Procurement is the process of acquiring goods & services from an external source and, on the surface, seems simple. Every kid launching their first lemonade stand quickly grasps the idea you need to buy stuff in order to make stuff, in order to sell that stuff. However, if the types of procurement were that simple for scaled businesses, then I wouldn’t have to write this article.
As with everything, complexity increases with scale. In larger organizations, the purchasing & procurement process often becomes its own department as it becomes necessary to tightly manage vendors, inventory, and budgets across the organization.
The procurement process typically involves sourcing, negotiating, and purchasing, all of which can take different forms. Here, I’ll delve into the four different types of procurement, discussing their associations with specific industries, relevant software tools that can help manage them, best practices, and common pitfalls you should avoid in order to effectively manage your spend.
1. Direct Procurement
Direct procurement refers to the process of acquiring goods, materials, or services that are directly incorporated into the end products or services that a company sells. These are goods that are used in the creation of whatever it is that the company sells and they have a direct impact on the production process.
In general, direct procurement is closely tied to the company's production operations, and managing it effectively can have a significant impact on the company's profitability. Direct procurement workflows leverage accounting best practices around 3-way matching and emphasize strong record-keeping processes.
Associated Industry Use Cases
Wherever a company needs to have a procurement department, it’s a good bet direct procurement is a major operational and financial priority. Some examples of industries that fit the bill are:
- Food and Beverage Industry: Direct goods procurement in the food and beverage industry involves purchasing raw ingredients, including grains, vegetables, fruits, meat, and dairy products (and unfortunately no small amount of chemical preservatives, emulsifiers, and food coloring), which are then used in the production of food items.
- Construction Industry: In this sector, sourcing materials like steel, concrete, timber, and other building materials represent the bulk of purchasing needs, which is why the construction industry has a ton of specialized tools to help manage purchasing needs.
- Pharmaceutical Industry: Direct procurement in the pharmaceutical industry involves acquiring active pharmaceutical ingredients, intermediates, and other necessary materials used in drug manufacturing. Biotech companies consume a ton of product in research as well as in the manufacturing process.
- Electronics Industry: This industry uses direct procurement to purchase components like semiconductors, circuits, batteries, and other parts used to manufacture electronic goods such as smartphones, laptops, and TVs.
- Textile and Apparel Industry: Direct procurement processes in this industry involve sourcing raw materials like cotton, wool, synthetic fibers, and other textiles used to produce clothing items.
- Aerospace Industry: Companies in this industry directly procure various materials like aluminum, titanium, and composites, as well as components like engines, avionics, and other parts for aircraft production.
ERP systems such as Oracle and SAP specialize in direct procurement via modules or add on products like SAP Ariba. SAP Ariba offers functionalities for supplier management, strategic sourcing, and procurement operations that can make a procurement team’s life much easier.
- Establish Strong Supplier Relationships: One of the most important elements of successful direct procurement is developing and maintaining good relationships with suppliers. This often involves regular communication, mutual respect, and the prompt resolution of any issues that arise with your purchase orders.
- Diversify Your Supplier Base: While maintaining strong supplier relationships is important, it's also crucial to have a diversified supplier base. Relying too heavily on one supplier can leave a company vulnerable if that supplier experiences issues. Keeping a back-up or two can minimize your risks here.
- Leverage Technology: Utilizing procurement software can automate many procurement processes, freeing up time for strategic decision-making. Advanced systems can offer real-time tracking, supplier management, inventory management, and predictive analytics.
- Implement Strategic Sourcing: This involves analyzing company-wide purchasing trends to identify opportunities for cost reduction, supplier consolidation, and process standardization. It can also help identify opportunities for bulk purchasing to achieve cost savings.
- Prioritize Quality Control: Ensuring the quality of procured materials is paramount. Regular audits and inspections can prevent substandard materials from affecting your production line and final product quality.
- Maintain Clear Documentation: Keep clear records of all procurement processes, from initial supplier contracts to final invoices. This will aid in audits, prevent misunderstandings, and provide a clear picture of the procurement lifecycle.
- Opt for Long-term Contracts Where Feasible: Long-term contracts can lock in prices, ensuring protection against market fluctuations. They also tend to foster stronger relationships with suppliers, leading to better collaboration and service.
