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how to calculate reorder level

Inventory management in e-commerce is harder and involves high fulfillment costs. 

One major difference between traditional and online retail is the placement of the order.  In e-commerce retail, there is a delay between when an order is requested on the website and when the products are taken out from the inventory to be delivered. 

In traditional retail, there is no delay between when the order is requested and taken out from inventory for delivery. This is because, in traditional retail, the products are taken directly from the shelf as soon as the customer orders. 

Thus, it is important that focus is laid on having a proper inventory control policy in place in the case of e-commerce retail. Such a policy would help in managing the product flows throughout the entire e-commerce supply chain. 

In this article, we are going to discuss one of the inventory control methods that e-commerce businesses use in managing inventory. It is called Reorder Point. We will also discuss how to calculate reorder level for an e-commerce business.

What is Reorder Point?

Reorder Point in inventory management refers to the point at which the e-commerce supplier needs to add additional inventory in order to maintain the inventory at the optimum point. This point is commonly called the Reorder Point (ROP). 

It helps in defining the level of stock at which the retailer needs to order for inventory to maintain the total inventory at an optimum level. This means that the Reorder Point ensures that the inventory is replenished instantaneously with no shortages. 

It is a valuable tool for e-commerce retailers as it helps them in determining the amount of inventory that retailers must keep on hand. Further, it also helps them to calculate how many items they need to order each time and the frequency at which they need to reorder. 

This method of managing inventory is used as a part of a continuous review inventory system. 

It is important to note that the choice of inventory strategy depends on how often the e-commerce retailer checks the inventory level. Retail businesses having random demand fluctuations typically follow either of the two inventory strategies: continuous review policy and periodic review policy.

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Continuous review policies are the ones in which the retailers continuously monitor inventories. Such continuous checks are expensive as compared to periodic checks. However, such a strategy helps in achieving and maintaining the desired level of service in the case of slow-moving products.

In contrast, the periodic inventory system is the one in which the inventory is reviewed at fixed intervals. Under this system, the retailers or suppliers determine the number of replenishment orders based on existing inventory levels and estimated demands before the next arrival.

This means that under a periodic inventory system, the retailers have to maintain extra inventory to prevent stock-outs between inventory reviews. This involves exceedingly high costs of inventory holding and logistics.

What is Safety Stock?

Safety Stock is also known as a ‘buffer’. It is the buffer stock needed to meet unexpected supply problems or sudden changes in demand. Thus, Safety Stock ensures that the supplier does not have to face stockouts. 

Stockout is a condition when the customer has to go empty-handed as the supplier does not have the stock of products. This may happen when the actual demand is greater than what the supplier expected. Or there is a delay in the lead time period.

There are different methods to calculate Safety Stock. The general formula to calculate Safety Stock is as follows.

Safety Stock Formula

Safety Stock = (Maximum Daily Sales Volume x Maximum Lead Time)- (Average Daily Sales Volume x Average Lead Time)

Let’s understand the Safety Stock Formula using the same example as above. Say, ‘Zapin’ is an e-commerce store selling consumer products. One of its suppliers is ‘Creme’ that sells body soaps. The annual sales for ‘Creme’ body soaps at ‘Zapin’ is 1200 SKUs of body soaps, an average of 100 SKUs of body soaps per month.

Thus, the Daily Sales Volume would be 3.33 SKUs. Suppose, the Maximum Daily Sales Volume of ‘Creme’ at ‘Zapin’ is 6.33 SKUs.  Also suppose, that ‘Zapin’ had 12 deliveries during these 12 months and the average delivery time is 10 days on average. While the maximum delivery time is 12 days. Thus, the Safety Stock for ‘Creme’ is as follows:

Safety Stock = (Maximum Daily Sales Volume x Maximum Lead Time)- (Average Daily Sales Volume x Average Lead Time)

Safety Stock = (6.33*12)-(3.33*10) = 75.96 – 33.33 = 42.63 = 43 SKUs

What is Reorder Quantity?

The Reorder Quantity refers to the number of units that a retailer must add to the inventory such that each inventory order minimizes the total inventory cost. 

In other words, the Reorder Quantity is the ideal order quantity a company should purchase to minimize its inventory costs. It refers to the quantity ordered in a single purchase so that the accumulated costs of ordering and carrying costs are at the minimum level.

Such costs may include holding costs of inventory, order costs, and inventory shortage costs.

The Reorder Quantity is also called Economic Order Quantity (EOQ). The following is the Reorder Quantity formula.

Reorder Quantity Formula

Reorder Quantity = (2*AD(in units)*OC (per unit)) / COI (per unit)*CC (% of unit cost)

AD = Annual Demand in units

OC = Ordering Cost per unit

COI = Cost of Inventory per unit

CC = Carrying Cost as a % of unit cost

Let’s understand this with the help of an example.

How To Calculate Reorder Quantity?

