How to calculate your reorder point and EOQ to increase profitability
Learn to master the key indicators for optimal stock replenishment
Your business is expanding, your sales are taking off and the forecasts are looking good for the coming months. Your hard work is finally paying off. Your small business is on the path to success and you should be delighted.
❗ However, you need to be aware that managing your stock only gets more complicated as you grow, and it shouldn’t be based on approximate forecasts, your intuition or even what you see in a crystal ball!
It is crucial to remain vigilant and ensure that you have monitoring indicators in place to support your development. When growth is on the menu, your attention must be focused on stocks.
It’s a question of balance
To have the right level of stocks you need to know how much to order and when to order it, with the aim of finding a balance between low storage costs and being able to meet customer demand.
In plain terms, it’s what you need to do to ensure that you have enough stock to meet customer demand, but also that this stock isn’t so large that it affects your profitability.
At the end of this article, you'll be able to download our reorder point calculator.
An imbalance in one direction or the other is harmful for the company. Here’s how:
THE CONSEQUENCES OF POOR STOCK MANAGEMENT
- Stock shortage, therefore sales can’t be made
- Reduced turnover
- Customer dissatisfaction with the risk of them going to the competition
- Too restrictive a choice that doesn’t encourage a sale
- Harm to the company’s image
- Effect on the Google rating of the quality of an e-commerce site
- Increased working capital requirement (WCR): additional financing needs
- Capital lockup and cash flow problems
- Increased charges (fixed and variable): renting additional storage space, staff and insurance, among others
- Reduced margin when selling surplus stock at a reduced price
- Obsolescence for certain product categories (for example foodstuffs) that could lead to stock being thrown away
So how should you reorder and manage stock levels? Below you will find the essential steps and formulas for optimising your ordering. To make it easier to understand and to assist with your own calculations, we have provided illustrations with each step accompanied by a concrete example. In addition, at the end of the article you will find a tool to download for calculating your reorder point.
But first of all, let’s look at the challenges of monitoring your stocks with precision.
We need to look at two separate parameters:
- Cost management
- availability management
Obtaining the perfect balance between these two elements will be the key to optimising your stock.
1. Cost management is shared between acquisition costs and holding costs.
Acquisition costs are all the costs connected to purchasing in your business, such as products, equipment and transport costs.
Holding costs are storage costs and all the costs connected to them (e.g. staff).
2. Availability management
While controlling your costs is essential, so too is guaranteeing the availability of your products. A customer who encounters a stock shortage is highly likely to be lost and turn to the competition instead. Availability has become a real selection criterion in e-commerce in particular.
Stock management and replenishment are a real challenge for many small businesses. Retailers, distributors and manufacturers experience stock issues that require an understanding of the basics of stock management, as well as implementing regular monitoring.
Step 1 : Segment your stock to improve analysis
The primary objective is to determine the priority points and concentrate your efforts on the section of the stock that requires special monitoring. There are two very similar approaches you can take.
The Pareto analysis
Named after the Italian economist Vilfredo Pareto, the Pareto law applies to many sectors, signifying that 80% of effects are due to 20% of the causes.
So when it is applied to stock management, it can be deduced that:
20% of the items in stock represent 80% of the value of the stock.
So you need to identify the 20% of products that represent 80% of the stock costs. To do so, you can draw up a diagram which will show which products require regular and specific monitoring.
Segmenting your products when you have a certain number of references makes it possible to adopt corrective measures and optimise the management of each item depending on its relative importance.
The ABC analysis
Inspired by the Pareto law, the ABC method simply establishes a classification using three groups instead of two. You therefore get:
- A items constituting 70-80% of the value of the company's stock and generally corresponding to 10-20% of the total products in stock.
- B items representing 15-25% of the value of the company's stock and generally 30% of the total products in stock.
- C items, in contrast, are those with the lowest value. The latter represent 5% of the value and generally around 50% of the total items in stock.
