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In a business, you can't afford to run out of stock or hold too many items in your inventory. You need to maintain an equilibrium between ordering items at the right time and keeping the right number of items as buffer stock. This can be done with reorder points and the safety stock formula. Read on to find out how they are calculated and check out our reorder point calculator to get a hands-on experience.
(in units)
(in units)
(in days)
A reorder point is a threshold that helps you maintain the right inventory level. It's a tool for keeping tabs on the inventory level of your items so that you do not run out of stock. Whenever the item count reaches the reorder point, you get automatically notified and you know it is the right time to create a purchase order with your supplier. The threshold is calculated based on your historical average demand and safety stock.
1
A reorder point keeps your business from running out of stock
2
You order items at the right time, not too early or too late
3
It also optimizes your holding costs and cuts down the chances of overstocking
Safety stock is like an extra cushion for your business. Safety stock adds some comfort by keeping you safe from fluctuations in your sales numbers. To understand how safety stock works, imagine you have set the reorder point for your item at 20 units. When your item count reaches this point, you will create a new purchase order. But what if there is a delay on your supplier's end? You might run out of stock before you replenish the items. Safety stock ensures you have enough on hand to avoid such a situation. It covers the risk of unexpected delays and cuts down the chances of going out of stock. Let's look at an example :
1
Safety stock is an extra measure to keep your business safe from running out of stock
2
It saves your business from fluctuations and delays
3
It reduces the chances of turning down a customer request due to stock unavailability
In this illustration, everything runs perfectly. Once your reorder point is triggered, you raise a new purchase order, and the items arrive on time. In such cases, the need for safety stock will not be felt because there is no fluctuation or delay in transport
In this illustration, the goods are arriving a few days late. Since there was no safety stock, by the time the new items arrive the store, you have already run out of stock! In these cases, safety stock is very necessary because it will help you to fulfill the demand for customers even if there is a delay
This illustration is similar as the previous but in this you reorder your items when the item level drops down to 30 instead of 20. The additional 10 units is your safety stock and proves to be a cushion for you during such delays. With safety stock, the chances of going out of stock is relatively low.
There are three main components for calculating reorder point :
Demand
Lead time
Variability
Safety stock
The lead time and variability in demand together make up a major part of the reorder point formula. Once these two variables are calculated, you will get the amount of items you need to maintain as safety stock. When the safety stock number is added to the average demand, you have your reorder point.
Calculating your safety stock is a crucial part of finding your reorder point. Safety stock incorporates the fluctuations in supply and demand, which gives a more reliable reorder point. In the following section, we have explained each variable of the reorder point formula and how it's calculated, with special emphasis on safety stock.
Demand refers to the number of units that you sell to your customers in a given period of time. But the number changes every day, month, and year, so to arrive at a common figure, we calculate the average demand. If you are calculating the safety stock for a year, then your average demand will be :
Average Monthly Sales
=
Summation of monthly sales
12
Average Daily Sales
=
Summation of daily sales
30.42
Lead time is the time taken for the goods to arrive at your store or warehouse after they have been dispatched by your vendor. Lead time is usually expressed in days, but in our example, since we are calculating average demand for a month, we'll need to convert it to months :
Lead time (in days)
= 10
Average number of days in a month
= 30.42
Lead time (in months)
= 10/30.42
= 0.33 months
Variability, also known as standard deviation, captures the difference between the actual monthly demand and the average monthly demand. Standard deviation makes the calculation of safety stock more reliable and precise. It is important to calculate variability to understand the likely fluctuations in your demand or lead time.
