Understanding how to calculate reorder points is a critical element of inventory management, especially when it comes to ecommerce fulfillment. Direct-to-consumer brands use a reorder point formula (ROP formula) to determine when they need to restock to avoid backorders.
There are a couple of approaches to determining reorder points based on different needs. Learn more about the importance of reorder points and how to calculate reorder points using the ROP formula with or without safety stock.
A reorder point, which may also be called an order point, indicates when to restock inventory to avoid running out of a product. When inventory levels hit their reorder point, a company will place an order—typically for a predetermined amount called the economic order quantity (EOQ)—to replenish its stock. While similar, ROP and EOQ are different measurements: while EOQ focuses on the size of an order, ROP determines restock timing.
Reorder points can vary by product. The order point depends on how long it takes to manufacture the item, usage rate, sale process, and more. For example: a brand’s top-selling product will have a different reorder point than a niche item, both because of the usage rate (order volume) and because the company is likely placing larger orders when restocking a popular product, which can impact lead time from the manufacturer. Ecommerce retailers that use multiple manufacturers will also need to consider the lead time for each supplier when calculating each product’s reorder point.
A well-calculated reorder point ensures new inventory arrives just in time to avoid a shortage and maximize fill rate.
Reorder points are used to avoid losses associated with backorders and overstock and to manage a company’s cash flow. As a company grows and expands its product mix, reorder points become increasingly important.
Tracking cash limits for reorders, managing promotional or seasonal products, and balancing warehouse storage fees against the risk of backorders can feel intimidating, but a ROP formula can simplify these inventory management challenges.
With the right reorder point associated with each SKU, companies can reduce the risk of stockouts. Running out of inventory means lost sales, unhappy customers, and the risk of damaging the brand’s reputation. Shoppers aren’t likely to wait for an item to come back in stock: 39% of consumers say they switch brands when encountering an out-of-stock item, while 32% go to another retailer. Only 13% report waiting for the item to become available.
Holding more inventory than necessary is expensive. Overstock ties up capital and runs the risk of wasting inventory—especially if the product has a short shelf life.
The shelf life of some products, like perishable food items, is obviously limited; but other items can become outdated and decrease in value. Apparel is susceptible to changing styles, technology can devalue as new models are introduced, and personal care products like makeup or deodorant can expire. If these products sit around too long, the company will be forced to sell them at a discount at best, and throw them away at worst.
Companies that outsource fulfillment will also see warehouse storage fees increase with the amount of inventory they hold. Keeping inventory lean is one way to reduce fulfillment costs and increase product margins.
Even the best laid plans are susceptible to uncertainty, whether it’s fluctuations in the cost of raw materials, economic pressure, or unexpected variations in demand. Using reorder points can help mitigate these issues by improving forecasting based on market trends.
Some companies with a high degree of complexity in their product mix, distribution network, or seasonal demand use third-party software or professional services to continually recalculate reorder points for optimal forecasting.
Inventory is an unavoidable liability—freak accidents like floods or warehouse pests are always a risk. Minimizing the amount of inventory on hand naturally reduces the financial losses a company would incur if its products were damaged.
In its basic form, the ROP formula is the average daily usage rate multiplied by replenishment lead time. For example: if Company A sells an average of 100 units of SKU 1 per day and it takes five days to receive an order from the manufacturer, the reorder point would be 500.
The basic ROP formula relies on average use, and demand can increase or decrease based on many factors. This means that inventory may not be diminished or may be completely gone when the new shipment arrives. To avoid the risk of over- or understocking, the ROP formula can be modified to include safety stock.
Each unique SKU will have its own reorder point. Companies with a large product mix may use ROP software to automate reorder point calculations for each product with and without safety stock to find the optimal ROP, but reorder points can also be calculated manually.
To determine the reorder point without accounting for safety stock, simply multiply the average order volume for a given SKU by the lead time to replenish inventory. This will indicate how much of a given product will hold the company over until a new shipment arrives.
While helpful, this ROP formula is basic, and does not account for potential freight delays or sudden spikes in demand.
Safety stock is additional inventory above the average order volume that companies hold to avoid backorders. Ecommerce brands use safety stock as insurance for the unpredictable, like manufacturer delays.
To calculate the reorder point with safety stock, follow the standard formula, then add the safety stock threshold. Using our earlier example, Company A’s reorder point for SKU 1 was 500: it sells an average of 100 units per day, and it takes five days to receive a new shipment. If Company A were to set its safety stock at 200 units, the new reorder point would be 700.
The appropriate amount of safety stock will also vary by SKU. Popular items or products that come from manufacturers with longer lead times will likely have a higher amount of safety stock.
Economic order quantity, or EOQ, determines the optimal size of a restock order. Reorder point, or ROP, determines when a inventory should be restocked.
Tracking sales, demand, and inventory to optimize ROPs can be a time-consuming and stressful task. When there are multiple suppliers and other factors added to the mix, the process is even more complex. Airhouse can help improve inventory management strategies to cut costs and optimize operations. Keep reorder points simple with Airhouse — contact us for a demo today. An Airhouse team member will be happy to discuss your needs and suggest reorder point solutions.
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