- Ensure Timely Delivery: Coordinate with suppliers to ensure on-time delivery of materials. Delays in the delivery of key components can hold up production, leading to delayed orders, increased costs, and dissatisfied customers.
- Sustainability Considerations: Consider the environmental and social impact of your procurement. Opting for suppliers that adhere to sustainable practices can boost your company's corporate social responsibility profile.
- Poor Supplier Management: A lack of proper supplier management can lead to quality issues, delays, and increased costs. For instance, if quality control measures are not in place, subpar materials or components could negatively affect the final product.
- Neglecting Contract Management: Improper handling or overlooking details in new supplier contracts can lead to disputes, cost overruns, and failure to deliver on time. Regular contract reviews and audits are essential to avoid this.
- Failure to Innovate or Adopt Technology: Today, many innovative solutions can streamline and automate procurement processes. Companies that fail to adopt such technologies may struggle to stay competitive and efficient.
- Inadequate Risk Management: It's essential to identify potential risks in the procurement process and develop strategies to mitigate them. These risks can range from supply chain disruptions due to geopolitical issues, natural disasters, currency fluctuations, or changes in regulations.
- Lack of Cost Optimization: Without a strategic approach to procurement, companies may miss out on opportunities for bulk buying, negotiating better terms, or identifying cheaper, equally reliable alternatives.
- Insufficient Planning and Forecasting: Poor planning or inaccurate demand forecasting can lead to overstock or stockouts, both of which can impact financial performance and operational efficiency.
Story Time: Wine in Kegs
When I took over operations at a wine-in-kegs packaging company (I know, pretty cool hey?), I noticed we were buying kegs by the truckload in order to keep the per keg cost minimized. However, those kegs sat unused for months at a time because production had not yet scaled to meet the demand; demand only spiked when wine was ready to be kegged. By building a forecast model that took into account seasonality at the wineries, we were better able to optimize our orders and ended up buying less in bulk.
Buying more frequently meant paying more per keg, but the kegs we had were contributing to revenue because they were no longer sitting unused. While input costs slightly increased, our business cash flows massively improved, improving our overall business health.
2. Indirect Procurement
Indirect procurement involves purchasing goods and services not directly related to manufacturing products but rather, those intended for internal use. This includes office supplies, software licences, IT equipment, and more.
The goal of indirect procurement is to ensure that all the operational resources needed for a company to function are available in the right quantities, at the right time, and at the right price.
Although indirect procurement may not directly contribute to a company's primary product or service, it can significantly impact a company's operational efficiency and cost management. As a result, it requires strategic planning, systematic execution, and ongoing management to maximize value and reduce potential risks.
Associated Industry Use Cases
Typically, indirect procurement is a larger portion of the spend pie if your business operates in an office environment. Indirect procurement is ultimately relevant to all businesses across all industries, as it involves resources necessary for running the company's operations, however some industries make heavier use of this category than others:
- Education: Schools, colleges, and universities use indirect procurement to purchase classroom and supplies, software, janitorial services, maintenance services, etc.
- Healthcare: Hospitals, clinics, and other healthcare facilities procure medical supplies, office supplies, and software.
- Retail: Retailers require store maintenance, IT infrastructure, software, and office supplies, all of which fall under indirect procurement.
- Technology: Tech companies procure items such as software licenses, office equipment, and catering for employees. If you work at a cool enough tech company, ping-pong tables and kombucha on tap can make up a significant portion of the operating budget!
- Hospitality: Hotels, restaurants, and other hospitality businesses procure items like kitchen equipment maintenance, IT services, and software.
- Finance and Insurance: These businesses often require indirect procurement for office supplies, furniture, IT hardware and software, security systems, and facilities management services.
- Transportation and Logistics: Companies in this industry procure items such as software for tracking and managing shipments, cleaning and maintenance services for facilities and vehicles, and office supplies.
Tools such as Procurify and Coupa Procurement provide intuitive, user-friendly tools for managing purchase requests, enabling businesses to have control over their spend and make cost-effective decisions, while providing automation solution to replace manual processes. These tools often handle the entire procurement cycle from purchase request to payment processing.
