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Understanding the Reorder Point Formula in Inventory Management

Simply stated, the goal of inventory management is to have the right amount of inventory in the right place at the right time. It’s the process of managing the flow of goods into and through the organization. An inventory manager aims to balance the risk of stock-outs with inventory holding costs, streamlining operations, and reducing waste.

Efficient inventory management supports sales through inventory availability. It keeps inventory at optimum levels, reduces inventory holding costs, and releases capital tied up in surplus inventory.

The inventory management reorder point formula supports these objectives. The formula uses historic sales and lead time to determine when to place the next order. Safety stock protects the business from supply delays and demand spikes. In this article, you’ll discover how to use the reorder point to balance your inventory.

What is Reorder Point?

The order point in inventory management is the lowest level of stock you should have on hand when you place the next order. It’s used as a trigger for order placement, ensuring you don’t run out of stock while you wait for the supplier to make and transport the next order to your store.

By waiting until the stock reaches the trigger point, you ensure you don’t hold excess stock. The reorder point formula includes the lead time demand to cover sales over the supply period and safety stock to cover supply and demand variability.

Why is reorder point important?

The reorder point helps management to strike a balance between opposing inventory costs. These are:

  • Inventory holding costs: These include warehouse space, insurance, inventory degradation, and obsolescence.
  • Stock-out costs: These cover lost sales, expedited transport costs, and the cost of disgruntled customers, who might not return to do business in the future.
  • Timely order fulfillment: Like managing inventory holding and mitigating stock-out costs, ensuring timely order fulfillment is crucial. A well-defined reorder point helps by replenishing inventory before it runs critically low, minimizing delays in fulfilling customer orders. This proactive approach enhances operational efficiency, satisfies customer expectations, and strengthens relationships throughout the supply chain.

Reorder point benefits for efficient inventory management

The reorder point formula can bring the organization a host of benefits, including:

  • Reduced holding costs: Avoid excess inventory by waiting for it to reach the calculated reorder point before reordering. Lower inventory releases investment capital and reduces the storage space you need. Insurance costs, interest, and damages will drop.
  • Prevents stock-outs: Ordering on time reduces the risk of stock-outs and lost sales, keeping customers happy.
  • Improves the order process: You can automate order placement, saving time and effort. Automated processes eliminate human error.

How to use the reorder point formula?

The order point in inventory management is calculated as: Re-order = Demand during lead time + safety stock

Where: The demand during lead time is the estimated sales during the time it takes to replenish the stock. For this, you need an accurate forecast.

The safety stock covers demand fluctuations over the lead time and replenishment delays. The size of the safety stock will depend on demand variability and the reliability of supply.

You need three basic bits of information to calculate the reorder point

These are:

  • Average daily demand variability: Work this out by dividing the total sales by the number of days in the period.
  • Lead time: The time it takes from the moment you place an order until the supplier delivers it.
  • Safety stock: The extra inventory you need as a buffer in case of a delivery delay or a spike in sales.

The ROP in inventory management triggers the next order and should balance your stock at the ideal level. The right inventory level balances the stockout risk with the cost of holding surplus inventory.

Relationship between safety stock and reorder point

Safety stock is the calculated excess stock businesses carry to reduce the risk of stock-outs. Safety stock is a buffer against inventory disruptions, including:

  • Demand spikes: Safety stock provides for sudden changes in demand.
  • Supply delays: Safety stock ensures you have stock if an order arrives late due to supplier or transport delays.
  • Operational inefficiencies: Safety stock covers internal inefficiencies, like order placement delays and damages.

Safety stock and the order point in inventory management are equally important. Yet, their purpose is different. Safety stock is a buffer against demand changes and variability in the supply chain. It’s based on historical demand variability, lead times, and its importance to the business. The reorder point is your trigger to place the next order. It includes safety stock to cover unexpected supply or demand changes.

Reorder point vs. safety stock

Safety stock isn’t a stand-alone concept. It goes hand in hand with the reorder point and is an integral part of the formula.

You’ll recall that the reorder point = Demand during lead time + safety stock

Safety stock is a buffer to protect the business from demand and lead time variability. With no demand fluctuations, damage, or seasonality, and perfectly timed lead time you could confidently exclude safety stock. Still, that is in the perfect world, so organizations must consider the risks. Then, calculate the required safety stock or risk losing sales.

The ROP in inventory management prevents premature order placement that could inflate inventory levels and the associated costs. Safety stock increases the stock holding. Excess stocks incur extra costs and can impact cash flow, tying up capital you could use more gainfully elsewhere. However, safety stock reduces the risk of stockout to an acceptable level. Safety stock is, therefore, a compromise between low inventory and lost sales.

