# Reorder Point System

Reorder point may be defined as the level of inventory when fresh order should be placed with the suppliers for procuring additional inventory, equal to the economic order quantity. The reorder point is a signal that informs when to place an order. Calculating the reorder point requires knowledge of the lead time between order and receipt of merchandise. It may be influenced by the months of supply or total dollar ceilings of the inventory to be ordered or held.

Re-order Point = Lead time in days x average daily usage of inventory

Lead time is time normally taken in receiving delivery after placing orders with suppliers

Example: Average daily consumption for a firm is 10,000 units. The number of days required to receive the delivery of inventory after placing an order is 20 days.

Reorder point = 10,000 units x 20 days => 200,000 units.

This means that the firm should place the order for replenishing the stock of inventory as soon as the level reaches 200,000 units

Safety Stock

Safety stock implies extra inventories that can be drawn down when actual lead time and/or usage rates are greater than expected. It can be defined as the minimum additional inventory to serve as a safety margin or buffer to meet an unanticipated increase in usage resulting from an unusually high demand and or uncontrollable late receipt of incoming inventory.

Determination of Safety Stock

The financial manager should determine the appropriate level of safety stock on the basis of a trade-off between the following two costs associated with it:
• Stock-out costs

Stock-out costs refer to the cost associated with the shortage of inventory. It is an opportunity cost of losing the benefits that would have been gained if stocks were there.
• Carrying costs

Carrying costs are the costs associated with the maintenance of inventory.

The larger the safety stock, the larger would be the carrying costs and vice versa. The larger the safety stock, the smaller would be the stock-out costs. So, based on the stock-out costs and carrying costs, safety stock will be determined attaining a trade-off between the two.

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