Reorder Point
Figuring out the right quantity of inventory to order is very important. If we don’t keep enough inventory at our warehouse, then we won’t have enough to fulfill all of our orders. If we keep too much inventory, then we will spend too much on storage costs, or we will have obsolete inventory.
A key question for managing inventory is, “At what point should we order more inventory?” In other words, what is our reorder point?
Reorder Point = Sales X Lead Time + Safety Stock
Let’s say that on average we sell 25 units per week, and when we order new inventory, it takes an average of four weeks to arrive. That means that if we have 100 units when we order new inventory, then by the time the inventory arrives, we’ll have zero units of inventory. Having zero units of inventory is quite risky, which is why companies want to maintain what is called safety stock. Safety stock is the extra inventory kept on hand. With our example, let’s say that we want to keep 50 extra units on hand (i.e., 50 is our safety stock).
Instead of ordering inventory when we have 100 units left, we’re going to order inventory when we have 150 units left (25 Sales X 4 Weeks + 50 Safety Stock). By the time the new inventory gets here, we still have the 50 safety stock.