If you are a manufacturer, wholesaler, or retailer and have repetitive orders of the same products, you have undoubtedly asked yourself at what stock level you need to replenish your inventory. The goal is to reduce inventory levels while being able to fill most of the orders that come through the door. Here’s how.
When you place a purchase order with a supplier, it will take some time for the inventory to reach your door. This is called lead time. A local supplier’s lead time may be one to four days, while an overseas supplier’s may be four weeks. Therefore, you should have at least enough inventory to last during the lead time.
Many things can happen during the lead time period. The supplier may delay in delivering your order, for example, or you may get an unexpected bounce in sales. So in addition to having enough stock during the typical lead time, you should also keep a bit extra, known as safety stock.
The reorder point, therefore, is calculated as follows:
Reorder point = lead time demand + safety stock
Lead time demand is what you expect to sell during the lead time period and is calculated as follows:
Lead time demand = lead time (usually in days) x forecasted daily unit sales.
If the lead time is 14 days and the forecast is three units per day, for example, the lead time demand is 42 units.
To calculate the reorder point, you need to know forecasted daily unit sales. Some businesses know this exact number because they already have standing orders from their customers. Other businesses, such as retail, look at past sales to determine this number. When looking at past sales, consider seasonal fluctuations. For example, if you sell snow boots, you would not look at January sales when forecasting for July; you would base the forecast on the previous year’s July sales.
The final piece of the reorder point calculation is safety stock, which is that bit extra just in case. The calculations for safety stock can be simple or extremely complicated, depending on whom you ask. Many people opt for the simple solution:
Safety stock = lead time demand x 50%
This simply states that your safety stock is half of the lead time demand. So if the lead time demand is 42, safety stock is 21. So now you can calculate the reorder point, which is 63 (42 + 21).
Once you know the reorder point, you need to determine how much to order. This reorder amount should minimize inventory carrying costs. Inventory carrying includes interest, taxes, insurance, and temporary storage (not rent, which you must pay regardless of inventory level).
Reorder amount =
au = annual usage in units
oc = order cost
acc= annual carrying cost per unit
This formula looks more complicated than it is. The annual usage is an easy number. This is how much you sold or used in production in a year. The order cost represents the cost of processing a purchase order from quote to payment. For a small business, you can use $15; for larger businesses, use $30. For the annual carrying cost per unit, use the cost of the product multiplied by 10 percent.
Continuing from the previous example, let’s see the following values.
au = 1,000
oc = 15
acc = $2 ($20 cost of product x 10%)
= 123 units
So when the stock level reaches 63 units, you place a purchase order for 123 units.
The good news is that inventory software will do most of the calculations for you. But you should be aware of how these numbers are calculated to ensure that your input data (forecast, lead times, past sales, etc.) are properly entered.
Ian Benoliel is the founder and CEO of NumberCruncher.com, a developer of inventory and order management systems for small and medium-size wholesalers and manufacturers.