A reorder point is the unit quantity on hand that triggers the purchase of a predetermined amount of replenishment inventory. If the purchasing process and supplier fulfillment work as planned, the reorder point should result in the replenishment inventory arriving just as the last of the on-hand inventory is used up. The result is no interruption in production and fulfillment activities, while minimizing the total amount of inventory on hand.
The reorder point can be different for every item of inventory, since every item may have a different usage rate, and may require differing amounts of time to receive a replenishment delivery from a supplier. For example, a company can elect to buy the same part from two different suppliers; if one supplier requires one day to deliver an order and the other supplier requires three days, then the company's reorder point for the first supplier would be when there is one day's supply left on hand, or three days' supply for the second supplier.
The basic formula for the reorder point is to multiply the average daily usage rate for an inventory item by the lead time in days to replenish it. For example, ABC International uses an average of 25 units of its green widget every day, and the number of days it takes for the supplier to replenish inventory is four days. Therefore, ABC should set the reorder point for the green widget at 100 units. When the inventory balance declines to 100 units, ABC places an order, and the new units should arrive four days later, just as the last of the on-hand widgets are being used up.
However, this formula for the reorder point is only based on average usage; in reality, demand may spike above or decline below the average level, so there may still be some inventory on hand when the replenishment order arrives, or there may have been a stockout condition for several days that has interfered with production or sales. To guard against the latter condition, a company may alter the reorder formula to add a safety stock, so that the formula becomes:
(Average daily usage rate x Lead time) + Safety stock
This formula alteration means that replenishment stock will be ordered sooner, which greatly reduces the risk that there will be a stockout condition. However, it also means that a company will have a larger investment in its on-hand inventory, so there is a trade-off between always having available inventory and funding a larger inventory asset.
Please note that the reorder point only indicates when to place a replenishment order; it does not calculate the amount of items that should be ordered (which is addressed by the economic order quantity formula). Better yet, consider using a just-in-time or material requirements planning system, which only order new inventory when there is a specific, identified reason for doing so.