Reimbursable expenses are often considered part of indirect procurement and tools such as Expensify are making it easier for businesses to track and manage expense programs. There are also an increasing number of tools that help businesses manage their SaaS subscription expenses.
Indirect procurement, while often considered non-strategic or less critical, can actually offer significant opportunities for cost savings and efficiency improvements if handled correctly. Here are some best practices for managing indirect procurement effectively:
- Consolidate Suppliers: As opposed to direct procurement, these aren’t business critical supplies so you’re typically fine if you have a delay in your supply. By reducing the number of suppliers you work with, you can increase purchasing power, simplify processes, and improve cost control. Centralizing purchasing authority can improve management here.
- Leverage Technology: Utilizing modern procurement software can help automate and streamline your indirect procurement processes. This can improve visibility, control, spend analysis, and efficiency, as well as provide data for more informed decision-making.
- Establish Clear Procurement Policies: Clear policies help prevent maverick spending and ensure consistency in procurement decisions. These policies should outline approved suppliers, purchasing thresholds, and approval processes.
- Implement a Procure-to-Pay (P2P) Process: A P2P process ensures that all steps, from initial requisition to final payment, are standardized and streamlined. This can help minimize errors, reduce processing times, and improve cost control.
- Strategically Manage Categories: Use a category management approach, grouping similar goods and services together to gain a better understanding of spend patterns and identify opportunities for cost savings or process improvements.
- Invest in Training: Staff involved in indirect procurement should be trained in the company's procurement policies, as well as techniques for negotiation, supplier management, and cost control.
- Track and Analyze Spend: Regularly tracking and analyzing your spend data can provide valuable insights into your procurement activities, helping to identify potential areas for cost savings or efficiency improvements. Regularly review contracts when they’re up for renewal, as most businesses are paying for software tools they don’t need nowadays.
- Build Strong Relationships with Suppliers: Just as in direct procurement, strong supplier relationships are extremely helpful in indirect procurement. These relationships can lead to better service, pricing, and responsiveness.
- Maverick Spending: This occurs when employees make unauthorized purchases or use unapproved suppliers. It can lead to a risk of fraud, overspending, non-compliance with company policies, and increased procurement risks.
- Fragmented Processes & Inconsistent Policies: Without standardized processes and guidelines, indirect procurement can become fragmented and inefficient. This can result in inconsistent purchasing decisions, increased exposure to risk, processing delays, and difficulty tracking spend or even confirming receipt of purchase.
- Lack of Spend Visibility: If companies are not effectively tracking and analyzing their indirect spend, they may miss out on opportunities for cost savings or process improvements or, alternatively, overspend without realizing it. Giving departments budgets doesn’t mean much if they can’t actually see what they’re spending!
- Failing to Consolidate Suppliers: Without a strategy for supplier consolidation, companies can end up with an unwieldy number of suppliers, making procurement processes complex and difficult to manage.
3. Services Procurement
Services procurement, also known as professional procurement, refers to the process of sourcing and managing the acquisition of people-based services from external suppliers. The services acquired can be of various types, including but not limited to professional consulting, IT services, marketing services, facility management, travel services, legal services, and more.
Unlike direct or indirect procurement, which often focus on tangible goods or materials, services procurement deals with the intangible and can thus be more complex to manage. Evaluating the quality of services, tracking the delivery of these services, and managing relationships with service providers requires different strategies and tools than those used for managing goods.
A crucial aspect of services procurement is the use of service-level agreements (SLAs), which are contracts that outline the terms and conditions of the service, including the quality, availability, and responsibilities of the service provider. SLAs ensure there’s a clear understanding between the company and the service provider about expectations and deliverables.
It is important to note that services procurement has some unique characteristics, but many businesses lump management of services into their indirect procurement processes and workflows, so you can consider services procurement a sub-category of indirect procurement (and I promise nobody will yell at you).
Associated Industry Use Cases
All industries (to some degree) will use and benefit from external services, but here are a selection of industries that commonly make extensive use of this category of procurement:
- Information Technology: This industry often leverages services procurement to outsource software development, system maintenance, cybersecurity, cloud services, and other IT-related services.
- Banking and Financial Services: These sectors regularly procure services like consulting, auditing, IT services, legal services, and marketing. They also hire agencies for compliance, risk assessment, and financial analysis services.
