compared to direct procurement, this is beginning to change in nearly all industries, and for companies of every size and description.

There are five major differences between indirect and direct procurement that enterprise purchasing managers, controllers, and C-level corporate managers all need to be aware of:

1. Creating Business Advantage: Direct procurement’s job is to source and manage suppliers who can support the business’ need for supply chain integration; these considerations usually don’t trouble people working in indirect sourcing.

2. Preferred Suppliers: In indirect sourcing, increasing your company’s use of a preferred supplier is critical to success. In the direct environment, very few (if anyone) on the manufacturing line will buy a component from a non-preferred supplier, while for many indirect categories everybody can use who they want.

3. Number of Stakeholders: In direct procurement, you are usually working with relatively few stakeholders (design engineers, quality managers, production specialists) who are located in a few centers of activity. The opposite is the case for the business stakeholders who influence indirect expenditure.

4. Buyer-Seller Power Relationships: Big companies can build a position of significant power over many key direct suppliers. On the other hand, almost by definition, indirect suppliers are not restricted as to which industries they can supply, so it is only on rare occasions that a company can use its volume buying power to attain a dominant position over an indirect supplier.

5. Measuring Savings: In the direct world, the focus is on cost of goods reduction. Every product has a bill of materials, and in most big companies, this is held within an ERP system. If procurement reduces the price of something, the impact on profit and loss is clear. With indirect, however, each saving made by procurement is open to questions: How much will we buy in the future? What level of compliance should we assume?

Types of Indirect Spend Categories

Indirect spend has been less discussed in the academic literature than direct revenue-generating expenditure. Before discussing the current literature in this area, it is important to define what is meant by indirect spend, commonly termed MRO (maintenance, repair and operational expenditure). Indirect spend refers to the following types of spend:

1. Electrical and mechanical parts and equipment (including materials to support capital projects)

2. Electronic parts and equipment (including computers and peripherals)

3. Professional equipment (including laboratory equipment and supplies)

4. Industrial supplies (including general maintenance supplies)

5. Safety and healthcare equipment, parts and supplies

6. Machine shop supplies (industry machinery, equipment and tools)

7. Office supplies and equipment

8. Chemical supplies and equipment

9. Vehicle and fleet parts, equipment and supplies

Given the breadth of materials and services covered by this definition, and the multiple channels through which they are procured, MRO is often a highly complicated area to manage. This complexity is also frequently seen as a deterrent for firms wishing to achieve quick-wins in value for money leverage.

Furthermore, these problems are compounded by sporadic buying patterns and by a number of barriers that are difficult to overcome, including a lack of meaningful data, fragmented supply chains, and embedded local personal relationships with suppliers. It is often felt, therefore, that indirect spend is a low-value and low-risk area to manage, and the lack of immediate cost-saving leverage that is often possible in other more direct areas of expenditure is sometimes a surprise for supply chain managers and spend control practitioners when they move into these areas of more indirect spend management for the first time.

Notwithstanding these limiting factors, however, indirect spend is now receiving increased attention within some organizations, including IBM, United Airlines, Harley-Davidson, Cisco Systems, Rolls-Royce and many others. Within these firms, there has been a realization that a large share of total external spend is indirect and that there is significant potential to obtain better deals.

Currently, indirect spend is recognized as a major area for potential improvement, with up to 20 percent of all purchases (by value) and 70-90 percent (by number) of purchase orders, shipment expenses, and invoices processed attributed to materials and services that are not used in the finished product. (Source: BusinessWeek)

A recent report from Fortune magazine has found that, on average, indirect spend is a significant proportion (up to 50 percent) of a company’s purchases and, therefore, can no longer be ignored when cost reduction is critical.

Furthermore, a recent study by Fortune magazine has found that, on average, indirect spend is a significant proportion (up to 50 percent) of a company’s purchases and, therefore, can no longer be ignored when cost reduction is critical. This study showed that significant improvement can be made in the indirect spend portfolio by consolidating, standardizing and outsourcing indirect items of spend to reduce costs and raise service levels.

This article is one of the most popular and well-read articles on Boston’s HubTechInsider.com, and I have received many telephone calls and emails from corporate spend management directors, academic researchers and business school students from across the globe. I am always available to answer any questions you may have regarding indirect spend management and software solutions to regulate “Maverick Spend”, and so please, feel free to drop me a line if you want to know more.

Clients that I have worked with in order to develop indirect spend management and eProcurement solutions for include Gulf States Paper Corporation, Phifer Optical Wire Products, Mercedes-Benz Project USA, Inc., Apple Inc., Nike, The United States Postal Service, JC Pennys, Target, Kohl’s, Best Buy, Borders, J Crew, L.L. Bean, JohnsonDiversey, Stop & Shop, Safeway, Lillian Vernon, Cole Haan, Kroger, Borders, Timberland, Hugo Boss, Armani Exchange, Giorgio Armani, Prada, Smith & Hawken, Harry & David, xpedx, AT&T, International Paper, Wegman’s, Winn-Dixie, Theory, Dollar General and Network Services Company.

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You’re reading Boston’s Hub Tech Insider, a blog stuffed with years of articles about Boston technology startups and venture capital-backed companies, software development, Agile project management, managing software teams, designing web-based business applications, running successful software development projects, ecommerce and telecommunications.

About the author.

I’m Paul Seibert, Editor of Boston’s Hub Tech Insider, a Boston focused technology blog. You can connect with me on LinkedIn, follow me on Twitter, even friend me on Facebook if you’re cool. I own and am trying to sell a dual-zoned, residential & commercial Office Building in Natick, MA. I have a background in entrepreneurship, ecommerce, telecommunications and software development, I’m a PMO Director, I’m a serial entrepreneur and the co-founder of several ecommerce and web-based companies, the latest of which is Tshirtnow.net.

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