 Hello and welcome to this session. This is Professor Farhad. In this session, we would look at the order points and safety stock, which is an extension of the EOQ, the economic order quantity. This topic could be covered in corporate finance course, cost and managerial accounting. This topic is covered on the CPABEC exam as well as the CMA. So a lot of people can benefit from this session. As always, I would like to remind you to connect with me on LinkedIn if you haven't done so. YouTube is where you would need to subscribe. I have 1,700 plus accounting, auditing, finance, tax, as well as Excel tutorial. If you like my lectures, please like them, share them, post them on your social media. It doesn't cost you anything. If they benefit you, it means they might benefit other people, subscribe to my YouTube and connect with me on Instagram. If you are looking for additional resources to supplement your accounting education, for example, if you're looking for a little bit help of enter into finance or cost accounting or you're looking for additional CPA material, check out my website, farhatlectures.com. If you want to add 10 to 15 points to your CPA exam, check out my website. What is the prerequisite for this session? You have to be familiar with the economic order quantity. The link is in the description. So what does the EOQ tells us? The EOQ determined the optimal quantity to order. Simply put, it tells us what is the best quantity to order to minimize the carrying cost as well as the restocking cost. Because those costs are considered substantial when we have inventory. Therefore, we assume that we order when the inventory reach zero. That's the assumption. But is this a correct assumption? Think about it. What happened if your inventory reaches zero? Well, the truck could be delayed. We could have a pandemic, like what's going on right now with the coronavirus. And we had pandemics before. The people that supply you, they could go on strike. It could be the weather may not allow the boat to cross the ocean. We don't know. But the problem is if you let your inventory reach zero, you are always running the risk of running out of inventory. And this is not good for your business. So that's the problem with the EOQ. It's not a problem. We have to kind of add to it a safety stock. What is a safety stock? A safety stock is a minimum level of inventory that the firm keeps on hand. So what we do is, okay, I understand when do we need to order the optimal quantity. But to be on the safe side, let's have maybe five, six, seven days of inventory on hand. Just in case we did not get the order on time. So simply put, we should not have a zero inventory at any time. We should not wait until the inventory reaches zero then to order. Why? Because there is uncertain delivery times. Many factors could affect the delivery. Again, we're living this today with the coronavirus where a lot of companies they ran out of inventory simply put because no one's flying. No one is, there's a whole to the transportation logistics industry. So you don't want to run into that. But this is an extreme example. But again, a strike could happen in China or a strike could happen in South Korea or a strike could happen in Japan. And this is your suppliers and you cannot get the ingredient that you need for your product. So simply put, we looked at this graph earlier. Simply put, what you do is you don't let your inventory, this is zero. You don't let your inventory reach zero. What you do is you'll have always a safety stock. So you will reorder at this point before your inventory reaches zero. You want to reorder earlier and we're going to see why. But at some point you should have a safety stock. So this is basically, you'd say this is zero for you but it's not really zero because you have a safety stock. But the question is when to reorder? Do you wait until you reach zero? And we said, let's assume the safety stock is 100. Do you wait until you reach the safety stock or you might want to reorder a little bit earlier? Well, we'll talk about this. Well, the point is when to reorder? Do you wait for here or do you reorder earlier? Obviously, the earlier you reorder, the better off you are. So obviously you don't want to reach your safety stock. So before inventory reach a critical level and in my opinion, the critical level of the safety stock, you don't want the safety stock. You want the safety stock to be a buffer, a buffer for you. So what do you take into account when you are determining the reorder points? The reorder points is when do you place the order? Say, look, I'm going to go ahead and place the order. So send it to me. Well, you take into account, obviously, the delivery or lead time. How long does it take your supplier to deliver that product to you? So simply put, we have something called the delivery time. Now, let's take a look at this example without the safety stock. And to illustrate this example, just to kind of let's work through some numbers because numbers will make it easier to understand. Let's assume you consume or you sell or you use 50 units per day of a certain product. 50 units per day. And if you use 50 units per day, it takes 10 times for your supplier to deliver those units. So times 10, so that's 500 units. So what we did is we took the delivery, the lead time, the delivery days, times how many units you consume, you use, you sell per day. And we say 500 unit is your critical points. So this is your 500 unit. So simply put, as soon as your inventory reaches 500 unit, you place the order. The order take 10 days, by the time the 10 days are ran out, then you have your inventory filled up again. Then your inventory will go down. Once you reach the 500 unit, then what you do, the system will trigger an order because this is 550 units times 10 days, then your supplier will deliver, then you're back to whatever you need to do, like 3,500 unit, then you run down again. So this is what you do. But again, what we're doing here is we are assuming there's no safety, there's no safety. So to make it, just to make sure we are in good shape, let's assume that rather than 10 days, at some point, the maximum that our delivery was late was five days. So let's assume at some point, over the average, over the years, we notice that the maximum over a period of five, seven, eight years, the maximum, let's assume the maximum three, the maximum that they were late, not 10, three. But also in addition to those three days, we would like to have an additional two days just to be extra. So what I want to do, I want to have five days of extra inventory on hand, just in case the 10 day delivery average time did not materialize, what does that mean? It means now I need to take 50 unit times, I'm gonna take 15 days, that's 750. So simply put, what's gonna happen is, I'm gonna have a 250 unit, which is five times 50, which is 250, that's a safety stock. And I'm gonna order 500 units at 500 unit before I reaches the 250 my safety stock. So simply put, I will need to trigger the order as soon as my inventory reaches 750. Why? Because it's gonna take on average 10 days to deliver, that's gonna bring me down to my safety stock. And hopefully they will deliver by 10 days. If they are late, I have five days of buffer zone. Now if they are late more than five days, then I'm in trouble, simply put. But if that's the case, you want to have maybe an alternative supplier. You might have to pay extra, but you always have to have a plan B. So the 250 is your plan B actually, you need to have a plan C now because your plan B ran out. So simply put, the safety stock is a plan B. Well, they're late 10 days, we have five more days to figure things out. And obviously as a manager, by the time you know that they're gonna be late, you wanna look for plan C because you don't want to wait until those five days are depleted. So this is the safety stock and the reorder point. Once again, it's very important to understand the EOQ, which is when to order, but you want to add the safety stock to your reorder points. So you are safe basically, that's it. It's hedging, part of managing your inventory, part of managing your business. As always, I would like to remind you, if you like this recording, like and share it. As always, I would like to also remind you to visit my website, farhat-lectures.com where you have additional resources to supplement your accounting education or your CPA exam. Study hard, stay safe. Your CPA is a lifetime investment. Don't shortchange yourself and stay safe, especially during those coronavirus days. Good luck.