The reorder point answers “when”, and the economic order quantity answers “how much”. Between them sits safety stock: the cushion that protects you when the supplier is late or demand jumps.
1 The four levels
| Level | What it means | What happens at it |
|---|---|---|
| Safety stock | A reserve untouched in normal conditions | Touching it is a warning, not a solution |
| Reorder point | The balance at which we order | A purchase order is raised |
| Maximum level | A ceiling not to be exceeded | Exceeding it freezes cash |
| Available balance | On hand less committed plus inbound | The figure a promise to a customer rests on |
On hand is not available
There are 500 units in the warehouse, of which 380 are committed to confirmed orders. Available is 120, not 500. Promise a customer on the basis of “on hand” and you sell the same goods twice. The sales screen must show available, not on hand.
2 When do we order? The reorder point
Daily usage
Average quantity going out per day
× lead time
From ordering to reaching the shelf
+ safety stock
A hedge against delay and demand spikes
= reorder point
The balance at which we order
Lead time runs until the item is physically on the shelf, not until it reaches the gate
| Average daily usage | 40 units |
| Usual lead time | 15 days |
| Usage during lead time | 600 |
| Safety stock (5 days) | 200 |
| Reorder point | 800 units |
So when the balance drops to 800, the order is raised automatically. And if the supplier is five days late, safety stock covers the gap without selling stopping.
Warning: if usage rises to 60 units a day and the reorder point is not updated, the item will run out before the shipment lands even though “the system is correct”. Levels are reviewed periodically, not set once at implementation.
3 Safety stock and service level
How much safety stock to hold is a trade-off between holding cost and stock-out cost, and it depends on three things: how variable demand is, how variable the lead time is, and the service level you are targeting.
| Target service level | What it means | Effect on safety stock |
|---|---|---|
| 90% | A stock-out in one cycle out of ten | Low |
| 95% | A stock-out in one cycle out of twenty | Moderate |
| 99% | A stock-out very rarely | Very high |
The last five points are the most expensive
Moving from 90% to 95% costs a lot, and from 95% to 99% costs several times more again — the relationship is not linear. Which is why not every item is given the same service level: a critical item that halts a production line deserves 99%, and an item with a substitute available in the market can live with 90%.
4 How much do we order? The economic quantity
The larger the order quantity, the fewer the orders and the lower the ordering cost — and the higher the storage cost. The economic order quantity is the point where the two effects balance and the sum of both costs is at its lowest.
| Order size | Annual ordering cost | Storage cost | Total |
|---|---|---|---|
| Very small | Very high | Low | High |
| Moderate | Moderate | Moderate | Lowest |
| Very large | Low | Very high | High |
- Ordering cost covers raising the order, following it up, receiving, inspecting and invoicing.
- A volume discount may justify going above the economic quantity — provided the saving exceeds the extra storage cost.
- Shelf life sets a ceiling that no discount, however attractive, should breach.
- A supplier minimum may force a larger quantity than the ideal, so negotiate it.
- The model assumes steady demand, so it does not suit seasonal or intermittent items.
Lesson summary
- “When to order” is answered by the reorder point; “how much” by the economic order quantity.
- Reorder point = usage during lead time + safety stock.
- Available is not on hand, and a promise to a customer rests on available.
- Safety stock depends on demand variability, lead-time variability and service level.
- Raising the service level costs several times more with each additional point.
- Levels are reviewed periodically, or they turn from a control into a cause of stock-outs.
5 Test your understanding
Three quick questions
Pick the answer you believe is correct and you will see the result immediately.
1. Daily usage 40 units, lead time 15 days, safety stock 200. The reorder point:
(40 × 15) + 200 = 800; that is, usage during the lead time plus safety stock.
2. There are 500 units in the warehouse, 380 of them committed. What should the salesperson see?
Selling is based on what is available; showing on hand leads to selling goods already allocated to another customer.
3. Daily usage rose from 40 to 60 and the reorder point was not updated. The expected outcome:
The reorder point is built on old usage, so the signal arrives later than the real need.