Inventory Shrinkage Guide
Inventory shrinkage is a common issue for retailers. It can lead to a drop in profits and require you to alter your accounting books, which will cost you even more time and money to fix.
To combat significant inventory shrinkage, you must familiarize yourself with what it is, why it happens, and the preventative actions you can take. When it does happen, you need to understand how to make correcting entries in your books for proper inventory accounting.
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What is inventory shrinkage?
Inventory shrinkage is when actual inventory levels are less than accounting has them recorded as. Usually this means something has gone wrong, either from an accounting error or theft.
Why should you track inventory shrinkage? For every piece of inventory that’s unaccounted for, you’re essentially throwing away money or losing product.
Whether inventory shrinkage occurs because of theft, shipping damage, or human error, it’s in the best interest of your company to prevent shrinkage.
How to calculate inventory shrinkage rate
Use the following formula to calculate your inventory shrinkage rate:
Inventory Shrinkage Rate = (Recorded Inventory – Actual Inventory) / Recorded Inventory
Then, multiply your inventory shrinkage rate by 100 to convert it into a percentage.
Let’s walk through an example.
Let’s say you recorded $70,000 in inventory value. Your cost of goods sold is $28,000. Your inventory’s book value should be $42,000 ($70,000 – $28,000).
However, due to shrinkage, your actual inventory value is $63,000. Use the inventory shrinkage rate to find out how much value you lost.
Inventory Shrinkage Rate = ($70,000 – $63,000) / $70,000
This equals 0.10. Multiply 0.10 by 100 to show inventory shrinkage as a percentage: 10%.
Your inventory shrinkage rate is 10%, which means you lost 10% of your inventory value to shrinkage.
Why you should calculate inventory shrinkage
Nobody wants to think about inventory shrinkage, but businesses can’t afford to ignore it.
Like most other business losses, inventory shrinkage impacts your bottom line. In order to discover precisely how inventory shrinkage has affected your business, you’ll need to calculate, track, and monitor it over time.
Even more importantly, calculating inventory shrinkage is key to minimizing it in the future, as an accurate calculation could give you a hint as to the shrinkage’s cause.
For example, if your inventory shrinkage percentage is consistently low, a sudden spike is probably just the result of a simple miscalculation. However, if it is always high, you should begin considering other, more nefarious causes, like shoplifting, employee theft, or vendor fraud.
The 4 main causes of inventory shrinkage
There are plenty of causes of inventory shrinkage, which will vary for brick-and-mortar and ecommerce businesses. What do the stats look like for shrinkage? According to SheerID, the reasons for inventory shrinkage are:
- Employee theft: 42.7%
- Shoplifting: 35.6%
- Administrative: 15.4%
- Vendor fraud: 3.7%
- Unknown: 3.9%
1. Consumer theft
AKA shoplifting. This happens when someone comes into your physical store and steals a product. Depending on the type of products you sell, theft can be easy to prevent (locked cases, ink tags, etc.), or require manual, psychical surveillance for smaller, less valuable items (food, produce, etc.)
2. Employee theft
With direct access to all of your products, employees may be capable of stealing from your inventory. With 42% of inventory shrinkage coming from employee theft, you definitely want to find ways to prevent it (e.g., proper warehouse management and security) and learn how to handle it when it occurs (which we’ll cover in a later section).
Damage refers to anything that causes the inventory to become unsellable. This includes broken packaging, cracks, tears, water damage, product expiration, and more.
4. Management errors
Management errors such as miscounting, wrong units of measurement used, or any other type of human error that was a mistake can lead to inventory shrinkage. This is even possible when automation is used for inventory management.
What happens if inventory shrinkage goes unnoticed?
Accounting for inventory shrinkage is crucial to growing your business. Without knowing where your products are going, you can lose out on profits, risk misrepresenting your value on accounting reports, and increase your cost of goods sold.
Loss of product
The most obvious problem is that inventory gets lost and can’t be retrieved. Since many products don’t have GPS trackers on them, you won’t know where they end up.
Money thrown away
Every piece of inventory that is lost is money down the drain. Your profits will be affected, which can affect hiring, expense management, and more.
Accounting and tax miscalculations
If your inventory reports and sales records don’t match, you will have to spend a significant amount of time reconciling your receipts and accounting records. If this information is full of errors, the IRS can get involved as well and potentially audit your business.
7 ways to prevent inventory shrinkage
The good news is there are a lot of ways to prevent inventory shrinkage. Any combination of these methods may work depending on whether you are warehousing products or have your own storefront.
1. Install item tracking
Tracking items isn’t hard and can help you see whether a piece of inventory disappeared out of the warehouse or the retail floor. For example, fashion retailers have had great success with the ink blot tag systems. Grocers are even able to lock their carts if they leave the vicinity of their parking lot.
2. Count inventory often
You can do this in a cyclic manner to minimize the amount of time it takes, but it’s very important to track and manage your inventory. It’s a best practice to use technology that can keep inventory counts update in real-time rather than in Excel, which is static and not synced to anything.
3. Surprise audits
If employees are stealing from you and they know when audits are coming, it gives them time to prepare. With a surprise inventory audit, you can more quickly find anomalies in your inventory counts without prompting staff.
4. Heightened security measures
If you’re a single brick-and-mortar store, it may be useful to install cameras and security systems in your shop or your inventory storage system. You can also make use of clear garbage bags to ensure no one is pretending something is trash but actually putting inventory in a bag that they take for themselves.
5. Split responsibilities
If one employee has access to recording and processing receipts, they could be tempted to falsify the reports. You can counteract this by letting different employees handle recording and processing receipts, or at least for quality assurance.
6. Educate employees
Employees may not be aware of how inventory shrinkage affects them. Use this as an opportunity to let them know how shrinkage affects them directly and indirectly, including how it decreases promotions, paychecks, employee profit shares, and more.
7. Work with a 3PL
Third-party logistics or 3PL providers are professional fulfillment companies that help ecommerce businesses store inventory in the 3PL’s fulfillment center to pack and ship orders. They take precautions to keep your inventory safe and secure while allowing merchants to outsource fulfillment, which is often costly and unproductive to manage in-house.
Most 3PLs provide transparent reporting and technology to help you control stock levels to prevent inventory shrinkage.
Inventory shrinkage management should be a priority for your business. With proper inventory control and management, you can account for and prevent shrinkage, no matter the size of your business.
As your ecommerce business grows and inventory becomes too expensive or challenging to manage in-house, consider using an expert ecommerce fulfillment company to help you. They can help you manage your inventory turnover rate and reduce your inventory carrying costs to save your business money.
Learn how a 3PL like ShipBob helps direct-to-consumer ecommerce brands manage their inventory and ship orders quickly and affordably by downloading the “How to Choose a 3PL for Your E-Commerce Business” guide below.
Inventory shrinkage FAQs
Here are answers to some of the most common questions about inventory shrinkage.
What is considered inventory shrinkage?
Whenever a SKU’s inventory levels are less than they were recorded to be for accounting purposes, there has been inventory shrinkage.
What are some reasons for inventory shrinkage?
Inventory shrinkage can be caused by theft, shipping damage, miscounting, and vendor fraud, as well as other factors.
Is inventory shrinkage an expense?
Yes, inventory shrinkage is considered an expense. Every piece of inventory that’s missing is essentially lost sales and money for your business, and should be considered an expense.