How to Calculate Reorder Points to Avoid Stockouts
Knowing how to calculate reorder point for your inventory can help you maintain a balanced inventory level and avoid the much-dreaded stockout and excess inventory problems that come with poor inventory control.
However, as easy as it might sound, calculating inventory reorder points isn’t a walk in the park as many variables need to be taken into account, namely safety stock, lead time demand, and even seasonality. But no to worry, we will get to that in a bit.
In this post, we will explore the concept of reorder point, discuss why calculating it is important for efficient inventory management, and also talk about the formula to use to calculate it.
What is Reorder Point?
A reorder point is that critical inventory level that triggers the action to replenish a particular stock item. It’s not just a random number but a calculated threshold that considers various factors to ensure your business can meet demand without interruption. In essence, it’s the bridge between maintaining optimal inventory levels and providing uninterrupted service to your customers.
Say you are a retailer dealing in unisex joggers. You sell about 50 units of products in a day, and it takes about 7 days to receive production orders from your supplier.
Intuitively, you know your minimum reorder point needs to be way above 350 (50 x7), or else you risk running into stockout problems. Don’t worry, we will show you how to calculate your reorder point (rop) without guessing it.
Why is Calculating Reorder Point Important?
Why is the reorder point so important, and how does it impact the overall health of a business?
A Shield Against Stockouts
First and foremost, the reorder point is your first line of defence against stockouts. Running out of products not only leads to lost sales but can also damage customer trust and loyalty. By identifying the exact moment to reorder stock, businesses ensure that their customers’ needs are consistently met, maintaining satisfaction and promoting repeat business.
A Balancing Tool
Inventory represents a significant investment for most businesses. Too much inventory ties up valuable capital and resources that could be better utilized elsewhere, while too little can halt sales and stifle growth. This is why balancing your safety stock level is crucial.
The reorder point helps maintain this delicate balance, ensuring that investment in inventory is optimized to meet demand without excess.
Enhances Cash Flow Management
Effective inventory management, guided by accurate reorder points, directly influences a business’s cash flow. By minimizing overstocking, businesses can free up cash that would otherwise be tied up in unsold inventory. This liquidity allows for more flexibility in operations, enabling investments in growth opportunities or cushioning against unforeseen challenges.
Responsive to Market Dynamics
Market demand is not static; it ebbs and flows in response to seasons, trends, and countless other variables. The reorder point allows businesses to be agile, adjusting their inventory strategies to these fluctuations. By regularly reviewing and updating reorder points, businesses can remain competitive and responsive, even in volatile markets.
Forecasting and Planning
Reorder points are instrumental in forecasting and planning for the future. By analyzing sales data and inventory turnover rates, businesses can make informed predictions about future demand and adjust their inventory procurement accordingly. This foresight is crucial for strategic planning, budgeting, and resource allocation.
A Catalyst for Supplier Relationships
Maintaining healthy supplier relationships is crucial for any business. By having a clear understanding of reorder points, businesses can provide suppliers with more accurate forecasts and schedules, fostering collaboration and reliability. This can lead to better terms, improved supply chain efficiency, and even innovations in product development.
What's the Difference Between Reorder Point and Economic Order Quantity?
Though sometimes used interchangeably, Reorder Point and Economic Order Quantity are totally different concepts.
While a Reorder Point acts more like a trigger alerting you when to place orders with your supplier, the Economic Order Quantity represents the optimal order size that minimizes the total holding costs and ordering costs associated with inventory.
The EOQ formula considers various costs, including the cost of holding inventory (storage, insurance, depreciation) and the cost per order (shipping, handling, order processing), to determine the most cost-effective quantity to order at one time. The goal of EOQ is to find the balance point where these combined costs are at their lowest.
The key difference between these two concepts is their purpose. While ROP focuses on when to order inventory to prevent stockouts and maintain service levels, EOQ concentrates on how much inventory to order at one time to minimize costs and meet customer demand.
Reorder Point Formula: A Step-By-Step Guide
Ready to perform a reorder point calculation? Here are the steps to go about it:
Step 1: Determine Your Lead Time Demand
Lead time is the period between placing an order with your supplier and receiving the goods. Demand is how much product you expect to sell during this period. Calculating your lead time demand involves multiplying the average daily sales by the average lead time in days.
Lead Time Demand = Average Daily Sales × Lead Time (in days)
For instance, if you sell an average of 50 units per day and your lead time is 10 days, your lead time demand would be 500 units.
Step 2: Calculate Your Safety Stock
Safety stock is the extra inventory held to prevent stockouts caused by fluctuations in demand or supply. To calculate safety stock, you need to know the standard deviation of lead time demand and your desired service level (the probability of not facing a stockout). The formula for safety stock can vary, but a common one is:
Safety Stock = Z-Score × Standard Deviation of Lead Time Demand
The Z-score corresponds to your desired service level (e.g., a Z-score of 1.65 for a 95% service level).
Step 3: Compute Your Reorder Point
Once you have your lead time demand and safety stock, calculating the reorder point is straightforward:
Reorder Point = Lead Time Demand + Safety Stock
This figure represents the inventory level at which a new order should be placed to replenish stocks before they run out, taking into account both the usual demand during lead time and a buffer for uncertainty.
Practical Example
Let’s put these steps into a practical context:
Average Daily Sales: 50 units
Lead Time: 10 days
Lead Time Demand: 50 units/day × 10 days = 500 units
Standard Deviation of Lead Time Demand: 30 units
Desired Service Level: 95% (Z-score = 1.65)
Safety Stock: 1.65 × 30 units = 49.5 units (rounded to 50 for simplicity)
Therefore,
Reorder Point: 500 units (Lead Time Demand) + 50 units (Safety Stock) = 550 units.
Best Practices for Managing Reorder Point
Here’s a comprehensive guide on best practices for managing reorder points, helping you maintain that delicate balance between too much and too little.
Step 2: Calculate Your Safety Stock
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1. Analyze Sales Data
Utilize your historical sales data to understand demand patterns. Look for trends, seasonality, and any factors that may cause demand to fluctuate. This analysis will provide a solid foundation for setting accurate reorder points.
2. Monitor Market Trends
Stay informed about market trends that could impact demand for your products. Economic indicators, emerging technologies, and shifts in consumer behavior can all influence demand and, by extension, your reorder points.
3. Refine Your Forecasting
Use a combination of historical sales data, market analysis, and any known future events to refine your demand forecasting. The more accurate your forecasts, the more precise your reorder points will be.
4. Include Safety Stock
Safety stock is your buffer against unpredictability. Calculate an appropriate amount of safety stock to include in your reorder points to protect against sudden spikes in demand or supply chain disruptions.
5. Implement Inventory Management Software
Modern inventory management systems like Uphance can automate much of the process, from calculating reorder points based on real-time sales data to notifying you when it’s time to reorder.
6. Use Data Analytics
Leverage data analytics tools to gain deeper insights into inventory trends, helping you adjust reorder points more accurately and responsively.
7. Communicate with Suppliers
Build strong relationships with your suppliers. Open communication can lead to better understanding of lead times, potential delays, or opportunities for bulk purchasing, all of which can influence your reorder points.
Conclusion
The reorder point is a crucial component of inventory management that, when calculated and applied correctly, can dramatically improve a business’s operational efficiency and profitability. By understanding and actively managing reorder points, businesses can ensure they have the right amount of stock at the right time, optimizing their inventory levels and improving their bottom line.