Let’s take the example of the company Martin MED Corp that sells medical equipment. Martin Richard is the director of the distribution company and wants to perform an initial analysis of its stock to optimise how it is managed. Let’s say that Martin Med has nine references in stock.
- The first step is to list the items in the stock and link their unit cost to them.
Martin has been using the erplain software to manage the company’s sales and stocks for several months, and now just needs to export a table that includes:
• the product name and its reference;
• the quantity and unit cost.
Then, the total value of each product needs to be calculated, along with the total value of all the stock.
- The second step is used to classify the products in decreasing order of value, then to calculate their percentage value by product and cumulatively, and finally the percentage quantity and cumulative percentage quantity.
➡ According to the 20/80 or Pareto analysis, 20% of the items in stock at Martin Med represent 80% of the value of the stock. These two references in stock (infrared lights and blood pressure monitors) are therefore those that must be monitored more regularly and carefully. We will see how below.
ABC stock method
➡ This kind of selective management, just like with the Pareto method, is used to set a different level of monitoring and different order procedures for the different groups. The company Martin Med will therefore have to perform rigorous monitoring and implement methodical and frequent order procedures for items in class A (references D and G). Group B can receive less monitoring, and group C even less.
As detailed above, this initial selection of stock items can consequently enable you to set up monitoring tools for products that require increased vigilance.
The company Martin Med will pay particular attention to reference D, the infrared light, and G, the blood pressure monitor.
Etape 2 : Calculating the reorder point
You have just identified the products in your stock that require closer monitoring. Remember that stock management starts at the purchasing stage.
In fact, when you order a product, it is important to pay attention to the delivery date and the quantity. You have several options for doing so, but here we will concentrate specifically on studying the reorder point method. It is a method that is particularly well suited to products that are consumed regularly.
In a system that involves just-in-time production, the reorder point method allows you to set a minimum stock that, once reached, triggers replenishment thus reducing storage and the associated costs.
- Replenishment Lead Time (in number of days)
This is the key element of the reorder point method, and includes:
- placing the order;
- the supplier receiving the order;
- processing the order;
- dispatching and transporting the order;
- delivery and receipt of the order.
Let’s look at the case of the company Martin Med again. As indicated above, of the two reference products that require monitoring, the blood pressure monitor will be the subject of our calculation. Martin Med buys this item in Germany.
The next step consists of calculating a consumption average.
- The average daily usage (in products units)
To calculate the average daily usage you need to calculate the average number of sales of a product per day.
If Martin MED Corp sold 730 blood pressure monitors in 12 months, the average number of products sold per day over one year (365 days) would be 730/365 = 2 units/day.
Therefore Martin MED Corp sells on average two blood pressure monitors per day each year.
As we know the average daily usage and the replenishment lead time, let’s see how to find the reorder point.
❗Reminder: The REORDER POINT is the level of available stock that, when reached, indicates to the company that it needs to issue a replenishment order (a reorder) so it can be delivered before a stock shortage occurs.
The four essential elements of the reorder point method:
- Stock management must be strict to minimise the risk of a shortage.
- The delivery lead time must be known and taken into account.
- Reorder should be performed in a set quantity and at a variable interval.
- A safety stock must be created to ensure product availability during replenishment.
Now we need to calculate the safety stock to allocate a value to this reorder point.
So what is a SAFETY STOCK and how can you calculate it ?
The safety stock is the stock level that limits stock shortages due to unpredictable factors. These unforeseen variations have many causes. Sometimes it is also referred to as buffer stock.
- an unpredicted exceptional order,
- a new "big" customer with orders that require rapid delivery,
- a weather event stimulating demand.
- a supply lead time that is longer than predicted (shortage of components),
- forecasts that do not match demand,
- unreliable deliveries.
There are several methods for calculating the safety stock:
We will limit ourselves here to looking at the "expert method".
