Cost Accounting: The Reorder Point
In cost accounting, the reorder point is the time when you should place your next order. You use reorder point to avoid running out of inventory — a stockout situation. Lots of bad things can happen if there’s a stockout.
To keep life simple, assume that the demand level is known — you know how much product you’re likely to sell. You also know the order lead time.
The reorder point formula requires a unit of time. That time period can be a week, a month, or a year. The choice is up to you.
Here’s the formula for reorder point:
Reorder point = number of units sold per unit of time x order lead time
Say you manage a hardware store. One of your products is a 20-ounce straight claw hammer. You decide to use one week as your unit of time. Your weekly demand level is 70 hammers. Your purchase order lead time is three weeks. Here is your reorder point for hammers:
Reorder point = 70 units x 3 weeks
Reorder point = 210 units
When your inventory level falls to 210 units, you order more hammers. You want to make sure that you don’t run out before your next order arrives. Now consider how many more hammers. The number you order is the economic order quantity (EOQ).
Safety stock (also known as reserve inventory) is the amount of inventory held at all times. You maintain the safety stock inventory, regardless of the purchases you make using EOQ. This inventory serves as a buffer against stockouts.
You maintain a safety stock to address uncertainty in the ordering process. There are several uncertainties related to purchases and inventory levels:
Demand: If actual demand is higher than planned, you can sell your safety stock and avoid a stockout.
Purchase order lead time: You might have a longer lead time than planned. Maybe your order takes four weeks to be delivered, rather than three weeks. If the increased lead time sharply reduces your inventory levels, you can sell your safety stock.
Suppliers: Safety stock can help you meet demand if a supplier can’t deliver your required purchase. A supplier may run short of product. An unusual situation (weather, or material shortage, for example) may prevent the supplier from making or shipping your product in a timely manner.
Safety stock is computed as
Safety stock = excess demand expected x purchase order lead time
Say you manage a discount store. As you prepare for the back-to-school season, you need to stock backpacks. The red mountain backpack has always been a big seller. You already determined demand for the backpack and other factors, including the economic order quantity.
As you set up your back-to-school store displays, you mull over creating a safety stock. You start by checking weekly sales from previous years, and you notice that the higher sales level has happened several times; sales have been 100 units higher than your weekly planned sales. You determine that safety stock should be 100 backpacks.
The purchase order lead time for the red mountain backpack is three weeks. Based on the data, here’s your safety stock:
Safety stock = 100 backpacks per week x 3 week lead time
Safety stock = 300 backpacks
You plan to hold 300 backpacks in stock in addition to your regular inventory level. The 300 units are your hedge against a spike in demand or a supplier’s delay in shipping product to you. If something unusual happens, you’re still able to fill orders. Note that your safety stock is a separate calculation from economic order quantity.