Calculating an Inventory Reorder Point

I’ve been training our assistant manager, Jessica, grooming her to take on more responsibility. We were in the stock room and I asked her, “What do you see in here?” She looked around and said, “Our inventory?” “That’s true,” I replied, “but I see something different than just inventory here. I see the cash I spent to buy this inventory, and I see that cash sitting on these shelves instead of sitting in my bank account.”

When you carry inventory, there are competing forces playing on the levels of your inventory. Pushing it up (and costing you more money) is the need for your business to always have product in stock so that your customers can buy it. Stockouts mean lowered customer satisfaction levels and oftentimes mean lost sales. Pushing it down is your desire as a business owner to have money in your bank account. In addition, if your inventory has a shelf life, like a perishable food, you have even more motivation to keep inventory levels as low as possible to avoid the potential of throwing away product that doesn’t sell in time.

So how does a savvy small business owner minimize the chance of running out of product while also minimizing the amount of cash he has tied up in inventory? The answer lies in selecting a reorder point that will trigger your system to buy more inventory that will arrive before you run out. This is a technique that big companies use to manage their multi-million dollar inventories, and there’s no reason why smaller businesses can’t do the same thing. The simple formula for the reorder point that I use in our business is:

(Average Daily Use * Lead Time in Days) + Safety Stock = Reorder Point

  • Average Daily Use – For my business, I initially took the last 365 days of sales for each item I have in stock and divided by 365. I learned though that I could make it even better if I adjust for seasonal variation, so if your business is seasonal like mine, you might want to look at usage during the same quarter of the previous year and divide by 90.
  • Lead Time in Days – Some people might tell you that lead time is the amount of time it takes from the time you order to the time you receive your product, and strictly speaking that’s true, but consider this scenario: Assume I place an order to Coca Cola for soft drinks every week and it’s delivered a week later. What happens if I place an order that doesn’t include a case of Sprite, but the day after I order we deplete the Sprite in inventory to the point where the system wants to order another case? That order signal could be sitting there for 6 days before I take action on it. For this reason, I add in the time between orders (6 days) to the delivery time (7 days) and arrive at my lead time of 13 days.
  • Safety Stock – The amount of this product that you want to be sitting on your shelf when the new shipment arrives. Since empty shelves look bad in a store, you want to make sure it at least covers what you display. You can also increase this number as needed to account for other risks like forgetting to place an order.

You can get as complicated as you like in customizing this formula to suit your unique needs, but once you punch it in to a spreadsheet, it’ll do all the number crunching for you. One other use I have for the inventory reorder point is as a flag for identifying items that I should consider eliminating. I’ll go in to more detail on this in a later post, but if the reorder point is very low, that’s a sign that I might not be selling enough of that product to justify keeping it as part of my product mix.

One great way to measure the effectiveness of your inventory is to calculate your inventory turnover. The equation can be found on Wikipedia. Since I started using this technique in our business, our inventory turns have increased from around 6 to around 7. That’s an 18% increase in efficiency!

Are you going to apply this approach in your business? Do you use a different technique for managing your inventory? Share your thoughts in the comments section. This article was originally posted on my blog, Small Business Ownership.