Predicting an optimal amount of stock for varying costumer demands is a critical component in balancing an operation’s inventory system. Your inventory system should act as a reserve of products to meet your sales needs, while minimizing the amount of cash you have tied up in inventory.
One of the most widely accepted methods used for effective inventory management is the reorder point formula, a standardized formula that triggers the system the instant your inventory drops to the reorder point and places an order before you hit a stockout.
While the reorder point is customized to your business needs, the formula is always the same: Reorder Level = Safety Stock + Average Daily Usage × Lead Time.
With proper implementation, this system can help achieve a cycle of restocking for optimal inventory levels for small, medium, or big businesses.
The Reorder Point Formula
The reorder point allows for optimization and automation by creating a cycle of purchasing that keeps your inventory system stocked to meet consumer demand. It is a model designed to determine the standard deviations of unit demand and lead time for consecutive product replenishment. The longer the lead times are and the greater the variability of demand and lead times, the more safety stock is needed.
Safety stock (also called buffer stock) is a minimum level of stock maintained to prevent stockouts or shortfalls. Safety stock maximizes customer service by fulfilling requests for products in the time it takes to replenish inventory. It also protects you if the shipment exceeds the projected lead time or if there is a problem with manufacturing.
Average Daily Usage
Daily usage is the quantity of each item you sell on a normal distribution day. It’s always a good idea to consider fluctuations during holidays when calculating daily usage. If you are seasonal and only open a few months per year, divide the total sales by the days you are operational.
Lead Time in Days
Lead time is the period between the point of ordering stock and when it is delivered. The reorder level should be higher than zero to allow a lead time that will prevent stockouts. However, you need to take into account a number of variables when calculating your lead time.
There could be a defect with some of your stock that requires returns, the supplier may not have provided you with the correct product, or there could be unexpected delays with delivery. This is your future inventory, so an accurate estimation of lead time, plus a window of error, is critical to maintain specific service objectives.
Reorder Point Formula Example
Assume your company sells 100 bottles each day and your supplier takes five days to deliver the order. You also have a safety stock supply of 500 bottles. Based on the reorder formula (R=S+D×L) your level will be 3,000 units(R)=500(S)+100(D)×5(L).
Implementation of the reorder formula has worked in a variety of business environments. It’s a cost-saving method that can help prevent stockouts, missed opportunities in sales, and a possible interruption in your operational process.