Reorder Point Basics.

Reorder Point is the signal to order more inventory used in many companies. To better understand reorder point, you need to understand the difference between the mechanics of a system (computer software) that uses a reorder point, and the method to calculate reorder point. This is important because almost all inventory software has the functionality to use a reorder point, but very few do a good job of calculating reorder point.

So let’s start with the mechanics of using a reorder point. The basic definition of reorder point is demand during the lead time plus safety stock. This brings up the first issue. Based on the definition of the calculation, you would reorder something when inventory drops below the reorder point. However, some systems will trigger a reorder when an item is “at” or below reorder point. You need to understand how your system uses the reorder point, before you start using it. This is especially true with very slow movers. For some very slow movers, you only want to keep one in stock, and reorder whenever you sell that one. If your system triggers reorder when inventory drops below the reorder point, you would set the reorder point to One. However, if your system triggers an order when you are at your reorder point, you would need to set it to zero. But first, you would need to see how your system reacts to a reorder point of zero, because some may see a zero reorder point as an item you don’t want to stock.

You also need to understand what your system is comparing reorder point to. What it should be doing is comparing it to on-hand plus inbound (on purchase orders or production). It may also subtract current allocations, such as open sales orders or production orders (for components or raw materials).

Understanding Lead Time.

Before we go any further, we need to understand lead time. More specifically, we need to understand what we need to use as lead time to get inventory in stock prior to need. For these purposes, lead time would be the time from first being aware you need to reorder, to when the item is in stock and available for sale. I typically refer to this as Effective Lead Time because it is not the same as the vendor lead time. If you ask your vendor what the lead time for an item is, he’s going to tell you the time from when he receives your order, to when he ships the item. Let’s say that is 5 days. But, if your inventory drops below reorder point on Monday, will you have the inventory in stock on Friday? If your vendor is next door and you immediately notify him of the order, maybe.

Let’s start at the beginning and look at how much time it takes from the time an item drops below reorder point, and you actually notify the vendor of your order. Many companies do not place orders every day, or at least not for all vendors. There are valid reasons for this, so let’s assume we only review and place orders for this vendor once a week. This is called the Review Period and needs to be added to the lead time. Think about it this way, if we place an order every Tuesday morning for this vendor, if something drops below reorder point Tuesday afternoon, our next opportunity to order it will be the following Tuesday. Even if you do place orders every day, you will probably need to add a day for the review period, unless you are being notified in real-time when inventory drops below reorder point and you immediately place an order.

Next, we need to look at how long it takes from the time the vendor ships, to the time we have it in stock. This obviously has to include transportation time, but that’s not all. Transportation time will cover the time until it arrives at your dock, but unless your people are waiting at the dock for it and immediately do the receipt transaction to get it in stock, you need to add receiving time. If the item doesn’t go into inventory until you put it away, you will also need to include putaway time. I will warn you at this point that while it’s important to consider all of this, you also need to consider what this will do to your inventory investment. Longer lead times will result in an increase in inventory investment, so there is a strong case to be made for reducing the amount of time it takes for all these additional tasks.

Ultimately, our 5-day vendor lead time turned into a 3-week effective lead time. That is what we need to use for the next step.

Understanding Demand During Lead Time.

While this sounds rather self-explanatory, but demand can get a little complicated. When we talk about demand during lead time, we are talking about the forecast future demand during the lead time period. This doesn’t necessarily mean you need a formal forecast. Most businesses using a reorder point to order just use the average of their historical demand. So if we have the following for weekly demand

we have an average weekly demand of 25 units. With our 3-week lead time, that gives a demand during lead time of 75 units. Therefore by calculating the average weekly demand, we are calculating our forecast even though we probably don’t think we are forecasting. It’s important to note that the forecast here is the quantity we are likely to sell, not the quantity we may possibly sell. If you look back at our history, you can see that most weeks, we sold more than 25 units. But we need to use 25 units in our demand during lead time calculation.

I should note here that using a simple average demand calculation for a forecast may not be the best estimate for you. If you have a trend, a weighted moving average or exponential smoothing may perform better, and if you have significant seasonality, you’ll want to incorporate that into your demand forecast.

Safety Stock.

Next, we need to calculate Safety Stock. Safety stock is used to account for demand variability, which would be those periods that have more than 25 units in sales. Once again, most businesses opt for a simple safety stock calculation like adding half the lead time demand or adding another week’s demand to the reorder point. I am a strong proponent of using a statistical safety stock calculation to get the greatest performance from the least amount of inventory. You can click the previous link to read my article on safety stock, or for more detail, check out my book Inventory Management Explained.

Our statistical safety stock calculation gave us 13 units of safety stock. Therefore our reorder point is demand during lead time of 75 units plus safety stock of 13 units to get us a reorder point of 88 units. That’s what we enter in the reorder point for this item in our inventory system; assuming our system initiates an order when we drop below reorder point, if it initiates an order “AT” reorder point, we will enter 87 units for reorder point.

Therefore, every Tuesday, when we review items for this vendor, if our item has on hand plus inbound of 87 units or less, we will order more.

Fixed Reorder Point versus Dynamic Reorder Point.

I just want to cover this briefly. What has been described in this article so far has been a Fixed Reorder Point system. That means that you calculate a reorder point, enter it in your inventory system, and it uses that repeatedly until you change it.

Dynamic reorder point implies the reorder point is not fixed. Typically, this means that the reorder point is calculated as it is needed. For this to happen, you need a more detailed forecast. When items are reviewed for reorder, a “Dynamic” system will look at the lead time and calculate the lead-time demand based on the lead-time period in the forecast. Therefore, for the item with a 3-week lead time, it would look at the next 3 weeks of the forecast and the sum of that forecasted demand. This is especially useful when you have significant seasonality or trend, because the next 3 week’s demand may be dramatically different from the most recent demand. These systems still basically calculate a reorder point, but you don’t actually see a reorder point in the system. They are just using the forecasted demand to create a reorder point that more accurately reflects what you expect to experience. They still need a safety stock quantity though; and that probably is fixed. My experience with inventory management software is that they do a pretty lousy job of actually generating/calculating a forecast, safety stock, or reorder point. While many of them try, the results are usually less than effective.

The good news is they generally do a good job of using a forecast, safety stock, or reorder point, and will often make it easy to import your own. So the best way to use a system with dynamic reorder points is to calculate your own forecast and safety stock quantities in excel, import them into your system, and let it do its thing.

What is an Optional Reorder Point?

Some systems have a place to enter an optional reorder point. Typically, this is just a value you can use for whatever purposes you need. For example, you may have an optional reorder point that is set higher than your normal reorder point when you place overseas orders and need to fill a container. You start by putting together a purchase order for the items that are below reorder point; then if you still have space to fill, you look at items that are below the optional reorder point. This helps to prevent you from ordering more of the stuff you already have plenty of. Similarly, if you are a manufacturer, you can use optional reorder point when you have excess capacity to fill.