Reorder points

What Are Reorder Points?

A reorder point is a specific inventory level that signals when a new order for a particular product or component should be placed to replenish stock. This critical metric falls under the broader umbrella of inventory management, a discipline within supply chain operations. The primary goal of establishing a reorder point is to prevent stockouts, which can lead to lost sales and decreased customer satisfaction, while simultaneously avoiding excessive inventory that ties up capital and incurs unnecessary carrying costs. By using a carefully calculated reorder point, businesses can maintain an optimal balance of inventory, ensuring continuity of operations and efficient resource allocation.

History and Origin

The concept underpinning reorder points has its roots in the early development of modern inventory control systems, which gained prominence in the early 20th century. While manual tracking and rudimentary methods of managing goods existed for millennia, the formalization of inventory models began to emerge with the rise of industrial production. A pivotal development was the Economic Order Quantity (EOQ) model, first introduced by Ford W. Harris in a 1913 paper titled "How Many Parts to Make at Once."⁸ This groundbreaking work provided a quantitative framework for determining optimal order sizes to minimize the total of ordering and holding costs. The principles established by Harris, particularly the focus on balancing costs and ensuring timely replenishment, laid a foundational groundwork for subsequent inventory management techniques, including the development and widespread adoption of the reorder point as a practical operational tool. The evolution of inventory management has seen significant technological advancements, from early mechanical systems to modern web-based and cloud-based solutions, all aiming to improve efficiency and accuracy in tracking and managing goods.⁶, ⁷

Key Takeaways

• A reorder point indicates the precise inventory level at which a new order should be placed.
• Its main purpose is to prevent stockouts while minimizing holding costs by optimizing inventory levels.
• The calculation typically considers average daily demand, lead time, and a predetermined safety stock level.
• Effective use of reorder points streamlines procurement and enhances operational efficiency within a supply chain.
• Modern enterprise resource planning (ERP) systems often automate reorder point calculations and alerts.

Formula and Calculation

The basic formula for calculating the reorder point is:

$\text{Reorder Point} = (\text{Average Daily Demand} \times \text{Lead Time}) + \text{Safety Stock}$

Where:

• Average Daily Demand: The average number of units of a product sold or used per day. This can be derived from historical sales data or demand forecasting.
• Lead Time: The number of days it takes for an order to be delivered once it has been placed. This includes all stages from order placement to goods receipt.
• Safety Stock: An additional quantity of inventory held to prevent stockouts due to unexpected demand fluctuations or delays in lead time. It acts as a buffer against uncertainty.

This formula ensures that there is enough stock on hand to cover the expected demand during the lead time, plus an extra cushion for unforeseen circumstances. The careful determination of these inputs is crucial for effective inventory optimization.

Interpreting the Reorder Points

Interpreting the reorder point means understanding its role as an actionable trigger within an inventory system. When the quantity of a particular item in stock drops to or below its calculated reorder point, it signals the need for procurement to initiate a new purchase order. For example, if a company's reorder point for a specific finished goods item is 200 units, then as soon as the inventory count reaches 200, an order should be placed.

This metric helps businesses strike a balance between meeting customer demand and controlling ordering costs and carrying costs. A reorder point that is set too low risks frequent stockouts, while one that is too high can lead to excessive inventory, increased storage expenses, and potential obsolescence. Businesses often rely on inventory control software to monitor stock levels in real-time and automate alerts or even order generation based on established reorder points.

Hypothetical Example

Imagine a small electronics retailer, "TechGadgets," that sells a popular model of wireless headphones. The store's management wants to implement a reorder point strategy to ensure they never run out of stock.

• Average Daily Demand: TechGadgets sells, on average, 10 units of these headphones per day.
• Lead Time: Their supplier typically takes 7 days to deliver an order from the moment it's placed.
• Safety Stock: To account for unexpected spikes in demand or potential shipping delays, they decide to keep a safety stock of 20 units.

Using the reorder point formula:

$\text{Reorder Point} = (10 \text{ units/day} \times 7 \text{ days}) + 20 \text{ units}$
$\text{Reorder Point} = 70 \text{ units} + 20 \text{ units}$
$\text{Reorder Point} = 90 \text{ units}$

Therefore, when the inventory of wireless headphones at TechGadgets drops to 90 units, the store should immediately place a new order with their supplier. This ensures that by the time the new shipment of headphones arrives in 7 days, they will still have at least 20 units remaining, preventing any disruptions to sales. This process helps the retailer manage both their raw materials and work-in-progress effectively, if they were to assemble the headphones themselves.

