Spend categorization does not have to be painful. Granted, it can be time-consuming and demanding, but the time spent on developing a robust category structure will pay off handsomely.
Extracting usable information from historical company spend data sounds easy in principle but in practice, it can be challenging. Without a firm foundation, the information you generate from the raw data may be incomplete, error-ridden, and unreliable.
What is spend catagorization?
Let’s start with a spend categorization structure that’s customized to your business. Spend is classified based on a hierarchy of categories, from general to specific, and extends down by up to 6-7 levels of granular detail.
Though it’s possible to extend the hierarchy beyond 4 levels, we find that the last levels are often either repetitive or an unfeasible level of granularity in terms of the categorization effort required.
A good rule of thumb is that the last level of the spend should be able to be sourced with a single RFP.
This hierarchy of spend categories is also called a spend taxonomy or a category tree - which is an essential part of the science or technique of spend categorization. Here is a simple example of a taxonomy for professional services:
Why is spend taxonomy so important?
The main objective is to provide a base for identifying strategic sourcing initiatives. Attention to taxonomy design is very important because it helps to classify your data accurately so that you can see what you’re spending on, how much, to whom, and what the scope for cost savings is.
Making informed decisions based on your spend is only possible when the data is complete, cleansed and allocated into meaningful buckets. These buckets must be relevant and meaningful in your industry sector and your organization.
The categories selected must be accepted and commonly understood by every level of management across all business units. If the categorization is too complicated it will create confusion; if it’s too simple, opportunities will be missed. Everyone needs to be talking the same language.
Align your categories with business needs including internal reporting requirements
Create a hierarchy with enough sub-categories within a category to be useful. If the spend data is grouped at too high a level, there may be savings opportunities missed. Too many levels may mean that sub-categories with small amounts of spend become timewasters.
The taxonomy or category tree should be structured from a supply market perspective to consolidate spend from suppliers of similar goods and services. Take advice from subject matter experts to ensure that your categorizations make sense and that they are complete, valid and accurate.
A common mistake in selecting category taxonomy is that the category should explain what goods or services were purchased, not who purchased them, what the source was, or which accounting process the purchases belong to. Rather than categorizing spend data based on these factors, they can be included as additional data points so that they can be used in analysis.
Categories and sub-categories must be unique and not duplicated in another part of the taxonomy. Each sub-category must be mutually exclusive, e.g. if auditing is a sub-category in Financial Services, it must not also appear as auditing under Accounting and collectively exhaustive, meaning all types of spend must have a place in the taxonomy.
Categories must be clearly defined, agreed upon, documented, and communicated. Thought must be given to the coding norms – numbers, naming conventions, and length of descriptions at each level.
Consider expanding growing categories with additional sub-categories e.g. mobile technology and hand-held devices within I.T. hardware.
Avoid having a category named “other”. All spend belongs somewhere.
Using an existing taxonomy vs a customized one
Developing your customized category hierarchy can be laborious but is time well spent. This is especially true for direct categories where spend tends to be very different across different companies, less so for indirect spend which has much more commonalities across companies.
The United Nations Standard Products and Services Code (UNSPSC) is an example of a well-known taxonomy of products and services. It is a four-level hierarchy using eight-digit numbers, with an optional fifth level. UNSPSC is an extensively used taxonomy of products and services, but it is not ideally suited to strategic sourcing.