Shrinkage Formula

Updated on January 3, 2024
Article byRishab Nigam
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

What is the 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.

Key Takeaways

  • Shrinkage formula occurs when there is a significant discrepancy between the number of objects listed in the book of accounts and those there physically.
  • Inventory shrinkage formula is represented = Inventory in Book of Accounts- Inventory in Physical Existence
  • Inventory loss is a significant problem for manufacturing and retail companies. Business or inventory value loss may be the outcome of inventory shrinking.
  • The company should closely scrutinize the management of the inventory daily. Stock shrinkage can arise due to errors the accountants make while stock valuation.
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 inventory levels. The shrinkage rate formula is represented as below:
Shrinkage Rate = Inventory Shrinkage Value / Inventory in Physical Existence
Shrinkage-Formula

You are free to use this image on your website, templates, etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Shrinkage Formula (wallstreetmojo.com)

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 of 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 by the actual value of inventory to get the shrinkage rate.

Accounting for Financial Analyst (16+ Hours Video Series)

–>> p.s. – Want to take your financial analysis to the next level? Consider our “Accounting for Financial Analyst” course, featuring in-depth case studies of McDonald’s and Colgate, and over 16 hours of video tutorials. Sharpen your skills and gain valuable insights to make smarter investment decisions.

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 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 reported $50,000 as the final inventory value per the book of accounts. However, the accountant observed that the business has $37,000 worth of finished products. Help the top management determine the overall shrinkage and the shrinkage rate 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 a shrinkage rate of 35.14%, which is very high. The management, therefore, has to investigate whether the shrinkage is due to theft or accounting errors.

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. Therefore, help the top management determine the overall shrinkage and the shrinkage rate 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. However, the shrinkage rate is comparatively low at 2.70%, and hence this shrinkage may be due to accounting errors while reporting the values in the book of accounts.

Relevance and Uses

It is 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 arising out of the comparison should be noted and reported to the top management.

Determining 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. For example, an inventory shrinkage may result from direct theft, which may have been done by either employees, vendors, or 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 shrinkage determination indirectly helps control how it is managed on a day-to-day basis.

Frequently Asked Questions ( FAQs)

What is the purpose of the shrinkage formula?

The figure known as shrinkage is used to calculate the overall staffing levels necessary to achieve your company’s objectives. Put another way; it’s the quantity of “overscheduling” you must do to have the appropriate number of agents on duty at any particular hour of the day.

Is the shrinkage formula only applicable to retail business?

No, this formula can be used by any business that maintains inventory, regardless of the industry. However, it is commonly used in retail and distribution industries.

What are some causes of shrinkage formula?

Factors such as theft, damage, inaccurate record-keeping, and supplier issues can cause shrinkage. However, theft is often the most significant contributor to shrinkage in a retail setting.

This article has been a guide to the shrinkage formula. Here we discuss the calculation of shrinkage value and its rate using a formula along with examples and a downloadable excel template. You can learn more about financial analysis from the following articles –