Shrinkage Formula

What is Shrinkage Formula?

The shrinkage comes into play when there is a substantial difference in the number of items mentioned in the book of accounts than as present physical. Considering the case of inventory valuationInventory Valuation Inventory Valuation Methods refers to the methodology (LIFO, FIFO, or a weighted average) used to value the company's inventories, which has an impact on the cost of goods sold as well as ending inventory, and thus has a financial impact on the company's bottom-line numbers and cash flow situation.read more, shrinkage is defined as the difference between the value of inventory mentioned in the book of accounts and the value of inventory that exists physically.

Inventory Shrinkage formula = Inventory in Book of Accounts – Inventory in Physical Existence.
  • The inventory in the book of accounts formula is represented as follows:
Inventory in Book of Accounts = Beginning Value of Inventory +Purchase of Raw Materials – Sales – Adjustments.
  • Similarly, from the above relationship, it is easy to derive the shrinkage rates observed in the levels of the inventory. The shrinkage rate formula is represented as below:
Shrinkage Rate = Inventory Shrinkage Value / Inventory in Physical Existence
Shrinkage-Formula

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Explanation of Shrinkage Formula

The formula for shrinkage value and shrinkage rate can be calculated by using the following steps:

  1. Firstly, Determine the value of beginning levels of the inventory.

  2. Next, determine the costs on adjustments, if any, on the inventory levels.

  3. Next, Determine the purchases made by the business for the financial year.

  4. Next, Record the sales made by the business for the financial year.

  5. Next, Add the beginning value of inventory and the purchases as recorded by the business.

  6. Next, deduct the resulting value in step 5 from the sales achieved by the business and corresponding adjustments in inventory levels to arrive at the book value of inventory.

  7. Next, deduct the actual value of the inventory from the book value of the inventory to arrive at the shrinkage value.

  8. Next, divide the shrinkage value determined in step 7 to the actual value of inventory to get the shrinkage rate.

Examples of Shrinkage Formula (with Excel Template)

Let’s see some simple to advanced examples of shrinkage formula to understand it better.

You can download this Shrinkage Formula Excel Template here – Shrinkage Formula Excel Template

Shrinkage Formula Example #1

Let us take the example of a manufacturing business that had reported $30,000 as the final inventory value as per the book of accounts. However, the accountant observed that the business has $28,000 worth of finished products. Help the top management of the business to determine the overall shrinkage in the inventory.

Solution:

Use the given data for the calculation of shrinkage value.

Shrinkage Formula Example 1

Calculation of shrinkage value can be done as follows:

Example 1.1

Determine the value of shrinkage as displayed below:

Shrinkage Value = $30,000 – $28,000

Shrinkage Value will be –

Shrinkage Formula Example 1.2

Shrinkage Value = $2,000

Therefore, the manufacturing business has an inventory loss of $2,000 due to the shrinkage reported between the book of account and actual value.

Shrinkage Formula Example #2

Let us take the example of a manufacturing business that had reported $50,000 as the final inventory value as per the book of accounts. However, the accountant observed that the business has $37,000 worth of finished products. Help the top management to determine the overall shrinkage and the rate of shrinkage in the inventory.

Solution:

Use the given data for the calculation of shrinkage value.

Example 2

Calculation of shrinkage value can be done as follows:

Shrinkage Formula Example 2.1

Determine the value of shrinkage as displayed below:

Shrinkage Value = $50,000 – $37,000

Shrinkage Value will be –

Example 2.2

Shrinkage Value = $13,000

Calculation of shrinkage rate can be done as follows:

Shrinkage Formula Example 2.3

Shrinkage Rate = $13,000 / $37,000

Shrinkage Rate will be –

Example 2.4

Shrinkage Rate = 35.14%

Therefore, the manufacturing business has an inventory loss of $13,000 due to the shrinkage reported between the book of account and actual value. It further accounted for shrinkage rate by 35.14%, which is very high value. The management, therefore, has to investigate whether the shrinkage is due to theft or accounting error.

Shrinkage Formula Example #3

Let us take the example of a manufacturing business that had reported $50,000 as the beginning inventory value as per the book of accounts. The business purchased $20,000 through the financial year and achieved sales of $30,000 for the financial year. It additionally made adjustments in inventory levels by $2,000.

However, the accountant observed that the business has $37,000 worth of finished products. Help the top management to determine the overall shrinkage and the rate of shrinkage in the inventory.

Solution:

Use the given data for the calculation of shrinkage value.

Shrinkage Formula Example 3

Calculation of Inventory on Book can be done as follows:

Example 3.1

Inventory in the book of Accounts = $50,000 + $20,000 – $30,000 – $2,000

Inventory in the book of Accounts will be –

Shrinkage Formula Example 3.2

Inventory in Book of Accounts = $38,000

Calculation of shrinkage value can be done as follows:

Example 3.3

Shrinkage Value = $38,000 – $37,000

Shrinkage Value will be –

Shrinkage Formula Example 3.4

Shrinkage Value = $1,000

Calculation of shrinkage rate can be done as follows:

Example 3.5

Shrinkage Rate = $1,000 / $37,000

Shrinkage Rate will be –

Example 3.6

Shrinkage Rate = 2.70%

Therefore, the manufacturing business has an inventory loss of $1,000 due to the shrinkage reported between the book of account and actual value. The shrinkage rate is comparatively low at 2.70%, and hence this shrinkage may be due to accounting error while reporting the values in the book of accounts.

Relevance and Uses

It is very critical for the accountants and the audit experts to monitor the physical inventory levels. Further, it has to be compared with the inventory levels, as mentioned in the book of accounts. Once the value is determined, the shrinkage, if any, arising out of the comparison should be noted and reported to the top management.

The determination of the shrinkage levels helps in better control over the inventoryControl Over The InventoryInventory 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 maintained. An inventory shrinkage may be a result of direct theft, which may have been done by either employee, vendors, or the customers.

Inventory shrinkage may also arise due to errors made by the accountantsErrors Made By The AccountantsAccounting errors refer to the typical mistakes made unintentionally while recording and posting accounting entries. These mistakes should not be considered fraudulent behaviour first-hand as this can happen with anyone and by anyone.read more while performing inventory valuation. Hence, it could be inferred that the shrinkage determination indirectly helps in the controlling aspect of how the shrinkage is managed on a day to day basis.

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