- Healthcare: This industry procures a wide range of services including IT solutions, waste management, cleaning services, equipment maintenance, consultancy, and recruitment services for medical professionals.
- Construction and Real Estate: These industries often rely on subcontracted services, such as architectural design, construction work, consulting, engineering, legal services, and property management.
- Retail: Retail businesses frequently procure services like IT support, logistics and distribution, marketing and advertising, cleaning, and security services.
- Government: Government agencies at all levels use services procurement to contract for a wide variety of services, ranging from IT and consulting to construction and healthcare.
- Manufacturing: Manufacturers often procure services like equipment maintenance, IT support, logistics, waste management, and consulting services to support their production operations and supply chain.
Zycus Procurement Suite provides solutions specifically designed for service procurement, with features like service requisition, vendor management, and contracts tracking.
- Define Clear Requirements: Since services are intangible, it can be challenging to articulate what you need. To overcome this, define your requirements clearly and in detail to ensure that potential suppliers fully understand what you're asking for.
- Establish Comprehensive Service Level Agreements (SLAs): SLAs set out what is expected from a supplier in terms of the quality of service, timelines, and responsibilities. This is crucial in managing performance and ensuring that the supplier meets the expected standards.
- Perform Due Diligence on Suppliers: Evaluate potential suppliers carefully to assess their capabilities, financial stability, and reputation. This can help ensure that they can deliver the required service and are reliable and trustworthy. Reference checks can be a great way to dig into the service quality.
- Regular Performance Reviews: Regularly evaluate the performance of your service providers against the agreed SLAs and key performance indicators (KPIs). This can help identify issues early and ensure that you're getting the expected value from the service provider.
- Unclear Specifications: There’s nothing worse than being a month into a project and realizing you set unclear expectations or were misaligned on scope. It’s tempting to jump into bed with a contractor who promises to solve all your problems, but accountability to set clear expectations still lies with the purchaser.
- Insufficient Supplier Evaluation: Not thoroughly vetting service providers before selection can lead to substandard service quality, unexpected costs, and issues with non-compliance.
- Neglecting Contract Management: Read those terms and conditions thoroughly. Nothing worse than being locked into a contract with someone who can’t deliver.
- Lack of Performance Tracking: Without regular performance reviews, it can be challenging to identify and address issues with service quality or supplier performance.
- Inadequate Risk Management: Service disruptions, supplier failures, and other risks can have significant impacts on the organization. Failing to identify, assess, and mitigate these risks is a common pitfall. Setting clear SLAs upfront will help mitigate risk.
- Ignoring the Total Cost of Engagement: Often, organizations focus only on the service cost and neglect other related costs such as management time, change management costs, transition costs, etc. This can lead to a misjudgment of the actual cost of the service. Someone inevitably still has to manage contractors to get the most out of their service.
4. Capital Procurement
Capital procurement, also known as capital equipment procurement, involves the acquisition of fixed assets and capital goods that a business uses to produce goods or services. These are typically large, expensive items that have a useful life of more than one year and are used to generate income or increase the company's production capacity. They’re considered an investment and are usually depreciated over their useful life.
Examples of capital goods include machinery, vehicles, computer hardware, buildings, and other types of equipment.
The process of capital procurement often involves a significant amount of planning and evaluation due to the high cost and long-term implications of these purchases. Companies may consider factors such as the lifetime cost of the asset (including maintenance and operating costs), the potential return on investment, financing options, and the asset's compatibility with existing equipment or infrastructure.
Capital procurement typically requires a multi-step approval process due to the substantial financial commitment involved. It may also involve negotiating financing terms or leasing agreements.
Associated Industry Use Cases
Capital procurement is a critical process in any industry that requires substantial investment in physical assets to produce goods or services. Here are some industries where capital procurement is particularly important:
- Manufacturing: This sector often requires significant investment in machinery, equipment, and facilities to produce goods. Examples include automobile manufacturers, electronics manufacturers, food and beverage producers, and more.
- Construction and Real Estate: These industries frequently invest in heavy equipment, tools, and buildings. Capital procurement can be a significant part of their operations, whether they're building homes, commercial buildings, or infrastructure projects like roads and bridges.
