How to solve the reorder point formula – Inventory management strategy

Successful e-commerce entrepreneurs know that inventory management can make or break the business. Too much inventory ties up necessary capital needed for other business operations. And low stock levels can drive potential customers towards the competition. But as a business grows, this can get tricky.

Enter: the reorder point formula.

It's the golden equation that provides e-commerce retailers direction when deciding on the perfect time to order new stock. But like most 'golden' solutions, it has conditions. The bigger your business grows, the more variants you'll have for each product.

This article will help you solve for those variants, give you a clear understanding of how to use the reorder point formula for your business, and help you solve some common problems e-commerce businesses experience when using it.

Table of contents

• What is the reorder point formula?
• How do you calculate reorder point?
• Using the reorder point in your inventory management system
• Reorder point problems and solutions
• Beyond the reorder point formula

What is the reorder point formula?

You won't be able to calculate reorder points without a clear understanding of what the reorder point formula is and what it can do for your business. Simply defined: the reorder point formula helps you pick the right time to order new products. If you want your business to scale, it's a necessary tool.

The reorder point formula is: Average sales per day x Lead time + Safety stock

Three metrics determine your reorder point:

• Average sales per day: The average amount of product sold per day.

• Lead time – or Average Lead Time: The time between ordering and receiving your product.

• Safety stock: The reserve stock you keep in case of a buyout.

To put these pieces together, you'll need to figure out how much you sell of a product on an average day (average daily sales) and multiply that number by your lead time – this gives you what’s also sometimes referred to as the lead time demand.

If your business doesn't operate with a safety stock or has a high day-to-day variable with sales, don't worry. It's possible to replace your average daily sales with a metric called daily maximum usage.

That may seem like a lot of metrics and maths to take in at once, but we'll break everything down in the coming sections. First, let's examine the importance of the formula and how you can use it in your business.

Why is the reorder point formula important?

Smaller businesses often sidestep using the formula and get by without a clear product ordering plan. But if you want to scale, you'll find the process difficult without a means of identifying the right time to order.

Poor inventory management can quickly become an expensive issue as storing excess stock levels will eat into your margins. It also ties up your cash in unsold inventory, which means you have less overall liquidity. And if you're working with items that depreciate – food or a trending item – they'll start losing value.

Ultimately, if you don't have proper reorder points for your business, it will affect your bottom line.

How you can use the reorder point in your business

Before moving on to the calculations, here are a few ways reorder points can help make your business successful.

• Never run out of stock – Putting up an 'out of stock' post is the easiest way to turn customers off to your business, resulting in lost sales. But with solid reorder points, you can almost guarantee this will never happen.

• Stop paying excess fees to rush restock orders – Business owners often make poor decisions when they're out of stock. But panic ordering is never a good thing. Reorder points remove this issue, and you'll never pay 'rush order' fees again.

• Increase margins – Poor inventory management affects every aspect of your business, from logistics to budgeting to organisation. With proper reorder point calculation, you'll avoid pitfalls that may cause you to have to take out a loan or dip into your reserves.

• Forecast accuracy – Without an inventory formula, you're flying blind into a thick fog. Reordering requires data. Otherwise, it's just instinct driving unnecessary risk.

How do you calculate reorder point?

With a definition and importance laid out, it's time to review step-by-step how to get accurate reorder points. Again, the reorder point formula is: Reorder point (ROP) = Average sales per day x Lead time + Safety stock. However, it's necessary to know how to figure out the three variables. And to do that, you'll need reliable, accurate sales data.

Before plugging the data into the reorder point formula, a key prerequisite is proper inventory management practices that net the correct data points. This includes – at the very least:

• Distribution costs

• Distribution timeframes (on average)

• Average monthly sales

• Customer demand

And you may need even more data. There's no doubt that the best way to track your inventory accurately is through an automated system using inventory management software. It's one of the best investments you'll ever make in your company.

Calculating average daily sales

Finding your Average sales per day isn't isn't difficult as long as your data is accurate. But for both average daily sales and lead time, we'll need a time period for both measurements. The further back you go, the more accurate your calculations will be. But three to six months will suffice, and it's what we'll use for our examples here.

To calculate your average sales per day, divide the number of orders fulfilled by the number of days in your time frame.

For example, if you run an ecommerce site that sells greeting cards, you would pick a specific card and look at your sales data for three months. If you sold 250 greeting cards in the past three months, the calculation would be:

250 / 91 days = 2.75.

Your average birthday card sales per day for the previous three months was 2.75.

Calculating lead time

Lead time is how long it takes between when you order a product from a manufacturer and its delivery. The timing and planning of your lead time for purchases is important, especially for manufacturers.

This may seem straightforward – especially for our birthday card example – but business owners often forget elements within the fulfilment process, like processing and approval delays. And if your manufacturer only takes orders on a specific day, this must also factor into the final number.

Accounting for delays in lead time

Returning to our example, let's say it takes one week for a birthday card order to arrive. However, it takes one day to get approval for the order and another day for the manufacturer to process the order. That's nine days total.

But unfortunately, the manufacturer only takes orders on Tuesdays. Since you can't be sure you'll always have necessary stock levels, it's important to take precautions and factor in six days for the reorder delay.

