Reorder Point of Inventory

Companies that deal in physical stock must always keep their stock replenished to generate revenues. It is crucial to do so as customers will require suppliers to provide their supplies whenever needed. However, the same may not apply to all companies as some may deal on a job-basis. Nonetheless, for most other companies, maintaining a specific level of inventory is crucial.

There are several ways in which companies may decide how much inventory to keep at a given time. Usually, companies set a range for the acceptable level of stock that they must maintain. There are several factors that a company’s management may consider when deciding on that level. Based on that level, they may also set a reorder point.

What is Reorder Point?

A reorder point is a level at which companies replenish their inventories. As mentioned, there are several factors that may play a role in deciding an optimum inventory level and a reorder point. A company’s policies will play the most significant part in this decision. For example, some companies may not need any inventory at all and will operate on a need basis. These companies can use a Just-In-Time system, which doesn’t require any physical stock.

For other companies, however, the reorder point will depend on the suppliers as well. For example, if suppliers take a long time to fulfill orders, their customers will have a higher reorder point. It is known as lead times. Some companies will also factor in a safety stock or minimum stock they would like to maintain for unforeseeable circumstances when making a decision.

Overall, a reorder point represents the units that trigger the purchase of new stock for companies. Therefore, it refers to the minimum unit quantity that companies have available before they reorder from suppliers. Usually, companies use dedicated software to track their inventories and warn them when they reach the reorder point.

READ:  Journal Entry for Bonds

How do Companies Calculate Reorder Points?

The formula for the reorder point is straightforward. It is the sum of a company’s safety stock and the demand during lead time. The formula is as below.

Reorder Point = Demand during lead time + Safety stock

However, each of these represents different aspects of inventories that companies must consider.

Demand during lead time

Demand during lead time is the product of a company’s lead time and its average daily sales. It represents the time it takes suppliers to deliver stocks and the sales a company makes during these days. When considering a reorder point, it is crucial to include demand during the lead time in the calculation. The longer the lead time from suppliers is, the higher the reorder point for companies will be.

The formula to calculate demand during lead time is as below.

Demand during lead time = Lead time x Average daily sales

Safety stock

Companies also maintain safety stock if there is a sudden increase in demands or suppliers fail to deliver on time. While estimating the demand during lead time can be crucial, keeping a safety stock is also critical in high-risk businesses. The calculation of safety stock includes various factors that companies must consider. The formula for safety stock level is as below.

Safety stock level = (Maximum daily orders x Maximum lead time) – (Average daily orders x Average lead time)

Therefore, the safety stock level represents the difference between the maximum anticipated demand and the average demand. Companies use this level to determine how much inventory they will need if the demand is at its peak. Some companies may also consider other factors when deciding on the safety stock levels.

READ:  True Up in accounting: What is It?

Example

A company, Orange Co., wants to establish a reorder point for its inventories. Currently, the company anticipates an average daily sales of 100 units per day. Orange Co.’s suppliers offer lead times of 5 days per delivery. Similarly, the company has calculated its safety stock level at 250 units. Therefore, Orange Co.’s reorder point will be as follows.

Reorder Point = Demand during lead time + Safety stock

Reorder Point = (5 days x 100 units per day) + 250 units

Reorder Point = 750 units

What is the Importance of Reorder Point?

Reorder point of inventory is crucial for several reasons. Firstly, it increases the company’s profits and helps it secure more customers. Companies that have physical stock available at all times are likely to make more sales than those that don’t. Similarly, it can be beneficial in preventing or minimizing stockouts.

Reorder point of inventory is also crucial in minimizing costs. Since there are handling, storage, and order costs associated with inventories, companies can decrease these with reorder points. Similarly, reorder points are helpful in budgeting in forecasting. It also allows for the smooth running of operations and results in better efficiencies.

Conclusion

Reorder point refers to the level at which companies must reorder new stock. Usually, companies consider their lead times, demand, and safety stock when establishing a reorder point. Companies that use reorder points obtain several benefits. These include maximizing sales, avoiding stockouts, minimizing costs, and helping in forecasts.

Scroll to Top