The Reorder Point
The reorder point formula is:
Reorder point = purchase lead time consumption + safety stock =average unit sales per unit of time * delivery lead time+ safety stock=average unit sales per unit of time * delivery lead time + excess demand expected x purchase order lead time.
The reorder point (ROP) is the level of inventory which triggers an action to replenish that particular inventory stock. When there is uncertainty in the demand or completion cycle, appropriate safety stocks must be used to buffer or compensate for uncertainties.
Several factors determine the delivery time for inventory and safety stock. In short, the efficiency of the replenishment system will affect how long the delivery time will take. Since the delivery time inventory is the expected inventory usage between ordering and receiving inventory, effective inventory replenishment will reduce the need for delivery time inventory. The determination of safety stock levels involves a fundamental trade-off between out-of-stock risks, resulting in possible customer dissatisfaction and sales losses, as well as increased costs associated with carrying additional stock.
For example, you manage a electronic components store. One of your products is a kind of ICs. You decide to use one day as your unit of time. Your weekly demand level is 7000 ICs. Your purchase order lead time is seven days and your safety stock is 1000 ICs. Here is your reorder point for ICs:
Reorder point = 7000 units x 7 days + 1000 safety stock
Reorder point = 50000 units
When your inventory level falls to 50000 units, you order more ICs. You want to make sure that you don’t run out before your next order arrives.
Safety stock (also known as reserve inventory) is the amount of inventory held at all times. You maintain the safety stock inventory, regardless of the purchases you make using EOQ. This inventory serves as a buffer against stockouts.
You maintain a safety stock to address uncertainty in the ordering process. There are several uncertainties related to purchases and inventory levels:
Demand: If actual demand is higher than planned, you can sell your safety stock and avoid a stockout.
Purchase order lead time: You might have a longer lead time than planned. Maybe your order takes four weeks to be delivered, rather than three weeks. If the increased lead time sharply reduces your inventory levels, you can sell your safety stock.
Suppliers: Safety stock can help you meet demand if a supplier can’t deliver your required purchase. A supplier may run short of product. An unusual situation (weather, or material shortage, for example) may prevent the supplier from making or shipping your product in a timely manner.
Safety stock is computed as
Safety stock = excess demand expected x purchase order lead time
Say you manage a backpacks store. As you set up your back-to-school store displays, you mull over creating a safety stock. You start by checking weekly sales from previous years, and you notice that the higher sales level has happened several times; sales have been 100 units higher than your weekly planned sales. You determine that safety stock should be 100 backpacks.
The purchase order lead time for the red mountain backpack is three weeks. Based on the data, here’s your safety stock:
Safety stock = 100 backpacks per week x 3 week lead time
Safety stock = 300 backpacks
You plan to hold 300 backpacks in stock in addition to your regular inventory level. The 300 units are your hedge against a spike in demand or a supplier’s delay in shipping product to you. If something unusual happens, you’re still able to fill orders. Note that your safety stock is a separate calculation from economic order quantity.
Now you must have a good understanding of the reorder point.
Thanks for reading.