Procurement Explained

Direct materials in procurement | direct vs. indirect

Jasmiina Toikka Jun 14, 2021

Procurement can be divided into indirect and direct material categories. Indirect and direct procurement vary from each other by their category characteristics and nature. In this article we will cover what direct material procurement is all about.

Direct procurement, or direct spend management, is the company process of purchasing or obtaining materials, resources, goods and services that are used in core operations of its business and eventually make up their product. Direct items are sourced and used in the production of goods and services for the end customer or client.

What are direct materials?

In cost accounting direct materials are any physical items built into a product. Simple examples of direct materials in manufacturing are ingredients for a cake, parts for a car and fabric for clothing. In manufacturing organizations, direct material spend represents the largest percentage of total spend, even up to 80%. This would equal to 80% of your pricing structure, competitive advantage, quality, customer satisfaction and innovation potential. Direct materials are easy to identify, measure, and are directly linked to the cost of production.  To bake a cake you need flour, eggs, dried fruit, sugar etc. These are the direct materials needed to make the cake.

Direct materials vs Indirect materials

Indirect materials are those materials that are used in production but do not form a part of the finished goods. Indirect purchases, both goods and services, are needed to support day-to-day operations. In the cake example, we use protective items such as gloves and other utensils as well as kitchen electricity and work clothes. While indirect materials enable the production process it is not possible to accurately allocate their costs to a specific product. The cost of direct materials on the other hand includes any expense directly associated with those raw materials. This may include transportation, insurances and import-related costs.  

The categorization of direct materials is industry and organization specific. Direct category groups vary between companies and industry fields based on the nature of their end products. Automotive direct materials could look very different from those in the pharmaceutical or food industries. Indirect procurement categories on the other hand tend to be relatively similar across industries. Indirect categories include marketing, business travel, IT, facilities and professional services.

What is a BOM?

BOM stands for bill of materials. It is a commonly used term in production landscape. Bill of materials is a list of all items needed to make a product. Cake ingredients list is a BOM. In manufacturing, a BOM includes a comprehensive list of raw materials, components, assemblies, and instructions required to construct or manufacture a product or service.

BOM is usually expressed in a hierarchical table format; the finished product at the top and items listed in descending order of importance or complexity. Each line item in BOM is likely to include the product code, item name, item number, item revision, description, quantity, unit of measure, size, length, weight, and specification or description of the item.

Direct materials and direct procurement

Direct materials and direct procurement are often used interchangeably but there are important differences. Direct procurement is the spend on raw materials, goods and services in order to produce goods or services. Direct procurement includes direct material categories of spend but can also include the indirect materials and services directly linked to the manufacturing process. In the cake example, bakery could have outsourced some of their workforce i.e. the bakers (direct services procurement). On the other hand, indirect procurement should include all the categories of spend that enable a company to maintain and develop its operations.

 

Direct materials have direct impact on end product and profitability of a company. Direct material procurement may be a complex and labour-intensive process. It is a business critical task to master that will have its direct impact on end product and customers. Direct procurement is dependent on the continuity of supply while market volatility and price fluctuations bring their own challenges to the equation. It can entail global suppliers, lengthy lead times, and heavy reliance on forecasting and logistics performance. Sourcing direct materials involves expertise, time, consideration and attention. Direct material procurement also requires extensive collaboration—there are numerous parties involved, internal and external, and multiple activities to plan, track, coordinate, and control.

 

Direct materials quality defines the quality of your product and therefore impacts on your competitive advantage and customer satisfaction. Therefore, quality management is an important part of direct procurement. Quality management practices vary based on material type and category. For instance food quality management could include food safety audits as automotive component quality management could include durability tests.

 

Spend and material forecasting

Direct procurement relies heavily on its supplier network and material availability and quality. The direct procurement connects multiple items purchased from various suppliers with varying delivery and production schedules. Complications on both sides of an order require sharing forecasts and visibility into the large volumes of data in accurate format and timely manner.

 

Direct procurement needs to understand its spend, bill of materials and aspects that may have impact on its future demand for those materials. Analysing the spend patterns of direct materials will help identify following improvements:

  1. cost savings
  2. process improvements
  3. effective production scheduling and demand planning
  4. inventory reduction
  5. efficient transportation and warehousing
  6. increased customer satisfaction.

Best performing companies recognize the need to analyze levers impacting bottom line performance – while also looking ahead to drive profitability. There are multiple tools for spend and material forecasting from spreadsheets to sophisticated solutions fit for large companies. Best-of-breed solutions can provide insights not accessible using ERP systems or Excel spreadsheets that may be clumsy and prone to error. See how Kellogg Company turned from backward looking number crunching to value added analysis: Kellogg's Case Study 

By mastering your direct materials procurement and forecasting you can master your business.

 

 

Photo by: @caities_cakes_amsterdam

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