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What is the reorder point, and how can you use it to optimize your product mix?

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If you run a business that sells physical products, you need to balance the demand and supply of your inventory. You don't want to run out of stock and lose sales, but you also don't want to overstock and incur unnecessary costs. How can you determine the optimal level of inventory to maintain? One useful tool is the reorder point.

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John Skelton MA CPIM CCI

Professor, Supply Chain, Operations and Logistics Management at Durham College
Fahad Khan

F&B Inventory & Costing Specialist | Menu Engineering | Pre-opening | ERP implementation
Asha Kanta Sharma

Manager - Finance & Accounts @ Opendoors Fintech | Financial Accounting

1 What is the reorder point?

The reorder point is the minimum quantity of inventory that triggers a new order from your supplier. It is calculated based on your average daily sales, your lead time (the time it takes for your supplier to deliver the order), and your safety stock (the extra inventory you keep to avoid stockouts due to variability in demand or supply). The formula for the reorder point is: Reorder point = (Average daily sales x Lead time) + Safety stock

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John Skelton MA CPIM CCI

Professor, Supply Chain, Operations and Logistics Management at Durham College
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I began my career with one of Canada's largest retailers. I was fortunate to have worked for many years on designing and implementing of computerized inventory management systems that used ROP. They were extremely successful projects which saved the company millions of dollars annually. I discovered that the reorder point model, while described by the simple formula ROP = DDLT + SS, is surprisingly versatile and amazingly powerful. I learned that, to be successful, ROP-centered systems: - must have deadly accurate sales data by SKU - inventory record accuracy must be over 99%. Hint: use cycle counting! - should use probabilistic models to calculate SS - should and CAN be designed to accommodate seasonal demand variations and promotions.

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Fahad Khan

F&B Inventory & Costing Specialist | Menu Engineering | Pre-opening | ERP implementation
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The level of inventory at which any business must place a new purchase order with supplier to avoid out of stock situation. Business owners can also take advantage of this thing if they are smart and know how to manage their reorder levels and can take advantage of off-peak seasons.

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Asha Kanta Sharma

Manager - Finance & Accounts @ Opendoors Fintech | Financial Accounting
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The reorder point is a crucial aspect of inventory management, determining the level at which a new order should be placed to replenish stock before it runs out. It helps businesses avoid stockouts and ensures a continuous supply of products. Understanding the reorder point can improve inventory management and product mix optimization. It involves calculating the reorder point, analyzing lead time variability, categorizing products by demand patterns, segmenting by product criticality, optimizing safety stock levels, prioritizing products, considering Economic Order Quantity (EOQ), evaluating order frequencies, integrating demand forecasting, and monitoring performance.

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2 Why is the reorder point important?

The reorder point helps you avoid stockouts and excess inventory, which can have negative impacts on your profitability and customer satisfaction. If you run out of stock, you may lose sales, damage your reputation, and create backorders that increase your operational costs. If you overstock, you may incur higher storage, handling, and financing costs, as well as risk of obsolescence, theft, or spoilage. By using the reorder point, you can optimize your inventory turnover, which is the ratio of your cost of goods sold to your average inventory. A higher inventory turnover means you are selling your products faster and more efficiently.

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Jesus Flores Guillaumin

Estudios de ingeniería de logística
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The reorder point is a point at which we must manage a minimum inventory level, but contemplating the cycle time of the product since we request it from the supplier, its movement, and must be properly monitored, i.e. reviewing fluctuations in demand, inventory in transit, returns, obsolescence, damaged product, this is in order to avoid a shortage or over inventory, which generates major problems.

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3 How can you use the reorder point to optimize your product mix?

Your product mix is the combination of products that you offer to your customers. It can be influenced by factors such as market demand, customer preferences, competition, pricing, and profitability. To optimize your product mix, you need to understand the contribution margin of each product, which is the difference between its selling price and its variable cost. The contribution margin indicates how much each product contributes to your fixed costs and profits. You can use the reorder point to adjust your product mix by ordering more or less of each product based on its contribution margin and demand. For example, you may want to order more of a high-margin product that has a high demand and a short lead time, and order less of a low-margin product that has a low demand and a long lead time. This way, you can maximize your profits and minimize your costs.

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4 How can you calculate the contribution margin of each product?

To calculate the contribution margin of each product, you need to know its selling price and its variable cost. The variable cost is the cost that changes with the quantity of production or sales, such as raw materials, labor, packaging, and shipping. The formula for the contribution margin of each product is: Contribution margin = Selling price - Variable cost

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5 How can you compare the contribution margin of different products?

To compare the contribution margin of different products, you can use the contribution margin ratio, which is the percentage of the selling price that is the contribution margin. The formula for the contribution margin ratio is: Contribution margin ratio = Contribution margin / Selling price The contribution margin ratio shows how much each product contributes to your fixed costs and profits for every dollar of sales. A higher contribution margin ratio means a higher profitability. You can use the contribution margin ratio to rank your products by their profitability and prioritize them in your product mix.

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6 How can you improve your product mix using the contribution margin ratio?

To improve your product mix using the contribution margin ratio, you can use a technique called the product mix optimization. This approach involves setting a target contribution margin ratio for your entire product mix and then adjusting the quantities of each product to achieve that target. Firstly, calculate the contribution margin ratio of each product and the weighted average contribution margin ratio of your current product mix. Then, compare the weighted average contribution margin ratio with your target contribution margin ratio. If they are equal, you have an optimal product mix. On the other hand, if not, you need to adjust your product mix by increasing the quantity of the products that have a higher contribution margin ratio than the target and decreasing the quantity of the products that have a lower contribution margin ratio than the target. This will increase your overall profitability and reduce your inventory costs. Finally, repeat the process until you reach the target contribution margin ratio or the optimal product mix.

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7 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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What is the reorder point, and how can you use it to optimize your product mix?

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1 What is the reorder point?

2 Why is the reorder point important?

3 How can you use the reorder point to optimize your product mix?

4 How can you calculate the contribution margin of each product?

5 How can you compare the contribution margin of different products?

6 How can you improve your product mix using the contribution margin ratio?

7 Here’s what else to consider

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