If your cash is tied up in keeping inventory on hand, it can’t be used to grow your business. But inventory is exactly what you need to grow. Here’s how to calculate your reorder point to ensure you always have enough — but not extra — available stock.
Lead Time Stock
Lead Time Stock = Average Daily Sales x Average Lead Time in Days
Lead time is the time it takes for a vendor to get you a product. Each vendor will supply products at different rates. Calculating the Average Lead Time will help determine the most likely time it will take to get a product, while calculating the Maximum Lead Time will give you an idea of what the worst case scenario might be. This number will give you the most likely amount of stock needed to cover the sales during the time between placing the order and receiving the stock.
Safety Stock = (Maximum Daily Sales x Maximum Lead Time) − (Average Daily Sales x Average Lead Time)
Safety stock is the excess inventory you need to prevent out-of-stock situations for important items. To calculate this, take the Maximum Daily Sales and multiply it by the Maximum Lead Time. This covers the bases for the worst case scenario. Subtracting out the Average Daily Sales and the Average Lead time will bring the number back to a more reasonable (and more accurate) number.
Safety stock is something you can calculate with a formula, but you’ll want to use your own insight and knowledge of the industry too. For example, if you are selling soccer jerseys and soccer season is coming to an end, you might get really high average sales numbers as a trend, but your personal knowledge will guide your decision to reorder knowing those averages will drop soon.
Reorder Point = Lead Time Stock + Safety Stock
Your reorder point is the minimum amount of product you need before an order needs to be placed. Add the Lead Time Stock amount to the Safety Stock amount and you will have the best reorder point for that item. This takes into account the most likely stock usage during the most likely delivery time, but also builds in a buffer, just in case. Ideally, using these calculations, you should never run out of product for your customer.
Calculating Your Reorder Points
This is a lot of information to take in, so let’s put it in action using the example of a “#1 Boss” coffee mug.
After adding up all the sales over the past month and dividing by 30 days, we get an average of 20 mugs sold per day. There was one day though where we sold 50 mugs. We will note these two numbers:
Average Daily Sales = 20 mugs
Maximum Daily Sales = 50 mugs
From there, look at all the deliveries (purchase orders and receipts) from the vendor over the past month, adding up the total number of days each delivery took and dividing by the total number of deliveries. The average delivery time was five days, but because of a holiday weekend there was one seven-day delivery period.
Average Lead Time = 5 days
Maximum Lead Time = 7 days
Then we’ll plug these numbers into our formulas —
Lead Time Stock=
20 Average Daily Sales x 5 Days Average Lead Time = 100 mugs
Safety Stock =
(50 Maximum Daily Sales x 7 Days Maximum Lead Time) − (20 Average Daily Sales x 5 Days Average Lead Time) = 250 mugs
Reorder Point =
100 Lead Time Stock + 250 Safety Stock = 350 mugs
Continuously Review Your System
A reorder point is not a set-it-and-forget-it task, since there are so many factors that change customers’ purchasing behavior. Sports stores will fluctuate between seasons. Grocers will see rises around holidays as their customers entertain at home.
As a good general rule, understand and review your safety stock and reorder point figures quarterly. Businesses like electronics distributors, however, will want to review these numbers more often as new products are released more frequently in that industry.
Aside from wanting to make sure each customer can buy the product they are looking for, it is perhaps more critical to be sure money is not tied into inventory that’s not going to move. Every dollar spent on inventory is a dollar not spent on marketing or growing the business. Set the right review schedule for your business and stick to it. Don’t be stuck with Pokemon shirts when Voltron becomes the new rage!