Inventory warning levels

Accurate record keeping is very helpful in various aspects of running a business and this historical data, if properly recorded, can help in inventory management as well. An entity can use its past experience stored in the form of records to give insights about inventory usage expected in the future. Using this data, following elements can be figured out:

  • Supply lead time (time between placing an order an receiving the delivery. For instance, order is placed on 1 Jan and it is delivered on 11 Jan, lead time would be 10 days.
  • Average consumption of inventory
  • Maximum consumption of inventory
  • Minimum consumption of inventory

Above mentioned elements can be used to define various inventory levels which help in managing the inventory properly. Remember, the aim is to avoid stock outs while at the same time, not keeping excessive inventory, as holding and maintaining inventory is costly.

Various inventory levels along with their formulas and interpretations are explained below.

 

Reorder Level

As the name suggests, reorder level is the level of inventory at which new order for purchase of inventory should be placed with the supplier. Purpose of setting this reorder level is to warn the entity to place a new order on timely basis, so as to avoid any stock-outs. But the main question is how to define this reorder level. There are several factors to be taken into account such as supply lead time, inventory demand during this lead time, degree of uncertainty in estimating the supply lead time etc.

Formula – Reorder level

If the supply lead time and demand of inventory can be estimated with sufficient degree of certainty and accuracy, following formula is used to calculate the reorder level:

Reorder level = Average inventory demand x Average supply lead time

However, if the supply lead time and demand of inventory are uncertain, an entity has to play safe in order to avoid any stock-outs and therefore, reorder level is set slightly higher. Following formula is used to calculate the reorder level:

Reorder level = Maximum inventory demand x Maximum supply lead time

Buffer stock/ minimum Inventory Level

As explained above, if the supply lead time and demand are uncertain, reorder level is set using a conservative approach in order to avoid stock-outs. This results in the entity holding more inventories as compared to its average needs. This additional inventory, which is the difference between reorder level based on uncertainty and reorder level based on certainty, acts as safety or buffer inventory. It is also called the minimum inventory level, the last warning, because if the inventory falls below this level, there is a risk that the entity will run out of stock before new order is delivered.

Formula – Buffer stock/ minimum inventory level

Units
Reorder level (Max demand x Max supply lead time) xx
Less:
Reorder level (Avg demand x Avg supply lead time) (xx)
xx

Maximum Inventory Level

Recall the aim of inventory management; avoiding stock-outs as well as avoiding excessive inventories. Reorder level and minimum inventory level are the warning levels to avoid stock shortages. On the other hand, maximum inventory level is the warning level to avoid excessive inventories as, above this level, inventory held is of no benefit and it only adds to the holding costs of inventory.

Another benefit of determining maximum inventory level is that it also indicates the storage capacity needed for inventory and the entity can make appropriate arrangements accordingly.

Formula – Maximum inventory level

Units
Reorder level xx
Reorder quantity xx
xx
Less:
Minimum demand x minimum lead time (xx)
xx

Following example will help to understand how these aforementioned inventory warning levels are calculated.

Example – Inventory warning levels

XYZ Company uses MATERIAL-A in its production of goods. Past experience suggests that supply lead time and demand of MATERIAL-A is uncertain which are given in the table below:

Supply Lead Time (days) Demand per day (units)
Average 10 130
Minimum 8 100
Maximum 12 160

Reorder quantity is 4,000 units. Find out the following inventory warning levels:

  1. Reorder level
  2. Buffer stock/ minimum inventory level
  3. Maximum inventory level

Answer

Reorder level

Maximum demand per day (units) 160
Maximum lead time (days) x  12
1,920 units

Buffer stock/ minimum inventory level

Reorder level based on uncertainty 1,920
Less:
Reorder level based on avg demand and avg lead time
(130 units per day x 10 days) (1,300)
620 units

Maximum inventory level

Reorder level 1,920
Reorder quantity 4,000
5,920
Less:
Minimum demand x minimum supply lead time
(100 units per day x 8 days) (800)
5,120 units