A major determinant of inventory levels and therefore working capital is the ability of a business to place purchase orders for inventory at the optimum time. The inventory reorder point calculation takes into account supplier lead time and safety inventory to determine the point at which the orders should be placed.
Reorder Point Formula
Inventory is one of the main components of working capital needed by a business. By calculating the reorder point a business can ensure that the correct level of inventory is held to satisfy customer demand and avoid lost sales, without compromising its financial performance.
The reorder point is the minimum inventory necessary to satisfy customer demand and is the level to which inventory is allowed to fall before a purchase order is placed, and uses the following formula.
Reorder point inventory = Lead time inventory + Safety inventory
Lead Time Inventory
If a business could place purchase orders with a supplier and obtain immediate delivery of the product then it would not need to hold any inventory to satisfy customer demand. Unfortunately, there is always a period of time (lead time days) between placing the order and receiving the goods.
The lead time inventory is simply the number of units of inventory the business must hold to cover customer demand for the product during the lead time between the business ordering the inventory from the supplier and it being received into the warehouse.
Lead time inventory = Lead time days x Daily demand
The lead time will depend on many factors including the type of product, the supplier, manufacturing lead times, the method of transport, and the location of both the supplier and the warehouse.
So for example, if a business sells 6,000 units of a product in 30 days and the supplier lead time days is 45 days, then the lead time inventory is calculated as follows.
Daily demand = Total units sales / Time period in days Daily demand = 6,000 / 30 = 200 units Lead time inventory = Lead time days x Daily demand Lead time inventory = 45 x 200 = 9,000 units
The business should place its next order with its supplier when the inventory reaches 9,000 units. It will take 45 days to deliver the order during which period the inventory will be used at the rate of 200 units each day. At the end of 45 days the inventory will have been reduced to zero and the new inventory will arrive.
The longer the lead time the longer the time delay between placing the order and receiving the inventory and the higher the inventory level must be at the reorder point.
The lead time inventory calculation referred to above assumes the daily demand and the supplier lead time are known, constant amounts. In practice both amounts will vary and the business will be in danger of running out of inventory at certain points in time. To allow for this it is normal to carry a level of safety inventory (safety stock) over and above the lead time inventory to provide a buffer against variations in both demand and lead time.
There are many ways to calculate the level of safety inventory but one of the simplest is to add a percentage of the lead time inventory as a buffer.
It should be noted that the safety inventory is not designed to cover all fluctuations in customer demand and supplier lead times, as this would lead to excessive levels of inventory being held.
For example, a business, based on past experience, might decide that a 20% buffer level is sufficient to allow for the majority of fluctuations. If the lead time inventory is 9,000 units (as calculated above), then the safety inventory is calculated as follows.
Lead time inventory = 9,000 units Safety inventory % = 20% Safety inventory = Lead time inventory x Safety inventory % Safety inventory = 9,000 x 20% = 1,800 units
The business would carry an extra 1,800 units of inventory to allow for demand and lead time variations.
Reorder Point Example
A business sells 23,400 units of a product in 90 days and has a supplier lead time of 14 days. Based on past experience the business has decided than a 30% safety inventory is needed.
The reorder point inventory can now be calculated as follows.
The first step is to calculate the lead time inventory.
Demand = 23,400 units Period = 90 days Lead time days = 14 days Daily demand = Total units sales / Time period in days Daily demand = 23,400 / 90 = 260 units Lead time inventory = Lead time days x Daily demand Lead time inventory = 14 x 260 = 3,640 units
The next step is to calculate the safety inventory
Lead time inventory = 3,640 units Safety inventory % = 30% Safety inventory = Lead time inventory x Safety inventory % Safety inventory = 3,640 x 30% = 1,092 units
Finally the reorder point inventory level can be calculated.
Reorder point inventory = Lead time inventory + Safety inventory Reorder point inventory = 3,640 + 1,092 = 4,732 units
The business should place a order with the supplier when the inventory level reaches 4,732 units as summarized in the diagram below.
Reorder Point and Financial Projections
The reorder point calculation is a management technique which enables a business to determine the minimum level of inventory needed to avoid the risk of being unable to satisfy customer demand.
By calculating this optimum reorder point level the business can use this value as a guide when adjusting the inventory days assumption in the financial projections template.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.