Inventory Shrinkage

What is Inventory Shrinkage?

Inventory shrinkage occurs when the number of products in stock are fewer than those recorded on the inventory list. The discrepancy may occur due to clerical errors, goods being damaged or lost, or theft from the point of purchase from a supplier to the point of sale.

When a business discovers a shrinkage in its inventory, any discrepancies should be accounted for to reconcile the records with the physical inventory count. The matching principle requires that inventory shrinkage should be recorded as an expense in the financial period in which it occurred to match it against the revenues for that year. A shrinkage expense account will be recorded under the Cost of Goods Sold (COGS) account.

How to Calculate Inventory Shrinkage?

A business may determine the value of the shrinkage by physically counting the stock and determining its value, and then subtracting the value of the stock from the inventory cost listed in the accounting records. Divide the difference by the amount of stock recorded in the accounting books to get the percentage of inventory shrinkage.

For example, assume that company ABC owns $100,000 of inventory recorded in its accounting books for a specific accounting period. If the company conducts stock inventory and finds the stock on hand to be $95,000, the amount of stock shrinkage is $5,000 ($100,000 – $95,000). The shrinkage percentage is 5% [ ($5,000/100,000) x 100].

Causes of Inventory Shrinkage

The National Retail Security Survey outlines the following five factors as the leading causes of inventory shrinkage:

1. Shoplifting

Shoplifting occurs when a customer exits a store with more than what they paid for at the cashier. Shoplifting accounts for 38% of inventory shrinkage, and it surpassed employee theft as the leading cause of shrinkage in the 2016 National Retail Security Survey. Even as stores increase security through the use of CCTV cameras, digital tags, and other means, some customers still manage to steal inventory.

2. Employee theft

Although employees should be at the forefront of preventing inventory shrinkage, some dishonest employees may steal from their employers. Employees may take some of the business stock to compensate for an amount they feel they are being underpaid, underappreciated, or undervalued. By being insiders of the company, they may quickly cover up the theft of inventory.

In most cases, the employer may not notice when one product disappears from a huge stock of over a thousand items. Instead, the employer/accountant will assume that the product went missing due to clerical errors during packaging or when loading goods onto a truck.

3. Administrative errors

Although most businesses have moved from paperwork to digital methods of record-keeping, administrative and paperwork errors are still among the leading causes of shrinkage. Administrative errors may include pricing mistakes, accidental reorders, missing or additional zeros, or left-out decimal points. To reduce such errors, inventory should be physically counted and re-counted even when the business relies on automated systems.

4. Supplier fraud

In businesses with complex supply chains, the inventory may at one point be handled by third parties who are not part of the company. The theft may occur during transit from the supplier’s warehouse to the business premises or when loading and unloading the products. Deliveries should be counted every time they enter or leave the business premises and recorded appropriately.

5. Unknown causes

Sometimes, inventory may disappear off the shelves and cannot be matched to any of the other causes of inventory shrinkage. Unknown causes represent about six percent of the total inventory shrinkage.

How to Prevent Inventory Shrinkage?

1. Implement a double-check system

The initial action that a business should take to prevent inventory shrinkage is to implement a double-check system. It should have more than one person assigned to important inventory management stages, such as signing invoices, recording stock, and accepting stock.

Getting a second person to verify the records helps prevent inaccuracy and omission of key details. A double-check system also helps to identify loopholes that may contribute to stock shrinkage and to implement measures to curb fraud.

2. Vet potential employees thoroughly

Before hiring employees, a company should vet potential employees and do a background check to weed out those with a history of stealing inventory. The company should contact the references and past employers to know the behavior and general conduct of a prospective employee.

If a prospective employee demonstrates a long history of improper conduct, the company should probably not hire them. Hired employees should undergo rigorous training on how to handle inventory appropriately and carry out stock-taking.

3. Automate inventory management

Automating the inventory management process can help prevent errors and omissions caused by humans. A dedicated inventory management software program will help reduce manual handling of stock and cut down on inventory shrinkage.

The software will hold all parties involved in the inventory management process accountable. It will track the location of the inventory from the point of origin to the point of sale, count the number of keystrokes, and produce logs for all the users who logged into the system.

4. Track inventory shrinkage

An organization should track the inventory shrinkage percentage over time to gauge whether there is an increase or a decrease in shrinkage. The inventory count should be compared to the previous inventory counts.

If the shrinkage percentage has decreased over time, it shows that the company’s inventory management techniques have reduced stock shrinkage. However, if the inventory shrinkage percentage increases over time, then the company should review the measures they have implemented to identify and correct any potential problems.

Real-World Data

According to the 2016 National Security Survey, businesses in the United States lost $45.2 billion through inventory shrinkage in 2015. The amount represented a significant increase from the $35.3 billion recorded in 2008 during the National Retail Security Survey (2008).

According to the 2016 survey, shoplifting and employee theft were the largest causes of inventory loss. In 2008, employee theft represented 42.7%, while shoplifting represented 35.6% of the total inventory shrinkage.

Additional Resources

CFI is the official provider of the Financial Modeling and Valuation Analyst (FMVA)® certification program, designed to transform anyone into a world-class financial analyst.

To keep learning and developing your knowledge of financial analysis, we highly recommend the additional CFI resources below:

• Tangible Assets
• Value Reporting Form
• Projecting Income Statement Line Items
• Projecting Balance Sheet Line Items
• See all accounting resources