Let’s now look at the example of the company Martin Med Corp again. Here are the monthly sales of blood pressure monitors from 2017.
The company sold 69 blood pressure monitors in November, which represents the maximum monthly sales. This corresponds to 69/30 (number of days in November) = 2.3 per day. Moreover, we have already calculated the average daily usage, or the average sales per day, which is 2. (see calculation above).
Maximum daily sales - average daily sales= 2.3 - 2 = 0.3
The safety stock in this specific case is therefore 0.3 x 20 = 6 blood pressure monitors.
Calculating the reorder point including the safety stock: This means therefore that the company Martin Med Corp must reissue a purchase order when there are 40 + 6, i.e. 46, blood pressure monitors remaining in stock. (see reorder point formula)
EOQ (Economic Order Quantity) or Wilson formula, what's that?
The Economic Order Quantity, also known as the Wilson formula, corresponds to the quantity of products to order to minimise the total annual cost of stock management, namely the acquisition costs (cost of placing an order + transport costs + cost of receiving the order) and the holding costs, while continuing to meet customer demand.
- Holding costs increase with stock quantity. To reduce them, you need to place lots of small orders.
- Acquisition costs increase with the number of orders. To reduce them, you need to place only large orders.
➡ The Economic Order Quantity is a balance between order acquisition costs and stock holding costs.
The following elements need to be in place to calculate the EOQ:
- annual demand is constant and known in advance,
- the unit purchase price is constant,
- all orders are delivered in one batch and at the same time,
- the delivery time is constant and known,
- the order cost is constant,
- the unit storage cost is constant,
- there are no stock shortages.
Let’s look more closely at the formula for calculating the Economic Order Quantity:
Several parameters should be taken into consideration when calculating it.
- N : Annual consumption.
- CC : Acquisition costs (cost of placing an order + transport costs + cost of receiving the order).
- P : Unit purchase price of a product.
- H : Stock holding rate. This parameter requires some explanation.
You know that your stock has a cost, but do you know the details? In general, we consider that stock is worth between 15% and 35% of its purchase price.
We can also calculate the holding rate. This gives you an idea of the value the stock represents. It corresponds to a ratio between the total holding cost (charges linked to using the stock) and the total value of the stock.
The holding costs are made up of:
- Financial costs (financial costs linked to cash advances)
- Warehousing costs (all the storage costs: salaries of warehouse workers, equipment maintenance costs, rent, information software)
- Depreciation costs (charges linked to stock variations)
Let’s now say that Martin Med Corp has a stock of $160,000 and that all the charges linked to this amount to $35,000. So its holding rate will be 35,000/160,000, i.e. 21.87%.
Let’s see the other formula parameters in the case of Martin Med Corp.
N = consommation de tensiomètres en 1 an soit 730 unités ;
CC = $28 (given value)
P = $179
H = 21,87%
So in each order, Martin Med Corp will have to order 41 blood pressure monitors.
It will now be useful to calculate the number of orders to be placed throughout the year to optimise costs.
In conclusion, to optimise the cost of their purchases without risking a stock shortage, Martin Med Corp will have to place 730/41, or 17 orders each year.
If you have followed all these steps, you really will be a stock management whizz! You can now continue to learn more about the topic, but you already have a good overview of logistics that will enable you to ramp up your company’s growth with peace of mind.
Everything you have learned will help you to predict and optimise your stock management. Every company that has stock to manage must put in place logistics indicators, which will have a positive effect on the entire business. Don’t make the mistake of thinking your company is not yet big enough to put in place regular and effective stock monitoring.
When you are equipped with intuitive and high-performing stock management software such as erplain, the data you use to make these calculations will be accessible in real time and will enable you to calculate your reorder point or Economic Order Quantity quickly.
You can also download and use our reorder point calculator, request it below.
Now it’s down to you. All you need to do is start using this logistics barometer and planning your purchases in an optimum manner!