What is Reorder Point?
Reorder point refers to that stage of inventory management in which the inventory needs to be reordered to ensure timely availability of goods for the sales. It ensures that a business can have a minimum product quantity in storage to prevent operational disruptions arising out of a stockout. At the same time, reorder point will prevent holding stock beyond the safety point to avoid incurring unnecessary storage costs.
- Reorder point defines a certain amount of stock that a business should maintain as a necessity to prevent having too much or too little merchandise available for sale.
- If your stock is too low, you may lose sales, so having it over the minimum level is essential.
- It is also essential to avoid overstocking because it will increase your inventory holding costs and diminish overall profits.
- To calculate the reorder point, you need to know your daily sales, lead times, and safety stock levels.
Some businesses make finished products like a cake out of raw materials such as butter, cream and milk, while some sell readymade finished goods like a fridge. Usually, for a business, inventory consists of raw materialsRaw MaterialsRaw materials inventory is the cost of products in the inventory of the company which has not been used for finished products and work in progress inventory. Raw material inventory is part of inventory cost which is reported under current assets on the balance sheet. or finished goods stored in a storage. Suppliers provide business raw materials or ready-made finished goods.
People involved with sales functions know that holding too many finished products in stock is bad for business. Holding an enormous size of raw materials is expensive as it increases the overall inventory holding costsHolding CostsHolding cost refers to the cost that an entity incurs for handling and storing its unsold inventory during an accounting period. It is calculated as the sum total of storage cost, finance cost, insurance, and taxes as well as obsolescence and shrinkage cost.. However, losing the chance to sell products because you forgot to order the raw materials or readymade finished goods at the right time is even worse. How does one determine that an inventory has reached a point where it needs to be reordered?
Every product held in inventory will have a different reorder level based on its usage, sales volume and lead time. Lead time in this context refers to the amount of time required to receive fresh supplies from the supplier. An accurate reorder point for each product will ensure that you always have enough stock to meet the consumer demand without using up excess capital resources.
Reorder Point Formula
Let us now understand the formula for calculating the reorder point.
Reorder Point = (Average Daily Usage x Average Lead Time in Days) + Safety Stock
Reorder Point = Lead Time Demand + Safety Stock
To understand the reorder point formulas better, let’s take a look at what each term means:
- Average Daily Usage: Average daily usage is the number of raw materials you consume or finished products you sell per day.
- Lead Time: The number of days between ordering a product from your supplier and having it on your shelves.
- Average Lead Time – The average number of days between ordering a product from your supplier and having it on your shelves.
- Lead Time Demand = Average Daily Sales x Lead Time.
- Safety Stock: Additional units of the merchandise that you store in your inventory in case the demand goes up too quickly or if there’s a problem with your supply chain to avoid running out of stock.
First, calculate your daily sales (a 30-day or weekly average is fine). Then multiply it by the number of days it takes between ordering a product from your supplier and receiving it. Then, calculate your safety stock and add both numbers. The result will be your official reorder point.
If you ever go below that mark, it’s time to set up new orders, or you may end up with empty shelves. While some aspects may change depending on the subtle nuances of your business, the formula remains the same. For example, if you need to buy supplies and then produce your merchandise, you will have to keep in mind both the delivery time and how much time it takes to manufacture the finished products.
Step by Step Reorder Point Calculation
Now, we’ll try and understand the whole process using an example.
#1 – Calculating Daily Usage and Lead Time
Firstly, we need data for our calculations. To get that data, you need to answer the following questions precisely:
- How many products do you generally sell in a week?
- How long does it take for a product to reach you when you order it?
- Do you order raw materials to make your product, or do you resell them?
Based on your historical sales data, you need to determine an average of how many products you can sell in a week. Start by taking the weekly sales figure and then divide it by the number of days in the week your business was open. Then, you need to determine how long it takes to receive a product after you order it.
#2 – Let’s look at an example using the lead time demand formula.
Clara is the manager of a home appliance store. She wants to know what is the reorder point for washing machines.
Every week, the store sells twelve machines, and it’s open from Monday to Saturday. It means that in a normal week, the store would sell around 2 washing machines per day.
It takes 4 days for products to arrive from the supplier. As the store resells the home appliances, there is no manufacturing activity involved, making the lead time equal to 4 days.
Using this information, Clara computes the first part of the calculation.
Average Daily Sales = 2 units
Lead Time = 4 days
Lead Time Demand = Average Daily Sales x Lead Time = 2 units × 4 days = 8 units
Now, let’s get to the second point of the calculations, which is the safety stock.
#3 – Safety Stock
Determining the safety stock is trickier because you will need to look at data that shows the long-time sales history of your store. The formula for safety stock is:
(Maximum Daily Sales × Maximum Lead Time in days) − (Average Daily Sales × Average Lead Time in days)
In Clara’s example, she already knows her average sales and lead time. Her average lead time is also 4 days. This is because it normally takes 4 days for restocking which is giving an average number. Had there been multiple entries for lead days, she would have needed to calculate the average lead time.
Now, she needs to look at data from previous months to find the maximum numbers. According to her data, the highest sale in a single day was 7 washing machines. Also, the longest it took for a product to arrive in her warehouse was 7 days. So, the safety stock level is as computed below:
Safety Stock Level = (7 × 7) − (2 × 4) = 49 − 8 = 41 units
#4 Reorder Point = 8 units (Lead time demand) + 41 units (Safety Stock) = 49 units
As soon as the stock level reaches 49 units, Clara will need to place a new order with the supplier. Businesses usually take the help of a reorder point calculator to arrive at this value as they deal with heavy numbers in managing the inventory.
Why is Reorder Point Important?
Forecasting and planning your inventory is essential for the success of your business. This can only happen if you have a clear idea of purchasing trends over a given period. By not having enough goods available in stock, you will lose sales. Customers may want to buy your products, but they won’t be able to make a purchase. So, they will probably go to your competitors.
As per a study, it was suggested that retailers lose 4% of their annual sales on average arising out of stockout situations. It was found that it costs manufacturers around $23 million for every $1 billion in sales. Reorder points help prevent your business from such stockout situations.
However, if you make the opposite mistake and order more of a product than required, you will not have enough space to store it. Your extra stock will quickly pile up, and the cost of holding it may increase significantly, especially if you need to rent more space to store it. Reorder points help businesses keep a minimum amount of inventory without running out of stock.
If this kind of planning is important for small businesses, it becomes even more central to large ones. You’ll want to automate the process as much as possible, so setting up a system based on this equation is necessary. By thinking about your business’s logistics, you can make sure that it’s operating at its optimum level.
This has been a guide to what is Reorder Point and its definition. Here we discuss its formula, step by step calculation, along with an example and its importance. You may learn more about finance from the following articles –