The reorder point or reorder level is a stock balance when a new purchase order should be issued to replenish inventory stock. In other words, it is the amount of inventory to be used during the lead time when stock will be replenished.
The formula to compute reorder point varies depending on the inventory’s consumption rate and amount of safety stock. In case of an inventory’s constant usage rate, the equation is as follows:
If a company doesn’t maintain safety stock:
Reorder Point = Daily Average Usage × Lead Time in Days
If a company maintains safety stock:
Reorder Point = Daily Average Usage × Lead Time in Days + Safety Stock
If an inventory’s usage rate is irregular and there isn’t any safety stock, the daily maximum usage should be used instead of the daily average usage.
Reorder Point = Daily Maximum Usage × Lead Time in Days
XYZ Ltd. is a structural steel retailer. The average daily sales of reinforcing bar is 25 tons. The inventory’s daily consumption rate is constant, and the lead time of 7 days is also constant. The management of XYZ Ltd. has refused to hold safety stock.
To compute the reorder point, we should put all data available in the formula above.
Reorder point = 25 × 7 = 175 tons
Let’s assume that XYZ Ltd. has irregular sales of reinforcing bar:
The lead time also varies between 5 and 9 days. To avoid disruption in sales, we should use both maximum daily usage and maximum lead time. Thus, the reorder point should be in tons.
Reorder point = 40 × 9 = 360 tons
As we can see, irregular daily usage forces companies to have more stock to avoid disruption in sales or production.
To avoid overstocking and an increase in cost, a company’s management can hold safety stock and use it to compensate for the extra usage of inventory.
Let’s consider Example 2 and assume that XYZ Ltd. has set up safety stock for an average usage of 5 days. Because the company has safety stock, it can use both average daily sales and average lead time to determine reorder point.
Reorder point = 25 × 7 + 5 × 25 = 300 tons
As we can see, the setup of safety stock allows holding a lower stock balance and reducing holding costs.
As we can see above, the reorder point depends heavily on the lead time. The longer it is, the earlier the new purchasing order should be placed. So the order cycle can be described as follows:
The maximum level of inventory equals the sum of safety stock and order quantity. When the stock balance reaches the reorder level, the new purchase order is placed. This balance is needed to operate during lead time. When the stock balance reaches the minimum level, the new order should be received, and the stock balance is replenished to the maximum level again. Then the following order cycle starts.
Safety stock is needed to avoid a shortage in inventory due to an increase in demand and/or a delay in delivery.