Reorder Point

The reorder point is the quantity of an item remaining in inventory at which a new purchase or production order should be placed. It is set so that the replacement stock arrives just as the existing stock is about to run out. If orders are placed too late, the business risks a stockout and lost sales; if they are placed too early, it ties up cash in stock it does not yet need.

The reorder point answers the question of when to order. It is usually paired with the economic order quantity (EOQ) model, which answers how much to order. Both are standard tools in inventory management, purchasing and working capital planning, and most inventory software calculates reorder points automatically for each stock item.

When demand and delivery times are steady, the reorder point is simply the stock that will be used while waiting for the order to arrive. To protect against variation, a buffer called safety stock is added:

• $\text{Average daily usage}$ is the number of units sold or consumed per day.
• $\text{Lead time in days}$ is the time between placing an order and receiving the goods, as explained under lead time.
• $\text{Safety stock}$ is extra inventory held to cover higher than expected demand or late deliveries.

A hardware wholesaler sells an average of 40 boxes of screws a day. Its supplier takes 6 days to deliver. Without safety stock, the reorder point is 40 times 6, or 240 boxes. The wholesaler has found that demand sometimes reaches 55 boxes a day and deliveries can take 8 days. One simple way to size safety stock is:

Here the maximum figures describe a bad but plausible period and the average figures describe a normal one. Safety stock is 55 times 8, or 440, minus 240, giving 200 boxes. The reorder point becomes 240 plus 200, or 440 boxes. When the stock count in the perpetual inventory system falls to 440, a new purchase order is issued. If the EOQ is 1,200 boxes, average inventory will be about 200 plus 1,200 divided by 2, or 800 boxes. Larger businesses often use a statistical method instead, setting safety stock as a multiple of the standard deviation of demand during the lead time to reach a chosen service level, such as 95 percent.

Reorder points directly affect how much money is tied up in stock. Higher safety stock raises carrying costs of inventory, such as storage, insurance, financing and the risk of obsolescence. It also lowers the inventory turnover ratio and lengthens days inventory outstanding, which in turn affects working capital and the cash conversion cycle. Lower safety stock frees cash but increases the chance of stockouts, rush orders at premium freight rates and lost customers.

Businesses therefore set different reorder policies for different items. Under an ABC inventory system, high-value A items are reviewed closely with tight reorder points, while cheap C items may simply be kept in generous quantities.

The simple formula assumes demand and lead time are predictable and that stock records are accurate. Seasonal products, promotions, supplier disruptions and inventory shrinkage can all make a fixed reorder point unreliable, so it needs regular review. Businesses using just-in-time manufacturing aim for very small safety stocks, relying instead on close supplier relationships and frequent deliveries, which reduces carrying costs but makes them more exposed to supply chain shocks.