Advanced Inventory Management - Reorder Point Model



The reorder point model works best with retailers that have available information on their point of sale system. This model was initially created for large companies to manage inventory but the same principals can be applied to small retail locations as well. Trying to run a small business is a tricky task that requires owners to be a jack-of-all-trades. On any given day you could be updating a balance sheet, working on advertising, interacting with customers, and constructing employee schedules for the coming weeks.

With all that and plenty more, trying to maintain independent inventory levels for an entire store can easily be overlooked or placed on the "oh I'll get to that tomorrow when I have more time" list.

A large portion of small retailers cash is invested in inventory to sell. This investment will greatly affect your cash flows, and as you know by now cash flows are the pulse that keeps your small business alive.

Here's a summary of how stores can implement an inventory management system called the Reorder Point Model.

Before using the ROP Model you must make some basic assumptions.

Demand for the product is (relatively) constant and uniform throughout the year

Lead time (time from ordering to receipt) is constant

Price per unit of product is constant

Ordering or start up is constant. (Other than the products themselves it does not cost you a substantial amount to place an order form suppliers)

All demands for the product will be satisfied from suppliers (If you order it, they will have it)

Safety Stock

After these are good to go you must establish a safety stock level. In order to compute the amount of safety stock you need to know the standard deviation of demand (referred to as demand variation in the excel file). Virtually all statistical software packages have the necessary built in routines to do this. If you do not have a statistical software package to do this, you can estimate your amount of variation by approximating how much your demand number might sway during a one-week or one month period (Experiment with different amounts of variation if you don't know your exact number). If your forecast is in terms of units per month, the standard deviation of demand will be in the same units, and so must the lead-time. Same applies to weekly forecast.

Description for the image to the right: The red line is your Inventory level over time. The blue area is your safety stock. and the line labeled R is the reorder point.

The equation to develop a safety stock will depend on your desired level of service. The desired level of service can be described as the amount of times you will be out of stock before the new shipment arrives. So if you just placed an order for a new shipment of running shoes, relying on your safety stock levels, you only want to "statistically" run out of inventory before the new shipment arrives one out of twenty times, then your desired level of service would be 95% (5% is 1 out of every 20).

Once you have an idea of your desired service level, standard deviation, and lead time you are almost ready to use the safety stock equation. The desired service level percent must be converted into a "z score". Check the probability table at the bottom to determine your z score. The secret is work form the inside of the chart out to find your z score number. Find your ideal percent first and the rest is on the left and top part of the table. For example a z score of 95% is equal to 1.64, a z score of 90% is 1.29.

The safety stock equation is as follows

SS = Desired Service Level x Standard Deviation x Square Root of Lead Time

Example: 1.64 x 150 x √.5

The lead time in this example is .5 because the demand and deviation is on a monthly basis and the lead time is two weeks, or half a month. If the demand and deviation are based off of a weekly forecast then the lead time under the square root would be 2.

After you are able to establish a safety stock level you are comfortable with the remainder of the process becomes much easier. Try experimenting with different levels of service and see what numbers you come up with. Always keep in mind that extra inventory is tying up cash that could be used in other parts of the business.

Whether or not such an investment is worthwhile depends upon your evaluation of various factors such as the expected additional revenue this can bring in from not missing sales, the added costs of the additional inventory, the competitive environment in which the business operates, etc. In other words, there is no hard and fast answer to the question of, "What should be the level of service for any specific item?".

Reorder Point

Description for the image above: The red line is your demand over time. The blue area is your safety stock and the line labeled R is the reorder point.

The reorder point equation is simply the average demand for your time period multiplied by the lead time for that same time period. If you sell 300 product Z's a month and the lead time for product Z is three weeks your equation would be as follows.

300 x .75 = 225

Remember that three weeks is approximately 75% or .75 of a month. Once you equate this number you add your already determined safety stock to the equation and this is your actual reorder point. Essentially the equation should look like this.

ROP = (Average Demand x Lead Time) + Safety Stock

Once your inventory level hits this number you (or your automated system) should be placing an order for another shipment of products.









Z Score Table

Advanced inventory management, like this model, can help bring the efficiency of small retail shops to the next level.