Say, ‘Zapin’ is an e-commerce store selling consumer products. One of its suppliers is ‘Creme’ that sells body soaps. The monthly demand for ‘Creme’ body soaps at ‘Zapin’ is 100 units. Further, ‘Creme’ incurs a fixed order placement, transportation, and receiving cost of $40 each time an order is placed. The per-unit cost of ‘Creme’ body soap is $2 and ‘Creme’  has a holding cost of 20%.  Accordingly, the number of body soaps that the ‘Creme’ manager should order in each replenishment lot would be:

Reorder Quantity = (2*AD(in units)*OC (per unit)) / COI (per unit)*CC (% of unit cost)

= (2*100*12*40) / 2*0.20

= 489.897 = 490 units

This means that ‘Creme’ should reorder 490 units each time to the manufacturer in order to minimize the inventory costs.

Understanding the Reorder Point Formula

As mentioned above, the reorder point reflects the inventory level that prompts the placement of an order for additional units. To determine the reorder point, an e-commerce retailer needs to determine the following three factors.

  • Quantity of inventory used or sold each day (Demand)
  • Time (in days) it takes for an order to arrive when an order is placed (Lead Time)
  • Quantity of inventory on hand in case there is an unpredictable event like delay in lead time or unexpected demand (Safety Stock)

The following would be the reorder point formulas if the demand remains constant and the lead time is known.

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Image Source: SAP

1. How to Calculate Reorder Level Without Safety Stock?

Reorder Point  = Daily usage * Lead time (in days) 

Where,

Daily usage = Number of Units Sold in a Month/Number of Days in a Month

Lead Time = Number of Days for an Order to Arrive

Let’s understand this with the help of an example. Say, ‘Zapin’ is an e-commerce store selling consumer products. One of its suppliers is ‘Creme’ that sells body soaps. The monthly demand for ‘Creme’ body soaps at ‘Zapin’ is 100 units. Furthermore, it takes 5 days for the soaps to reach the ‘Creme’ warehouse. Thus, the reorder point for ‘Creme’ would be:

Reorder Point  = Daily usage * Lead time (in days) = (100/30)*5 = 16.67 = 17 units

This means that when ‘Creme’ is left with 17 SKUs of body soaps in its warehouse, it must reorder additional SKUs of soaps.

2. How to Calculate Reorder Level With Safety Stock?

The following is the Reorder Point when an e-commerce supplier maintains Safety Stock:

Reorder Point  = [Daily usage*Lead time (in days)] +safety stock

Safety Stock = (Maximum Daily Sales Volume x Maximum Lead Time)- (Average Daily Sales Volume x Average Lead Time)

Considering the same example as above, let’s say that the monthly demand for ‘Creme’ body soaps at ‘Zapin’ is 100 units. 

Thus, the Daily Sales Volume would be 3.33 SKUs. Suppose, the Maximum Daily Sales Volume of ‘Creme’ at ‘Zapin’ is 6.33 SKUs.  Also suppose, that ‘Zapin’ had 12 deliveries during these 12 months and the average delivery time is 10 days on average. While the maximum delivery time is 12 days. Thus, the Safety Stock for ‘Creme’ is as follows:

Safety Stock = (Maximum Daily Sales Volume x Maximum Lead Time)- (Average Daily Sales Volume x Average Lead Time)

Safety Stock = (6.33*12)-(3.33*10) = 75.96 – 33.33 = 42.63 = 43 SKUs

Thus Reorder Point for ‘Creme’ would be, 

Reorder Point  = [Daily usage*Lead time (in days)] +safety stock =  (3.33*10) + 43 = 75.96 = 76 SKUs

This means that when ‘Creme’ is left with 76 SKUs of body soaps in its warehouse, it must reorder additional SKUs of soaps.

Why is the Reorder Point Formula Important?

It is important for retailers or suppliers to calculate the reorder point as it protects them against inventory shortages. 

As per the Reorder Point Formula, reorders are placed to replenish the inventory to its maximum level of stock when the inventory level is less than or equal to the reorder point.

Inventory control through Reorder Point Planning helps retailers in monitoring inventory. Further, it helps them in maintaining inventory at a level such that supplies must be available at all times and there is no shortage.

In other words, the purpose of this system of inventory control is to ensure that the right resources are available in the quantity and at the right time. Not having enough stock to fulfill customer orders would mean poor experience for customers and production cessation for manufacturers.

Another fundamental objective of calculating the optimal order point is to minimize total inventory costs. Inventory costs may include the cost of holding the inventory, costs of reordering, and costs of shortage of inventory.

If there is a lack of inventory, it can result in the termination of the production process. Thus, such a condition demonstrates that inventory management is a cause of concern for the retailer, manufacturer, or supplier.

On the other hand, holding too much inventory means working capital gets tied up in warehousing, storing, packaging, and administering inventory. It may also mean lost opportunity cost. 

