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How the reorder point formula can reduce stockouts in your inventory

Holding too much inventory ties up capital and eats into business profits with increased carrying costs. At the same time, not enough stock causes slow order fulfillment, the potential for missed sales, and lost revenue.

Reorder point (ROP) is a supply chain management technique that businesses can use to guide this delicate balancing act to improve inventory operations, avoid stockouts, and maintain ideal inventory levels.

What is the reorder point?

The reorder point is the minimum number of units a company needs to have in stock to fill sales orders or meet production targets. Once inventory dips below the calculated reorder point, replenishment is triggered through a new purchase order.

Regularly calculating reorder points removes the mystery from inventory cost control and helps your business maintain optimal service levels.

Why should your business know your reorder points?

Reorder points help to ensure products and cash flow in the right direction, at the right time. With accurate reorder points for all of your product SKUs, you can meet customer demand in a timely fashion to improve cash flow and avoid the bloated costs of overstock.

Primary business benefits of using reorder points include the following:

Cost control

Inventory carrying costs typically account for 15-30% of total inventory costs. This affects the profit margin on goods sold. By using the most optimal reorder levels, businesses can keep storage and warehousing costs low to protect profits.

Optimal inventory levels

By reordering a predetermined amount of replenishment inventory according to demand forecasts, you can avoid sunk costs from inventory shrinkage and obsolescence.

Supply chain optimization

The reorder point calculation takes into account delivery lead time from suppliers. By keeping track of average delivery lead time, you can identify your most reliable and least reliable suppliers and make more informed procurement decisions.

Improved forecasting

To accurately calculate reorder points, you’ll need to have strong records on sales volume and trends over a certain time period. As you build this body of data, you can improve forecasting to better meet customer demand.

Now, let’s see how to find the reorder point.

How does the reorder point formula work?

The reorder point formula takes into account three factors: average daily sales or usage, average delivery lead time, and safety stock.

Reorder Point = (Average Daily Usage x Average Lead Time in Days) + Safety Stock

First, let’s define all of the components that make up this equation.

Components of the reorder equation

Average daily sales or usage

Average daily sales is the average number of units sold or used per day over a defined time period. Three months or 90 days is a good starting increment to use. A retailer would measure the average number of units sold, while a manufacturer would calculate the average number of components used per day.

Let’s say you sold 40 units of an item in March, 60 in April, and 46 in May.

Over those three months (or 92 days) that averages out to 1.5 units sold on average per day.

Average delivery lead time

Average delivery lead time is the average amount of time it takes for a shipment to arrive from the time the order was placed. Average delivery lead time changes with fluctuations in seasonal demand, the quantity ordered, and distance from the up-chain supplier. For a reasonable measure, take an average of the past three months of POs for the SKU item you want to set a reorder point for. If your sales cycle is longer or shorter, adjust accordingly.

Safety stock

Safety stock is the amount of inventory a business holds to mitigate the risk of shortages or stockouts. The safety stock calculation is the difference between the maximum daily sales/usage and lead time, and the average daily usage and lead time.

(Max. Daily Usage x Maximum Lead Time) – (Average Daily Usage x Average Lead Time)

Let’s say a manufacturer used 10 units of a component on their busiest day of production. The longest time it would take the supplier to deliver this component is 15 days. And let’s assume that the average daily use is 1.5 units, and the average lead time is 12 days.

(10 x 15) – (1.5 x 12)

150 – 18 = 132 

The manufacturer should hold 132 safety stock units to avoid bottlenecks in production.

The reorder point formula in action

Now we’ve got all reorder point sub-metrics ready. Let’s continue with the manufacturer example and calculate the reorder point.

Reorder Point = (Average Daily Usage x Average Lead Time in Days) + Safety Stock

Average daily usage = 1.5 units

Average lead team = 12 days

Safety stock = 132 units

(1.5 x 12) + 132 = 150

Therefore, the manufacturer should reorder this component when stock falls to 150 units. By doing so, the company can prevent stockouts and avoid dipping into safety stock while they wait for new stock to arrive.

How to start using the reorder point formula in your business

If you have at least one procurement cycle and one sales cycle worth of data, you can start using the reorder point formula to improve your inventory operations.

Businesses with a limited number of products can start with excel spreadsheets and format cells to turn red when inventory levels reach the reorder point.

For growing retailersmanufacturers, or wholesalers, working with dozens or hundreds of spreadsheets can be time-consuming and error-prone. If your business falls into this category, consider the benefits of inventory management software.

A modern inventory management system can bring greater efficiency to inventory processes through automation and digital tools. For example, real-time inventory tracking allows staff to see what’s in stock, what’s on order, and where each item is located. Software tools can also collect and present data on purchase orders, sales fulfillment, and demand forecasting on a single user dashboard.

With this information readily available, inventory managers can avoid wasting time manually searching through spreadsheets and crunching numbers. Some inventory management tools also enable businesses to generate customized reports on inventory stock by item, vendor, delivery date, assembly, and more. Rich inventory insights like these empower businesses to fine-tune their reorder points and overall inventory management processes.

Final thoughts

Keep in mind, reorder points are not static. Sales volumes fluctuate, and supply delivery times vary. Demand for certain product lines may grow or fall.

To maintain an accurate reorder point, check the underlying metrics — average daily sales/usage and average lead time — at least once per quarter. If you have a high season and low season, or seasonal bad weather that slows down deliveries, factor this in.

An effective reorder point ensures that your business keeps flowing— it helps you fulfill orders quickly, protects your margins, and keeps customers happy.

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