Practical Applications

Reorder points are a fundamental tool across various industries for managing physical inventory. In retail, they ensure that shelves remain stocked with consumer goods, preventing lost sales and enhancing the shopping experience. Manufacturing companies use reorder points for components and sub-assemblies to maintain continuous production flows, preventing costly line stoppages. Even service-based businesses that rely on consumables or spare parts, such as automotive repair shops or medical clinics, utilize reorder points to manage their critical supplies.

In the context of broader economic trends, supply chain disruptions, such as those experienced during and after the COVID-19 pandemic, have highlighted the increased importance of robust inventory strategies, including the dynamic adjustment of reorder points and safety stock levels.⁵ Businesses are increasingly looking to technology, including advanced analytics and automation, to improve the visibility and management of their supply chains, directly impacting the effectiveness of reorder point systems.⁴ For instance, the Federal Reserve actively monitors supply chain bottlenecks as they can significantly impact the availability of goods and contribute to inflationary pressures in the economy.³

Limitations and Criticisms

While reorder points offer a straightforward and effective method for inventory control, they are not without limitations. The basic reorder point formula assumes relatively stable demand and lead times. In environments with highly volatile demand, erratic supplier lead times, or significant seasonality, static reorder points may lead to either frequent stockouts or excessive inventory. Maintaining adequate working capital to support the inventory levels indicated by reorder points can also be a challenge for businesses, especially smaller ones.

Moreover, the model can be less effective for products with short shelf lives or those subject to rapid technological obsolescence. Critics also point out that relying solely on a fixed reorder point may not fully account for external factors like global economic uncertainty or unforeseen supply chain shocks, such as geopolitical conflicts or natural disasters.² For example, while traditional inventory management models often provide theoretical perfection, they may prove less suitable in the practical context of specific firms due to their restrictive assumptions.¹

Advanced inventory management systems often incorporate more complex algorithms, machine learning, and real-time data feeds to dynamically adjust reorder points, addressing some of these traditional limitations. Concepts like Just-in-Time (JIT) inventory, which aims to minimize inventory holdings, present a different philosophy that seeks to reduce reliance on large safety stocks and frequent reorder triggers, though JIT also has its own sensitivities to supply chain volatility.

Reorder Points vs. Economic Order Quantity

Reorder points and Economic Order Quantity (EOQ) are both crucial concepts in inventory management, but they address different questions:

Confusion often arises because both are integral to effective inventory control. The reorder point tells you when your stock reaches a level that necessitates replenishment, while the EOQ tells you the ideal size of that replenishment order to be placed at the reorder point. They work in tandem: once the reorder point is hit, the business places an order for the quantity determined by the EOQ calculation.

FAQs

Q1: What happens if a business doesn't use reorder points?

Without reorder points, businesses risk running out of stock unexpectedly, leading to lost sales, dissatisfied customers, and potentially expensive rush orders. Alternatively, they might overstock, tying up capital and incurring high storage costs. Implementing a structured approach to inventory tracking helps avoid these issues.

Q2: How often should reorder points be reviewed?

Reorder points should be reviewed periodically, especially when there are significant changes in demand patterns, supplier lead times, or business objectives. Factors like seasonality, new product introductions, or changes in supplier reliability can necessitate adjustments. Many businesses integrate this review into their regular forecasting and planning cycles.

Q3: Can reorder points be automated?

Yes, most modern inventory software and ERP systems allow for the automation of reorder point calculations and alerts. Some advanced systems can even automatically generate purchase orders when a reorder point is reached, streamlining the procurement process and reducing manual effort.

Q4: Is safety stock always necessary for calculating a reorder point?

While it is technically possible to calculate a reorder point without safety stock, doing so significantly increases the risk of stockouts. Safety stock acts as a crucial buffer against uncertainties like unexpected demand surges or delays in delivery, making it a critical component for reliable inventory management.

Q5: Do reorder points apply to all types of inventory?

Reorder points are most commonly applied to independent demand items, such as components, raw materials, or finished goods that are consumed or sold directly. For dependent demand items (parts used in the production of another item), other planning methods like Material Requirements Planning (MRP) are typically used.