Reorder Point

Definition: The reorder point (ROP) or re-order level is a specified minimum level of inventory or stock of a particular product at which a firm decides to replenish or place a new order for that product. This new order (or reorder quantity) may be in the form of raw materials or finished goods.

Hence, a reorder quantity is the volume of goods ordered by a business to replenish its stock when the existing stock reaches a reorder point or level. It is crucial for an organized supply chain management.

The ROP is closely associated with the Economic Order Quantity (EOQ) model. Simply put, the EOQ is a model that tries to help businesses determine the optimal quantity of a product they should order at the lowest possible costs (for example, holding costs and order costs).

Content: Reorder Point

Reorder Point Explained

Every business unit must always keep a specified quantity of inventory (either raw materials or finished goods). This is essential to ensure daily operational efficiency in terms of production (in the case of raw materials) and sales (in the case of finished goods).

Thus, each business must adopt stock control measures that should help it to precisely determine when to order new inventory from suppliers. One such stock control measure is the reorder point.

If all the supply conditions are met, an optimal reorder point should ensure that the new orders are brought in just as the last of the old stock is used. For producers, this means that production activities are not disrupted. For traders, it helps to maintain an optimal stock of inventory.

Since the rate of demand differs for all purchase items, their reorder points will also be different. It can be said that the higher the demand, the more the reorder levels and vice-versa.

For example, assume a retailer stocks the same quantities of product A and product B. If the demand for product A is twice as high as that of product B, it follows that the reorder point for the former will be more than that of the latter, ceteris paribus.

The speed of supply (lead time) can also vary and lead to varying reorder points as well. Consider a firm that has a couple of suppliers for the same product. Assume that it takes supplier A four days to deliver the product and supplier B eight days. The reorder point for supplier A would be when the quantity of the remaining inventory can only meet four days demand. For supplier B, the reorder point will occur when the available stock can only satisfy the demand for the next eight days.

Assumptions of Reorder Point

Following are the various inferences kept in mind while determining a reorder point:

  • Constant rate of demand
  • Replenishment orders are placed when inventory levels reach the reorder point
  • Constant lead time
  • Orders are delivered per batch
  • Each batch of replenishment orders occurs at once

Properties or Components of Reorder Point

The main components of the reorder point are as follows:

  • The average daily demand or sales
  • The lead time, and
  • The safety or buffer stock

Reorder Point Formulae

To determine the reorder point, the company may or may not use the safety stock. Following are the two ways of calculation:

Without Safety Stock

The average daily demand and lead time are collectively referred to as the lead time demand. The formula is:

Reorder Point Without Safety Stock

Here,

Average Daily Demand: The average daily demand is simply the average number of units sold daily over a specified period. It is computed as:

Average Daily Demand

For example, assume that company A sold 738 units of a product between August 1 and October 31 2019. The average daily demand for the period is:

738 ÷ 92 = 8 units

Lead Time: The above-mentioned lead time is the time lag between the order and delivery of a product. It can also be calculated in average terms. However, to calculate the average lead time, there must be a record of previous lead times.

The formulae of lead time and average lead time are as follows:

Lead Time
Average Lead Time

For instance, the lead times for company A for three orders placed between August 1 and October 31 2019 are as follows:

  • August = 7 days
  • September = 9 days
  • October = 5 days

Therefore, the average lead time for company A = (7 + 9 + 5) ÷ 3 = 7 days

With Safety Stock

The company can measure the reorder point inclusive of the margin stock with the help of the given formula:

Reorder Point With Safety Stock

Here,

Lead Time Demand: Lead time demand can be calculated as follows:

Lead Time Demand

Note that both demand and lead time should be expressed in the same unit e.g. days, weeks, etc.

Safety Stock: The safety stock is a specific quantity of inventory that a business keeps aside to avoid a stockout “just in case” of sudden demand or supply shocks. For example, certain factors (say, seasonal factors) can cause a temporary surge in the demand for a product.

Also, an unexpected breakdown in a supplier’s production plant can extend the lead time of a placed order. In both instances, a company with a safety stock can temporarily cope with the variations in either demand or supply (or both).

The safety stock can be calculated by:

Safety Stock
  • Multiplying the maximum number of units demanded per day by the maximum lead time
  • Multiplying the average number of units demanded per day by the average lead time
  • Subtracting the result of the latter from that of the former

Where:

  • The maximum number of units demanded per day is the highest number of units of a product sold by a business in one day
  • The maximum lead time is the longest lead time recorded by a business
  • The average daily demand and average lead time are as described above

For instance, if the maximum number of units demanded per day is 14 and the maximum lead time is 9 days. Using the average daily demand and average lead time from above, the safety stock is:

(14 x 9) – (8 x 7) = 70 units

Note that not all businesses incorporate the safety stock into their reorder point calculations.

Examples

Without Safety Stock

Company A sells 8 units of a product each day, on average. It takes an average of 7 days for new orders placed by company A to be delivered. Therefore, the reorder point is:

8 x 7= 56 units

Hence, a new replenishment order should be placed for that particular item any time the existing stock decreases to 56 units.

With Safety Stock

If company A holds 70 units of the product as safety stock, then the reorder point will be:

8 x 7 + 70 = 126 units

Importance of Reorder Point

Though it seems to be a small term, reorder point is significant for smooth business functioning, in the following ways:

Importance of Reorder Point
  • Inventory management: It ensures that a business always maintains the most optimal stock level. This helps in avoiding holding costs associated with overstocking. It also prevents stockouts and their consequences such as loss of sales, angry customers, and others
  • Avoids Unnecessary Stocking: It helps prevent the sinking of capital into excess inventory.
  • Forecasting Tool: Businesses that frequently use the reorder point calculation are likely to be in a better position to accurately forecast trends in products demand and supply.
  • Space Management: It helps firms optimize their inventory space by reducing unnecessary stock maintenance.
  • Continuous Production: For producers, it helps to ensure that the production process continues without interruption.
  • Decision Making: It is a significant factor to consider when taking other business decisions like working capital allocation.

Criticisms of Reorder Point

When we think of disadvantages, the foremost points that comes in mind are as follows:

Criticisms of Reorder Point
  • Fluctuating Data: The reorder point concept assumes constant rates of demand and lead time. But both variables are likely to experience periods of fluctuations in reality. This can make it difficult to precisely calculate an appropriate reorder point.
  • Involves High Cost and Time: For companies with a vast number of stock-keeping units, calculating and managing each reorder point can be tedious and time-consuming (even with the use of modern software).
  • Unsuitable for Vast Product Category: Also, companies with a large product base may find it hard to sequence their reorder points and may have to fix them randomly. This is because, in such scenarios, the need to reorder does not necessarily follow any specific pattern.

Conclusion

The reorder point is one of the important techniques in inventory management. For traders (both wholesale and retail) it helps to determine the appropriate time to place new orders for inventory. For producers, it helps to ascertain when to source for and produce finished goods.

 It should be noted though that change is a constant factor in the reorder point concept. This is because each of its variables is bound to change with time.  For most firms, the reality is that the reorder point for each product will change from time to time, especially according to demand and supply conditions.

Thus, it is necessary to review reorder points periodically, for example, after every quarter or a couple of quarters. The greater the data a firm has on previous demand and supply, the brighter the chances of calculating an optimal reorder point.

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