- Transportation and Logistics: Companies in these sectors invest heavily in vehicles (trucks, ships, aircraft, etc.), warehouses, and logistics equipment. For airlines, for example, purchasing or leasing aircraft is a critical part of their operations.
- Healthcare: Hospitals and other healthcare providers invest in costly medical equipment, from MRI machines to surgical tools, along with the facilities to house them.
- Oil, Gas, and Mining: These industries need to procure heavy machinery, drilling equipment, safety gear, and more. Capital procurement decisions are often very high-stakes given the potential for risk in these industries.
- Energy and Utilities: Energy producers, whether they're operating in renewable sectors like wind and solar or traditional sectors like coal and natural gas, often need to make substantial capital investments in power generation and distribution infrastructure.
- Telecommunications: Telecommunication companies require significant investments in infrastructure such as transmission towers, data centers, and networking equipment.
- Education: Educational institutions, especially universities and colleges, often engage in capital procurement to build or upgrade facilities, such as laboratories, classrooms, libraries, and dormitories.
Capital procurement tends to be more complex than regular direct and indirect procurement, and so, it’s often accomplished in “old school” manual ways. However, tools like purchasing management software and ERP solutions can help with contract and approval management to ensure the process goes smoothly.
Capital procurement involves significant investments and long-term implications for an organization, making it essential to have effective management strategies in place. Here are some best practices for managing capital procurement:
- Strategic Planning: Capital purchases should align with the organization's long-term strategic objectives. An effective capital procurement process should include a thorough assessment of the organization's needs and a strategic plan for fulfilling those needs.
- Thorough Evaluation: Due to the significant financial commitment involved, capital purchases require careful evaluation. This includes assessing the total cost of ownership, the expected lifespan of the asset, the potential return on investment, and the asset's expected impact on operations or productivity.
- Stakeholder Engagement: Engaging stakeholders, including end-users and senior management, in the procurement process can ensure that the purchased assets meet the organization's needs and have buy-in from those who will use or be affected by the assets.
- Competitive Bidding: It's essential to encourage competition among potential suppliers to secure the best possible price and terms. This might involve issuing a Request for Proposal (RFP) or a Request for Quotation (RFQ) to multiple suppliers.
- Supplier Assessment: Along with evaluating the product or asset, assess the supplier's reliability, financial stability, and reputation in the market. This can help mitigate risks associated with supplier performance or solvency.
- Negotiation: Given the high cost of capital purchases, negotiation is a crucial step in the procurement process. It's not just about getting a reasonable price – also consider factors like delivery timelines, warranty terms, after-sales support, and financing options.
- Contract Management: Contracts for capital purchases can be complex and should be carefully managed. Ensure that all terms and conditions are clearly understood, and all parties' responsibilities are outlined.
- Risk Management: Identify potential risks associated with the capital purchase and develop strategies to mitigate these risks. This might include risks related to delivery delays, asset performance, supplier issues, or changes in market conditions.
- Lack of Strategic Planning: Failure to align capital procurement with the organization's strategic objectives can lead to wasted resources and investments that don't contribute to the organization's goals.
- Inadequate Supplier Evaluation: Choosing a supplier solely based on the lowest price without evaluating their reliability, financial stability, and reputation in the market can lead to substandard quality, delivery delays, and poor after-sales service.
- Neglecting Total Cost of Ownership: Focusing only on the initial purchase price and neglecting the total cost of ownership (including maintenance, operating costs, and disposal costs) can lead to unexpected expenses and unprofitable investments.
- Poor Contract Management: Failing to understand and manage the terms and conditions of the contract can result in legal disputes, cost overruns, and unsatisfactory performance.
- Neglecting Risk Management: Failure to identify and mitigate potential risks related to the asset's performance, delivery delays, supplier issues, or changes in market conditions can lead to unexpected problems and costs.
- Inadequate Financing Considerations: Not considering different financing options or neglecting to negotiate the best terms can result in higher costs and unfavorable financial commitments.
At the end of the day, it all boils down to responsible capital management. Bring together the right stewards of your organization and they’ll figure out how to make the best purchasing decisions; whether that’s right out of the gate or after making a few errors is dependent on the resources available to them from the start.