How can you calculate the reorder point in a continuous review system?

1 The basic formula

The reorder point is the inventory level that triggers an order to replenish the stock. To calculate it, you need to know three things: the demand rate, the lead time, and the safety stock. The demand rate is the average number of units sold per time period, such as a day or a week. The lead time is the time it takes from placing an order to receiving it. The safety stock is the extra inventory you keep to protect against demand variability and supply uncertainty. The basic formula for the reorder point is: Reorder point = (Demand rate x Lead time) + Safety stock This formula assumes that the demand and the lead time are constant and known, and that the order quantity is fixed.

2 The demand variability factor

In reality, the demand and the lead time are often variable and uncertain, which means that the reorder point based on the basic formula may not be enough to prevent stockouts. To account for this variability, you need to add a factor that reflects the standard deviation of the demand and the lead time. The standard deviation is a measure of how much the actual values deviate from the average. The higher the standard deviation, the more variability there is. The demand variability factor is calculated as: Demand variability factor = z x sqrt(LT x SD^2(D) + D x SD^2(LT)) Where z is the service level factor, LT is the average lead time, SD(D) is the standard deviation of the demand, and SD(LT) is the standard deviation of the lead time. The service level factor is a value that depends on the desired probability of not having a stockout. For example, if you want a 95% service level, z is 1.65.

3 The revised formula

To incorporate the demand variability factor into the reorder point calculation, you simply add it to the basic formula. The revised formula is: Reorder point = (Demand rate x Lead time) + Safety stock + Demand variability factor This formula gives you a more realistic and reliable reorder point that reduces the risk of stockouts and overstocking.

4 An example

Let's say you sell widgets and you use a continuous review system to manage your inventory. You know that your average demand rate is 100 widgets per day, your average lead time is 5 days, and your safety stock is 200 widgets. You also know that your standard deviation of demand is 20 widgets per day, and your standard deviation of lead time is 1 day. You want a 95% service level, so your z value is 1.65. How do you calculate your reorder point?

Using the revised formula, you can plug in the values and get: Reorder point = (100 x 5) + 200 + (1.65 x sqrt(5 x 20^2 + 100 x 1^2)) Reorder point = 500 + 200 + 92.2 Reorder point = 792.2 This means that you should place an order when your inventory level reaches 792 widgets.

5 The benefits and limitations

Using a continuous review system with a reorder point can help you optimize your inventory management and improve your customer service. By monitoring your inventory level constantly and placing orders based on your demand, lead time, and safety stock, you can avoid running out of stock and losing sales. You can also reduce your holding and ordering costs by minimizing your excess inventory and frequency of orders.

However, a continuous review system with a reorder point also has some limitations and challenges. For one thing, it requires accurate and timely information on your demand, lead time, and variability, which may not always be available or easy to obtain. For another thing, it may not be suitable for products with high demand variability, low demand frequency, or high order costs, as it may result in too many small orders or too much safety stock. In these cases, you may want to consider other inventory systems, such as periodic review or economic order quantity.