In this scenario, the total time for a birthday card order lead time in days is:

9 + 6 = 15 days average lead time

Returning to our lead time demand formula, let's plug in all the numbers: 15 (Lead time) x 2.75 (Average sales per day) = 41.25 (Lead Time Demand)

Calculating Safety Stock

To complete the reorder point formula, we must enter one more element: safety stock. It's the extra stock availability you keep in case you have a large influx of sales or supply chain issues.

Many companies attempt to predict their future sales and keep an inventory according to those predictions, but things don't always align with the forecasts. A healthy safety stock level will help keep your business moving in these situations.

What is the formula for safety stock?

The formula to calculate safety stock is: (Maximum daily usage x Maximum lead time) – (Average sales per day x Average Lead Time) 

For our birthday card example, we already calculated the average sales per day and average lead time. With those numbers stored, let's focus on maximum daily sales and maximum lead time.

What is my maximum daily usage?

We calculated the average daily sales – or usage at 2.75. But let's say there were a couple of days in the three-month calculation period where you sold up to seven cards. That's your maximum daily usage.

What is my max lead time?

The average lead time factored to 15 days. But what if something goes wrong with the delivery? Last year, the card manufacturer had a two day delay due to paper shortages, and a snowstorm caused a three day delay with the shipment. That's an extra five days on the total lead time. Putting these elements together, we get: 15 (average lead time) + 5 (delay days) = 20 (maximum lead time)

The safety stock calculation

Using the variable from this section and the previous section, let's put everything together from the original formula for our safety stock calculation.

(7 x 20) - (2.75 x 15) = 98.75 in safety stock.

Reorder point formula example

With all the data put together, the greeting card company can now use the formula to get a reorder point value for their birthday cards. One last time, the reorder point formula is:

Reorder point (ROP) = Lead time demand + Safety stock

For our example, that would be:

41.25 + 98.75 = 140

When the greeting card company's birthday card stock drops to 140 units, it's time to reorder more stock.

Reorder point and safety stock: what's the difference?

Reorder points and safety stock levels are similar in that both exist to help with stock shortages. But there is a key difference.

Reorder points help you know when to order more stock, so you never hit your safety stock level. Whereas, safety stock exists as a last option you would only use in an emergency. It ensures that your stock level never goes down to zero.

An accurate reorder point will ensure that you never have to tap into your safety stock.

What is the ideal reorder point?

The purpose of calculating reorder points is to ensure you keep enough stock to satisfy your orders and never have to dip into your safety stock. In essence, there is no ideal reorder point because the formula tells you when to reorder stock for every product in your inventory. You'll find that as you scale, implementing the formula throughout your entire product line is necessary to keep inventory levels in check.

Using the reorder point in your inventory management system

Calculating and managing your reorder points can be difficult, especially if you're using multiple spreadsheets to manage your inventory. This is where planning and automation become valuable assets.

There is a wide range of inventory management software programs available that can help you set stock alerts and track your inventory levels as they reach their reorder point. They're also the best way to implement reorder points in the inventory management system you use for your business.

But a little planning and a classic Excel spreadsheet can also suffice for smaller businesses.

Reorder point problems and solutions

The reorder point formula helps businesses solve a wide range of inventory issues. But there are also some common problems associated with the formula itself. Remember that every business is different, and you may need to adjust things and add in other data points to create a formula that works for you. Below are a few common problems and solutions associated with the reorder point formula.

The reorder point formula assumes static lead times

Unfortunately, the reorder point formula assumes that your lead times will always be consistent. But this doesn't always work out for many businesses – think about an online auto parts store, for example. There are a wide range of factors that can cause blockages to stock availability, ranging from weather to supply chain issues.

It's difficult to calculate these issues manually. But to solve this common problem, it's crucial that you regularly review and update delivery schedules in your inventory system. This is the only way to ensure you have accurate reorder points.

Reorder point calculations are disconnected from customer satisfaction

Reorder points come from a wide range of stock and purchase factors – think daily average sales. But there's not a direct relationship in the formula to customer service and customer satisfaction. The formula focuses completely on stock turnover.

This is true. All inventory control practices are designed to satisfy orders as quickly as possible. But it's up to you to go above and beyond with additional service factors for total customer satisfaction. This includes following up on sales and sending out customer surveys to enhance your fulfilment process.

Inadequate safety stock formula cannot account for demand and supply variability

Ecommerce business owners often assume that safety stocks serve as a buffer for demand or lead times. It certainly applies when demand and lead time are consistently predictable, but not so much during times of unpredictability.

The fact is that different businesses have different factors that will impact their supply chain – and in turn, their safety stock formula. You can use the common formula above, but you may need to make adjustments or add in additional data. Things like your reorder period, order quantity requirement, and upstream failure can affect your safety stock calculations.

Beyond the reorder point formula

As stated, reorder point calculations can also be performed manually, but automated reorder point calculators are faster and more accurate. And remember that the equation and each of the sub-equations to get your reorder points must be run for your entire product line.

In addition, you must update and run the formula often to ensure accuracy – especially for businesses affected by seasonality. It's highly recommended to opt for an inventory management program that can both run the calculations for you and analyse the data you put in.

These programs may come with additional costs, but you could actually lose more money by not making the investment.