Calculating reorder point with safety stock

To calculate safety stock, you must assess several factors, including:

  • Demand variability.
  • Lead time variability.
  • Required service level.
  • Supply chain uncertainties.

There are a few methods for calculating safety stock:

Basic safety stock formula

Using this formulation, a business holds a certain number of stock days over and above the reorder point. To demonstrate:

If a business wants to keep five days of additional stock, it will calculate its average demand over five days and set that as the safety stock level. Let’s assume their average demand is 200 units a day. Five days stock at average demand is 1,000 units so they will set their safety stock at 1,000.

Standard deviation safety stock

A more robust method of calculating safety stock is to use the service level and standard deviation to statistically assess the stock needed to ensure the perfect stock level based on past demand.

Safety Stock = (Z × σ demand) × √Lead Time

Where Z is the Z-score for the required service level. You’ll find this value on a standard normal distribution table.

σ demand is the standard deviation of demand during the lead time

Lead time must be stated in the same time frames as demand, for example, days.

Dynamic safety stock

Safety stock is calculated in real-time based on changing demand, supply variability, and other factors. They involve the use of artificial intelligence and the application of advanced statistical forecasting techniques.

Choosing the best method

The best way to calculate safety stock depends on several factors:

  • Item characteristics: How important is the item to your organization? How much does demand fluctuate?
  • Lead time variability: How reliable is your supply chain?
  • Inventory cost: How much does the safety stock cost to store?
  • Stockout cost: The cost of lost sales.

Calculating reorder point without safety stock

Safety stock is a vital part of inventory management, but it may not be necessary in some instances.

  • Predictable demand and a reliable supply chain: Demand is stable, and your supplier has a reliable supply history.
  • Just in Time deliveries: Businesses that use JIT aim to keep inventory at low levels. These businesses arrange frequent deliveries, using visual systems to replenish stock.
  • Non-critical items: It may not be cost-effective to hold an extra stock of non-critical items.
  • Perishable goods: A perishable goods surplus could lead to high spoilage.
  • Highly customized products: If the business tailors its products to customer requirements, it may keep component safety stock. Finished product safety stock would not be possible. Under such conditions, customers will wait for their customized products.

Where safety stock is not required, omit it from the inventory management reorder point formula. In low-risk environments, businesses reap the benefits of lower on-hand inventory.

Reorder point and safety stock examples

Two real-world examples show how to reorder point and safety stock work together:

A Bakery

  • Product:Eggs
  • Average Daily Demand:200 eggs
  • Lead Time:5 days from order placement to delivery.

Reorder Point Calculation

The bakery wants to avoid running out of eggs during the lead time. So, they establish a reorder point to trigger a new order when inventory drops to a certain level.

Using a basic method:

  • Reorder Point (ROP) = Lead Time (days) x Daily Demand
  • ROP = 5 days X 200 eggs/day
  • ROP = 1,000 eggs

Safety Stock

The bakery knows demand sometimes spikes by up to 100 eggs per day. To ensure they have enough eggs to cover the demand they keep a safety stock of 200 eggs.

How it Works:

  • The bakery maintains an inventory level above the reorder point of 1,000 eggs most of the time.
  • When the inventory level reaches 1,000 eggs a new order is placed.
  • The safety stock of 200 eggs is a buffer. If demand spikes during the lead time, the extra 200 eggs cover the additional needs while the bakery waits for the new order.

Online Electronics Retailer

  • Product:Laptops
  • Demand:Variable demand depends on promotions and new releases
  • Lead Time:2 weeks (from order placement to inventory receipt)

Reorder Point Calculation

Because of the high demand variability, the retailer uses more advanced methods to cover demand fluctuations. The retailer chooses an acceptable service level and uses the factor from the service level table.

Safety Stock

In this instance the retailer is unwilling to risk lost sales, deciding to keep safety stock to maintain a 99% service level. They use historical data and statistical analysis to find the correct safety stock.

The retailer sets a reorder point based on the calculated lead time, and average demand with safety stock to support the desired service level. In this example, the safety stock is higher than in the previous example to support highly variable demand, avoiding lost sales.

Takeaways

  • In both examples, the reorder point triggers a new order to maintain baseline inventories.
  • Safety stock is a buffer in both instances, but the amount and importance differ because of product characteristics.
  • The safety stock level chosen depends on the item’s demand patterns, lead times, and business priorities.

Achieve your inventory objectives with reorder points

For years the reorder point has helped organizations achieve their inventory objectives, supporting service-level goals with the least inventory. Managing and balancing inventories to support sales and optimize inventory is crucial for business success. Organizations that get it right can build a competitive advantage that is difficult to rival.

Improve your service levels, cash flow, and inventory holding costs. Release capital invested in inventory and use it to fund new projects and grow your business.

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