Maximize inventory and capital with the right reorder point

Maximize inventory and capital with the right reorder point

The reorder point is the most important thing when it comes to purchasing from a vendor. It enables you to maintain the right stock in your warehouse.  If your reorder points are not frequent enough, you will have lost sales. Also, if they are too far apart, inventory will accumulate and you will have unnecessary capital tied up in inventory that doesn’t move.

In this article, I will explain what reorder points are, why they are important, and how to calculate them.

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What is a Reorder Point?

The reorder point (ROP) is the level of inventory that triggers an action to replenish that particular inventory stock. It is a minimum quantity of an item that a company holds in stock so, when stocks drop to this quantity, the item must be reordered.

For example, if you have 300 candy cases in stock, the reorder point is 200 and the reorder quantity is 150. It means that, when the stock reaches 200 cases, you must order 150 cases.

Why are reorder points important?

Reorder points (ROP) make sure that you always have enough stock of each SKU to meet your customers’ demands. However, you must be very careful when selecting the ROP; if you set it too low, you risk running out of stock, but if you set it too high, you risk tying up excess capital in inventory.

Calculating reorder points goes hand in hand with having a clear idea of buying and selling trends over a given period. The more data you have for each SKU, the more accurate your expected demand, reorder point, and reorder quantity will be.

How to calculate a reorder point?

Maintaining proper inventory levels is a delicate balance between consumer demand and supplier reliability. As mentioned before, storing too much inventory eats up your budget in terms of warehousing costs and available capital, but you also need enough inventories to account for unexpected demand or supply problems. The standard formula to calculate the ROP is:

reorder point formula
Reorder point formula

Where:

Daily Average Usage is the quantity sold of that SKU over a period divided by the days of the period.

Lead Time is the average time taken by the supplier to deliver the product to your warehouse from the moment you placed the order. You must take into account not only the manufacturing time but also the transportation time and customs clearance time if applicable. For example, the lead time for a PO of candy placed to a domestic supplier with the timings shown in the illustration below is 40 days (just add up all the times). This means that you need to have enough stock on hand to cover these 40 days of sales.

Lead time
Lead time calculation

Safety Stock is a contingency quantity to cover unexpected events and maximum deviations for sales and lead times. The standard formula is:

Safety stock = (Maximum Sales * Maximum lead time) – (Average Sales * Average lead time).

Continuing with the same example, suppose that, on an average day, you sell 100 boxes of candy. But on weekends, you can sell as many as 150. As for lead times, their usual lead time is 40 days, but in peak seasons it can climb as high as 60 days. Then the safety stock will be:

(150 x 60) – (100 x 40) = 5,000

This means that you need to have about 5,000 boxes of safety stock on hand to guard against the unexpected.

With the data in this example the Reorder Point for the candies is:

4,000 (Lead time demand or 100 x 40) + 5,000 (safety stock) = 9,000

So, once the stock hits 9,000 boxes of candy, you need to place a new order for 4,000 units. At 9,000 boxes, you have enough stock to last until the new order arrives, while holding enough stock (5,000) as a buffer against an unexpected increase in demand or supply chain problems.

What is missing?

So we now know how to calculate the ROP to cover the demand of an item even in contingent situations. But what many distributors fail to ask is: Is this vendor profitable? The answer to this question is what I call the Vendor’s Financial Cycle (VFC). The VFC is the capital resource that you have to commit to pay the vendor´s bills on time. A vendor with a positive VFC is an ally that helps you grow your business; whereas a vendor with a negative VFC drags down your capital. Let me illustrate the concept with an example. I already addressed this issue on https://www.laceupsolutions.com/are-my-vendors-helping-me-a-guide-to-vendor-selection/.

I hope this article has been helpful. I will continue to publish information related to Warehouse Management, distribution practices and trends, and the general economy. If you are interested in this article or would like to learn more about Laceup Solutions, register to keep you updated on future articles.

You can also watch this related video

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