Inventory management is crucial in supply chain businesses. Balancing stock levels is a significant factor that can make or break a business. In 2013, the American giant Target launched its expansion into Canada. Unexpectedly, the company encountered inventory management challenges. Inefficient supply chain systems resulted in widespread stockouts, while other products were overstocked. This misalignment between supply and demand and inaccurate product data resulted in colossal financial losses and tarnished Target Canada’s reputation, eventually forcing it to exit the market in 2015.
Supply chains often face the challenge of balancing the need to avoid stockouts while minimizing excess inventory. Adopting a systematic approach to this issue can help reduce costs and alleviate stress, ensuring inventory levels align with customer demand. Once your inventory system is established, clearly understand when and how much to order. This can be efficiently managed using an inventory system called reorder points.
Reorder points signal when it’s time to place a new inventory order, helping prevent stockouts. It usually triggers the procurement of a specific quantity of replenishment stock. Ideally, your new inventory should arrive as the existing stock is depleted, assuming that purchasing and supplier fulfillment proceed smoothly. This approach ensures that production and fulfillment processes remain uninterrupted, maintaining optimal inventory levels.
How Reorder Points Optimize Inventory Management
Reorder points enable a supply chain company to reorder inventory swiftly and confidently using data rather than starting from scratch each time. This straightforward, rule-based approach streamlines inventory management, saving time and reducing costly errors.
Balancing the conflicting needs of inventory management can help a business operate more efficiently. Setting and using reorder points for inventory replenishment minimizes the risk of both excess stock and stockouts. Ordering too early can lead to surplus inventory, some of which may still need to be sold. Waiting too long to reorder can result in stockouts due to delays between placing an order and receiving the items. Properly managing this balance ensures smoother operations and reduces potential disruptions.
In today’s world, perfect information is unattainable, and rising costs and increasing customer demands complicate inventory management. In an ideal scenario, restocked items would arrive exactly when needed without excessive fulfillment or holding costs. However, the reality is that logistical constraints, such as a limited number of delivery trucks, prevent single orders from being delivered on demand. Even if a large fleet were available, immediate delivery would still be unfeasible, and the costs would be prohibitively high for small online merchants.
Businesses often place large orders in advance to prepare for future demand. Retailers maintain “safety stock” or extra inventory to manage anticipated customer flow and account for variability and uncertainty. This buffer helps address sudden spikes in demand or unexpected market changes, ensuring customer needs are met even in fluctuating conditions.
Reorder points determine when to restock inventory by accounting for lead times and potential operational delays. Ideally, you should place a reorder when your inventory reaches a level approaching depletion. This ensures that by the time your replenishment order arrives, you will be close to running out of your safety stock or have nearly exhausted your inventory.
Variables to Calculate Your Reorder Points
Reorder points serve as thresholds or triggers for inventory management. When stock reaches the level set by the reorder point, it’s time to take action. This process can often be automated, but it’s wise to have staff verify the reorder for large transactions or when not simply restocking from your warehouse. Reorder points help simplify and streamline the decision-making process for when to replenish inventory.
Using reorder points is straightforward, especially with an inventory management system that provides real-time visibility. You simply place new orders when inventory reaches the reorder point. The more complex aspect is calculating these reorder points, which depends on various factors influencing the calculation.
A basic reorder point calculation involves three key variables. This assumes your business purchases inventory for resale rather than for manufacturing products.
Daily Sales Velocity
How many items do you sell daily? To determine this, calculate your total sales over a specific period. For example, if you run an online store selling OLED TVs and sold 180 units between January and March 2023, this data helps establish your daily sales rate.
To determine your daily sales velocity, divide the total sales quantity by the number of days in the sales period. For example, with 180 TVs sold over 90 days, the calculation is:
180 TVs ÷ 90 days = 2 TVs sold per day
Therefore, your business averages 2 TV sales each day.
Lead Time
Lead time measures when an item is procured, fulfilled, and sold to a customer. It should be measured using the same time unit as your sales velocity. Ensure you have multiple purchase orders to verify this data. Shipping times can vary based on order size—larger orders may take longer. Additionally, compare lead times during peak and off-peak seasons to understand how timing affects fulfillment.
Let’s apply this to our previous example to calculate lead time. If you ordered a new stock of TVs from January to March and the total delivery time was 16 days for three orders, divide the total delivery time by the number of orders to find the average lead time. This gives you an average lead time of 5.3 days for your OLED TVs.
In this case, we’re considering the lead time for the vendor as a whole rather than individual items or multiple receiving locations.
Safety Stock
Buffer or contingency inventory serves as extra stock to handle unexpected situations, such as sudden spikes in demand or unforeseen delivery delays. This inventory acts as a safeguard and requires its own calculation. Including this buffer in your reorder point computation helps account for uncertainties.
You must factor in lead time and average daily sales to determine your safety stock. For instance, if your business experienced a sales surge in January and has 14 days’ worth of extra stock, calculate your safety stock by multiplying average daily sales by lead time. Using our previous example of 2 TVs sold per day and 14 days, your safety stock would be 28 units.
Reorder Point Calculation Formula
With all variables now established, we can proceed to calculate the reorder point.
Reorder point = (daily sales velocity) × (lead time in days) + safety stock
Reorder Point Calculation:
To calculate the reorder point, use the formula:
\[ \text{Reorder Point} = (2 \times 5.3) + 28 = 39 \text{ units} \]
When your inventory level reaches 39 units, it’s the optimal time to place a new order. Despite a low daily sales volume, the extended lead time significantly impacts reorder points. Ordering replenishment stock promptly minimizes the risk of stockouts. Balancing inventory availability with financial investment is crucial, as maintaining a higher stock level requires more capital.
The reorder point calculation does not determine the quantity of products to order. This is addressed by a separate calculation called the Economic Order Quantity (EOQ). Reorder points simply indicate when to reorder. Implementing systems like Just-In-Time (JIT) or Material Requirements Planning (MRP) can further streamline inventory management by ordering stock only as needed.
Takeaway
Reorder points are a practical method for ensuring you have adequate inventory to meet customer demands without overstocking, which can be costly and cumbersome. By refining your calculations, you can transform inventory management from a complex task into a smooth, automated process that requires minimal oversight. Establishing well-calculated reorder points can enhance efficiency and provide long-term benefits.
Aratum provides robust solutions for managing multiple reorder points across various items. Our inventory management software allows you to monitor thresholds and streamline platform integration. Book a demo to discover how Aratum can optimize your inventory practices.
The featured photo of this article was sourced from Tima Miroshnichenko on Pexels.
