The problem: stockouts or overstocking
If you order an item too late, it runs out on the shelf and the customer goes to a competitor. In a pharmacy, this may mean a patient who cannot find their chronic medication. If you order too early or in large quantities, inventory piles up, money is frozen, and the stock may even expire. The solution is to set two numbers for each important item: the reorder point, which is the balance at which you issue a purchase order immediately, and safety stock, which is the extra quantity that protects you from fluctuations in demand or supplier delays.
The basic formula
Reorder point = Average daily usage × Lead time in days + Safety stock
- Average daily usage: the average quantity sold per day over a suitable period, such as the last 90 days, excluding unusual days or adjusting for seasons.
- Lead time: the days from issuing the purchase order until the goods arrive and are ready for sale, not just the shipping time.
The first part of the formula covers what you will sell while waiting for the order. Safety stock covers the surprises.
Calculating safety stock two ways
The simple method: worst case
Safety stock = (Maximum daily usage × Longest lead time) − (Average daily usage × Average lead time)
It is easy and needs no statistics, but it tends to overstate because it assumes the worst demand and the worst delay happen together.
The statistical method: service level
Safety stock = Z × Standard deviation of daily usage × Square root of lead time
Here Z is a factor reflecting the required service level, i.e. the percentage of order cycles in which no stockout occurs. The common value for a 95% service level is approximately 1.65, and for 99% about 2.33. This formula assumes the lead time is relatively stable.
Example 1: a pharmacy and a chronic medication
A pharmacy in Riyadh sells a common blood pressure medication. Data for the last 90 days:
| Description | Value |
|---|---|
| Average daily sales | 20 boxes |
| Maximum daily sales | 30 boxes |
| Average lead time from the distributor's warehouse | 3 days |
| Longest lead time | 5 days |
- Safety stock (simple method) = 30 × 5 − 20 × 3 = 150 − 60 = 90 boxes
- Reorder point = 20 × 3 + 90 = 150 boxes
When the item's balance reaches 150 boxes, the order is sent to the supplier. If a box costs 18 SAR, the safety stock alone represents 1,620 SAR invested as insurance against stockouts.
Using the statistical method: if the standard deviation of daily sales is 6 boxes, the lead time is 4 days and the service level is 95%: safety stock = 1.65 × 6 × 2 = 19.8, i.e. approximately 20 boxes, and the reorder point = 20 × 4 + 20 = 100 boxes. The large difference from the simple method shows how much the worst-case method overstates when fluctuation is moderate.
Example 2: an auto parts store and an imported item
An auto parts store in Dammam sells brake pads for a popular model. Average sales are 4 sets a day, and maximum sales are 6 sets. The item arrives from a distributor outside the region in 7 days on average, and sometimes 10 days.
- Safety stock = 6 × 10 − 4 × 7 = 60 − 28 = 32 sets
- Reorder point = 4 × 7 + 32 = 60 sets
If management finds 32 sets too many for an item costing 120 SAR (3,840 SAR frozen as safety stock), it can negotiate with the supplier for a guaranteed lead time of 7 days, reducing safety stock to 6 × 7 − 28 = 14 sets, and the reorder point to 42 sets.
The store example shows that safety stock is not a number the accountant sets alone; it is the result of the business's relationship with the supplier. A supplier who is punctual saves you more frozen money than a small price discount from an unreliable supplier. That is why it is useful to record the date each purchase order is issued and the date it is actually received, so you know each supplier's real lead time instead of relying on their promises.
Implementation tips
- Apply the precise calculation to the highest-value and fastest-moving items first, and do not waste your time on marginal items.
- Recalculate every quarter or before peak seasons, because demand in Ramadan or winter differs from the rest of the year.
- The reorder point only works with a perpetual inventory system that gives you the actual balance in real time.