Good inventory management is about striking a balance. You should have enough stock to keep your customers happy, but not so much that you can't pay the water bill. Inventory is basically cash in a lockbox that you can only open with a product sale.
This means that when you decide to lock up cash in inventory, you must have a solid understanding of how to manage that inventory. Otherwise, you’re locking up those dollars for no good reason. Trust me when I tell you that uncontrolled inventory levels will kill a business.
In a recent engagement with a small retailer, we discovered that their inventory management processes were a major issue. They simply didn’t understand:
Why it was so important nor
How to do it.
Yes, they understood that inventory management was important. But they didn’t fully appreciate how its mismanagement had downstream affects.
This essay is the first in a series of four essays over the coming weeks about inventory management. This week we are discussing Reorder Point.
Reorder Point answers the fundamental question,
When Do I Reorder?
You’re In the Inventory Management Business
For that small retail store, not understanding inventory management or their stock levels were, by far, their biggest problem. If you don’t know why doing a thing is important, you’ll never bother learning how to do it properly.
To fix this issue, I told them that they weren’t in the widget-selling business; they were in the inventory management business. No matter what their store sold, they must always ensure their inventory levels were optimized. This new way of thinking means that they have to be experts in managing their inventories.
And what does that mean? It means efficiently managing inventory across three components:
Reorder Point
Safety Stock
Economic Order Quantity
We’ll be discussing these three aspects to inventory management over the coming weeks, but this week, we’re talking about Reorder Point.
What is a Reorder Point?
The reorder point (RP) is the level of inventory that, when your inventory levels drop to that count, you place a new order. It helps you restock before running out, keeping customers happy and cash flow in check.
Steps to Set Reorder Points:
I should start that there are many inventory management systems or out there that will calculate automatically what we will learn to do manually. But, we don't have to spend money to effectively manage our inventory. Just a little math does the trick just fine!
1. Calculate Your Average Daily Demand:
First things first, you need to know how much you sell each day. Don’t guess; use your sales data. You could measure customer orders or sales receipts. Look at a month or two, count how many units you sold, and divide by the number of days.
For example, if you sold 300 units in 30 days, that’s 10 units per day. Easy math, right? And don’t be afraid of fractions of a unit. We’re doing math here and fractions are permissible.
At the end of the day, you're looking to measure the average amounts of inventory that are taken off the shelf on a normal day.
2. Determine Your Lead Time:
Next, figure out your lead time. That’s a fancy way of saying,
“How long does it take for the stuff you ordered to show up at your door?”
If your supplier typically takes 7 days to deliver, then that’s your lead time. Just make sure you’re not counting on that one magical day when everything showed up in 24 hours! We’re looking for typical, average lead times.
3. Add Some Safety Stock:
We’re going to talk about Safety Stock, what it is and how to calculate it next week. But for now, just understand that this is your emergency stash. It’s that extra roll of toilet paper you hide in the back of the closet.
Safety stock is there to protect you against the unexpected. If demand spikes, or your supplier leaves on vacation, you have the inventory to weather these disruptions. As I said, we’ll discuss how to calculate Safety Stock level s next week.
4. Calculate Your Reorder Point:
Now, here’s where the magic happens. The formula for RP is simple:
Reorder Point = (Average Daily Demand × Lead Time) + Safety Stock.
For example:
If you sell an average of 10 units a day, your lead time is 7 days, and you keep 20 units as safety stock, your reorder point is:
(10 × 7) + 20 = 90 units.
In practice, what this means is that when your inventory level drops to 90 units, you start calling your vendor to place an order. And yes. It truly is that simple.
Now, contrast this to the bad old days of inventory management by just walking around and eyeballing your inventory. You’d look at your shelves, notice that you’re a little low on some widget or doohickey and you put in an order to replenish. Who knows if you actually needed that doohickey. But it looked low so you put in an order, tying up yet more cash into that lockbox.
When you set data-driven reorder points, you’re taking control. No more guessing games. You’ll know exactly when it’s time to reorder, keeping your shelves stocked and your customers smiling.
The Catch
But there’s a catch! This absolutely presumes that you have the data (or can estimate it) to run these calculations. This means then that, if you want to take your inventory management to the next level and move beyond merely eyeballing and unnecessarily locking up cash, you need to keep track of the relevant variables.
The Shameless Plug
If you’re thinking that you’d like some assistance in getting your inventories organized and optimized, or if you’re thinking that your business could use some general optimization, please schedule a zoom call to discuss what’s on your mind.
I am 100% confident that whatever issue or pain point you are facing, I have seen it before and have a solution ready – made for you.
Inventories out of control? I’ve got a solution.
Accounting completely confused? We can fix that too.
Business processes inefficient and costing you money? Completely solvable.
So please, don’t hesitate to reach out. I offer a free 1-hr consult to discuss your issues and create a plan to tackle it.
Every business needs an annual check up.
The 5D Business Check Up measures your business across the 5 major dimensions common to every business:
Sales & Marketing
Finance & Accounting
Operations
Inventory Management
Strategy & Planning
The 5D Business Check up starts with over 40 questions that delves into your personal observations as well as objective measurements taken directly from your financial statements. Once your questionnaire is complete, you will recieve a formal report assessing the strengths and weaknesses of your business with recommendations to improve.
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