Inventory Shrinkage

Updated on April 4, 2024
Article byWallstreetmojo Team
Edited byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Inventory Shrinkage?

Inventory shrinkage is defined as the difference between the inventory amount listed in the books of accounts and the actual inventory that physically exists; such shrinkage usually happens due to theft, damage, or due to error in counting.

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The one having a retail business is likely to face theft, shoplifting, or other forms of fraud, bringing unforeseen inventory losses. Such losses are a big problem for any business that carries physical goods. Hence, businesses must have proper Without controls and monitors in place to trace the root causes of inventory shrinkage.

Key Takeaways

  1. The term inventory shrinkage refers to the discrepancy between the amount of inventory stated in the books of accounts and the actual inventory; this shrinkage typically results from theft, damage, or a counting error.
  2. Theft and error are the two main causes of shrinkage. It will not appear as shrinkage if you take steps to account for a change in your inventory, such as removing an item from stock for store use, lowering an item’s sale price due to its condition, or giving an item to a charity.
  3. Losing a few items or units of inventory due to physical damage should be expected; however, theft and shoplifting can be concerning. As a result, it implies that your team lacks credibility and may struggle with difficulties like low motivation or workplace complaints.
  4. It is difficult to cut losses and keep them to a minimum. It requires commitment and ongoing focus, starting before a candidate is hired and lasting throughout each business day.

Inventory Shrinkage Explained

Inventory Shrinkage is a significant issue that needs careful consideration of your business processes and identifying associated loopholes. Once they are identified, an optimal solution can be implemented to reduce inventory shrinkage. Reducing losses and keeping them at a minimum is not easy to do. It takes dedication and constant attention, the attention that must begin before an applicant is hired and continues each business day. A successful loss prevention program will eliminate, or at least greatly reduce, those opportunities – and give you a much better chance of being alerted when a violation of any part of that program occurs.

As a rule of thumb, it is a fact well known that physical inventory in the retail business consumes a large share of working capitalWorking CapitalWorking capital is the amount available to a company for day-to-day expenses. It's a measure of a company's liquidity, efficiency, and financial health, and it's calculated using a simple formula: "current assets (accounts receivables, cash, inventories of unfinished goods and raw materials) MINUS current liabilities (accounts payable, debt due in one year)"read more. In other words, inventory is money that is stashed in your warehouse. Hence, any type of theft or shoplifting that might be happening in your warehouse should be accounted for and must be stopped.

Although losing a few pieces or units of inventory due to physical damage can be normal, theft and shoplifting, on the other hand, can be worrisome. Consequently, it suggests that your workforce is not credible enough, and they may have issues such as a lack of motivation or workplace grievances as well.

Also, recurring Inventory Shrinkage may lead to a lot of complications in inventory controlInventory ControlInventory control is adopted by organizations to properly manage the inventory/stock stored in the course of business to minimize storage & carrying charges for the inventory and satisfy its customer’s demands in the market.read more.

Causes

Shrinkage is primarily caused by two things – theft and error. If you take action to account for a change to your inventory, such as removing an item from stock for store use, reducing the sale price of an item because of its condition, or donating an item to a charity, it will not show up as shrinkage because you have accounted for it.

#1 – Theft

There are three categories of theft:

  • Theft by employees
  • Theft by customers
  • Theft by vendors

#2 – Error

Error, on the other hand, is the unintentional loss of inventory value, with no dishonesty involved. Mistakes such as mispricing, entering inaccurate data into the IMU file, or neglecting to adjust the inventory when actions take place such as removing an item from a display for store use or donating an item to a local charity, are all examples of shrinkage caused by an error.

A different type of Shrinkage can be referred to as the loss of raw materialsRaw MaterialsRaw materials refer to unfinished substances or unrefined natural resources used to manufacture finished goods.read more during a production cycle. For example, while baking food items, the baker will experience shrinkage throughout the production process due to ingredients left behind with the utensils as well as due to evaporation. This is termed spoilageSpoilageSpoilage is defined as waste material released during the normal manufacturing process, where the spoiled material is known as scrap material if it is no longer useful.read more or waste as well, and it can occur due to normal or abnormal circumstances.

Formula

A formula to calculate Inventory Shrinkage is by finding the total financial value of all inventory in the financial year/quarter and subtracting the total inventory as obtained after the cycle count.