Thus, it is extremely important to tightly control the existing stock to prevent the retailer’s financial performance disruption. 

Also, managing inventory through reorder quantity and reorder point help in optimizing order fulfillment. That is, the availability of the right amount of inventory can be picked, packed, and shipped off to customers more quickly and easily.

Strategies For Reorder Point Planning

Businesses need to plan strategically for the types and quantities of materials they need to purchase to manufacture the products. They must ensure that they are able to meet current as well as future customer demand at the lowest possible cost. 

Reorder Point Planning helps businesses maintain inventory at low levels. Businesses understand that a poor decision in any area of the production cycle can lead to a huge loss for the company. Thus, it’s important for businesses to maintain appropriate levels of inventory by aligning production with rising and falling demand.

Reorder Point Planning works on the fundamental principle of carrying out continuous checks on inventory. This helps the business to determine whether the stock falls below the reorder point.

In case, the available stock falls below the reorder level, a business generates an order for inventory. Thus, a business must follow the practices below for Reorder Point Planning.

1. Consider Uncertainty in Demand and Lead Time

Businesses must consider the uncertainties when optimizing the supply chain and design. There are primarily two factors that bring in the element of uncertainty when it comes to decreasing inventories and making supply chains leaner. These include uncertainty in demand and lead time uncertainty.

In some cases, uncertainty in lead times has essentially no effect. Thus, it can be ignored or included in lead time demand modeling. But mostly, lead time fluctuations strongly degrade system performance. This is the case with businesses that have to undertake component inventory control in their assembly systems. That’s because they have random component procurement times or lead times. 

Note that assembly systems are sensitive to the lead time of components. In other words, all components must be present to begin the assembly of the final product. Therefore, businesses with assembly systems must consider the lead time uncertainties precisely.

2. Use Inventory Control Software

An inventory management software provides tools to improve and manage inventory levels. It helps a business to efficiently fill customer orders and track the movement of materials. Such information empowers businesses to provide their technicians and warehouse staff with the ability to carry out operations n the stockroom automatically and seamlessly. 

The inventory management software tracks physical counts of materials and changes in stock such as a material receipt, issue, transfer, or a return. Such a system ensures that the materials are available on the job at all times and there are no delays due to shortage. Further, inventory management software also helps a business to pick up materials in advance based on the work orders. Additionally, such software also ensures speedy receipt and back-order reporting to and from shipping and receiving.

Thus, the ease of operations through inventory management software ensures that your inventory levels are optimized. 

The best part about these systems is that they are highly secured. That’s because they use security features including SSL authentication certificates for user authentication and client-side data encryption.

When To Use Reorder Point Planning?

Reorder Point Planning does not work well for all materials requirements planning scenarios. It works best in the following circumstances.

1. Independent Demand Items

Reorder Point does not work well for material items that are lower in the Bill of Materials than the end product. Such items are the items dependent on demand for the final products. 

Reorder Point Planning does not work well for dependent items because the point of demand for the lower-level items occurs at the point of the ROP for the higher-level items. 

This means Reorder Point Planning works well for items that are subject to independent demand. To calculate Reorder Point, an entity uses the following formula: Average demand during lead time + Safety Stock.

Safety stock describes a level of extra inventory that a business maintains to reduce the risk of stockouts or shortfalls in raw materials. Such shortfalls may occur due to uncertainties in supply and demand. 

Thus, the inventory planner would place additional items with the suppliers when the items touch the Reorder Point. This will replenish the on-hand inventory.

2. Impossibility of Forecasting

The Reorder Point Planning works well in scenarios where it is difficult or impossible to forecast the average demand for the materials. It also cannot be used in scenarios where the history of the demand for a business has been stable.

If Reorder Point Planning is used as an inventory control method in such scenarios, there are high chances that the assumptions used for forecasting demand are invalid. This may have a huge impact on the accuracy of material planning.

In such cases, one has to use a sophisticated material planning system. However, items having a stable demand can use Reorder Point Planning to control inventories. That’s because in such cases the associated raw material supply plan is dependent on the finished good supply plan.

3. Discernability in Demand Patterns

In many cases, it is impossible to forecast the demand as it is impossible to determine the pattern of demand. Such indiscernibility in demand patterns cannot create a good forecast despite using a great mathematical algorithm. 

If a business wants to statistically forecast the demand, it can do it only for those products that have a historical demand pattern.

On the other hand, the products having a stable demand are difficult to forecast. That’s because actively forecasting for such products does not add any value to the material planning or supply chain planning. Why so? A product having a stable demand does not require any forecasting.

Now, one of the common factors that make the demand unforecastable for an item is that such an item has a lumpy demand. Take for instance the demand for service parts. They might have a great demand in a specific month. But then for coming months, such parts may have no demand at all.

In such cases, sending a forecast to the material planning department is not a good idea. Instead, planning managers must consider using a simple moving average to calculate the demand forecasts.

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