Inventory management: reorder point and economic purchasing

In the assignment (see previous post) our decision making in regard to Inventory Management was focused on combination of only two parameters: reorder point and economic purchasing.

The reorder point is the inventory level that, when it’s reached, triggers new purchase ordering. The reorder point is calculated to ensure we won’t get short of materials while waiting for new purchase order to arrive. The reorder point usually embraces some reserved quantity – safety stock for the cases of higher demand than it was predicted:


Diagram based on picture from Managing Business Process Flow by Ravi Anupindi and others

The size of purchase order was to be a compromise between fixed costs per order and losing or earning interest on our cash balance, e.g. a large purchase order quantity could help us save on order fixed costs but might also cause more loses (opportunity cost) from interest that wouldn’t be earned. The optimal size of purchase order can be calculated using the formula for EOQ (Economic Order Quantity):



In case of our assignment, fixed cost per order was given to us, expected annual demand could be calculated based on sales forecast, and unit holding cost per year could be calculated based on annual interest we would lose if we buy one unit of material and keep it for one year. There are some considerations for practical use of this formula that I’ll mention later.

© Andrey Maslov