Inventory Shrinkage = Booked inventory-Physically Counted inventory

Where Booked Inventory = Beginning Inventory + Purchase – (Sales + Adjustments)

To account for this loss of inventory via the perpetual accounting method, you would: increase the cost of goods soldCost Of Goods SoldThe Cost of Goods Sold (COGS) is the cumulative total of direct costs incurred for the goods or services sold, including direct expenses like raw material, direct labour cost and other direct costs. However, it excludes all the indirect expenses incurred by the company. read more and decreases the inventory by the difference for the recording period.

Your balance sheet would show a credit to the inventory line item for the value that was lost—showing that you have incurred higher expenses (cost of goods), and a lower gross profitGross ProfitGross Profit shows the earnings of the business entity from its core business activity i.e. the profit of the company that is arrived after deducting all the direct expenses like raw material cost, labor cost, etc. from the direct income generated from the sale of its goods and services.read more will lower your taxable income. However, you might choose to record your shrinkage separately instead of including it in your costs of goods sold.

Examples

Let us consider the following inventory shrinkage examples:

Example 1

For example, your records may show that you should have $5,000 in inventory because you had $6,000 worth of inventory, sold $2,000, and bought $1,000 more. Total the actual value of inventory that you have in stock. This number may be different from the book value because of losses, damaged goods, or theft.

Subtract the actual amount of inventory from the amount that you should have according to your financial records. For example, if you expected to have $5,000 but only had $4,850, you would subtract $4,850 from $5,000 to get $150.

Divide the difference by the amount you should have to calculate the shrinkage rate. In this example, you would divide $150 by $5,000 to get 0.03.

Multiply the shrinkage rate by 100 to convert it to a percentage. Finishing this example, you would multiply 0.03 by 100 to determine a shrinkage rate of 3 percent.

Example 2

ABC International has $1,000,000 of inventory listedInventory ListedInventories list is the systematic record of the raw material, work-in-progress and finished goods available with the company. All the stock items are entered along with their SKU number or inventory Id, name, description, unit price, quantity, value, reorder level, reorder time, quantity in record and discontinuation status.read more in its accounting records. It conducts a physical inventory count and calculates that the actual amount on hand is $950,000. Calculate its inventory Shrinkage.

Inventory shrinkage will be – 

Example - 1.1
  • = $1,000,000 – $950,000
  • = $50,000

The amount of inventory shrinkage is therefore $50,000 ($1,000,000 book cost – $950,000 actual cost).

Inventory Shrinkage Percentage will be – 

Inventory Shrinkage %
  • = $50,000 shrinkage / $1,000,000 book cost
  • = 5%

The inventory shrinkage percentage is 5%.

Inventory Shrinkage Journal Entry

Following is the example of journal entryExample Of Journal EntryA journal entry example would be the country's purchase of machinery, where the machinery account would be debited and the cash account would be credited.read more for an inventory shrinkage that makes for you to record this event. This journal entry debits an appropriate expense accountExpense AccountExpense accounting is the accounting of business costs incurred to generate revenue. Accounting is done against the vouchers created at the time the expenses are incurred.read more; the expense account is a shrinkage expense — for $50,000. A journal entry also needs to credit to the inventory account for $50,000.

Journal Entry Example

How to Prevent?

Inventory shrinkage can be reduced by putting some simple processes in place:

Inventory-Shrinkage

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  • Implement a double-check system.
  • Give products unique identities.
  • Conduct employee meetings and training.
  • Automate inventory management with software.
  • Plan for busy periods.
  • Track inventory shrinkage over time.

Frequently Asked Questions (FAQs)

How is shrinkage in inventory determined?

Conduct a physical inventory count, determine its cost, and then deduct that cost from the cost indicated in the accounting records to determine the amount of inventory shrinkage. To calculate the inventory shrinkage percentage, divide the difference by the quantity in the accounting records.

Are shrinkage KPIs used?

The pace at which the inventory value has decreased due to loss, theft, or incorrect record-keeping is measured by the KPI known as the inventory shrinkage rate.

What is the primary factor behind shrinkage?

When a store has fewer things in stock than in its recorded book inventory, the accounting word “shrinking” explains the situation. Employee theft, shoplifting, mistakes in administration, vendor fraud, product damage, and other factors can all cause shrinkage.

This has been a guide to what is Inventory Shrinkage. Here we explain the formula along with examples of how to calculate it, how to prevent it & its causes. You can read more from the following articles –

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