When running a business, you likely face setbacks due to unforeseen costs. Unplanned expenses, like inventory shrinkage, can lead to a profit drop and require you to alter your accounting books.
To combat significant inventory-shrinkage, you must familiarise yourself with what it is, why it happens, and preventative actions you can take. And when it does happen, understand how to make correct entries in your accounting books.
What is Inventory Shrinkage?
Inventory-shrinkage is a business scenario wherein there is a mismatch between the inventory list and actual products in stock.
A nominal amount of shrinkage is normal for every business because you need to have some room for unforeseen losses, losses due to damage to goods in transportation, and several other reasons that we have discussed below.
But when the shrinkage becomes noticeably larger, you must surely investigate it without delay and see how it can be prevented.
Causes of inventory shrinkage
Here are some of the most common reasons for inventory-shrinkage:
Waste and spoilage
Waste and spoilage mainly occur in the food and beverage industries. It occurs when a store doesn’t sell or a restaurant doesn’t use perishable goods before their expiration date. This contributes to shrinkage because the inventory becomes a loss.
Damage
Damage occurs when products become unusable because of unexpected problems or accidents. This includes goods that customers may return because of damage, which contributes significantly to damage-based shrinkage in retail environments. Common causes of this type of damage include items falling in the store or breaking during shipping.
Theft
Theft often occurs in two fundamental ways: externally, such as shoplifting, and internally, such as when an employee steals from the company. Internal thefts often occur at the point of sale (POS), where employees can use POS systems to adjust inventory numbers. Employee theft and shoplifting are major causes of inventory-shrinkage in many industries.
Human error
Human error occurs across all levels of a business. This may include miscounting, using wrong units of measurement and incorrect portioning or storage of food and beverages. Although most businesses have moved to keep digital records rather than paper records, administrative and paperwork errors may also cause inventory-shrinkage.
Some administrative human errors can include pricing errors, accidental reorders, additional or deleted zeros or missing decimal points.
Vendor fraud
Vendor fraud, or supplier fraud, is when the company or manufacturer selling products to an organization doesn’t deliver the promised amount. Organizations’ staff inventory specialists to count and monitor incoming products to ensure inventory is correct, ensuring the organizations find the errors.
Vendors can also deliver damaged products or perishable goods that are about to expire. When this happens, it can go unnoticed and cause inventory-shrinkage when discovered.
Calculating Inventory Shrinkage
To determine how much shrinkage your business has, calculate your inventory-shrinkage rate. This rate is a percentage that represents how much inventory your business lost due to damage, theft, errors, etc. The lower your inventory-shrinkage rate, the less inventory you lose.
To find the inventory-shrinkage rate, you need to know the cost of goods sold, how much inventory you have, and how much was lost to shrinkage.
First, calculate your cost of goods sold and subtract the amount from your inventory. Subtracting your cost of goods sold from your inventory shows your inventory’s book value or the recorded amount.
Recorded Inventory = Inventory – Cost of Goods Sold
Once you know the amount of inventory you should have, determine how much inventory you have. This shows you your inventory losses.
To find the inventory-shrinkage rate, divide your inventory losses by the amount of inventory you should have.
Use the following formula to calculate your business’s inventory-shrinkage rate:
Inventory Shrinkage Rate = (Recorded Inventory – Actual Inventory) / Recorded Inventory
Multiply your inventory-shrinkage rate by 100 to convert it into a percentage.
Different Types of Inventory Shrinkage
There are many types of inventory-shrinkage which every owner or business must be aware of.
Inventory shrinkage at the manufacturer’s end:
If the manufacturing process is not carried out in a streamlined manner due to a lack of raw material, labour issues, or any other reason, it results in inventory-shrinkage. So, shrinkage of inventory at a manufacturer’s end means that the manufacturing process is slowed down due to certain reasons.
Inventory shrinkage at the vendor’s end:
Sometimes the vendor is not efficient and delivers poor-quality goods or the inventory ends up getting damaged fully or partially in transit. If timely action is not taken such inventory-shrinkage will continue.
Inventory shrinkage at the retailer’s end:
This type of inventory-shrinkage happens at the retailer‘s end due to several reasons like internal theft, external theft, or shoplifting.
Inventory shrinkage due to the nature of the industry:
In some industries like restaurants and hospitality, there is shrinkage mainly due to the expiration of raw materials or spoilage.
The average inventory-shrinkage rate varies from one industry to another. According to experts, the ideal inventory-shrinkage rate should be 1% or 2%. The lesser the better and for that the causes must be understood, and preventive measures must be taken on time.
How To Reduce Inventory Shrinkage?
Depending on your workplace, you can use any combination of prevention methods. Here are several practical ways to prevent inventory-shrinkage:
Install tracking devices
Tracking devices help you locate products throughout their entire lifecycle within the organization for which you work. You can hard-wire delivery trucks, install plug-in devices on delivery vehicles or place a tracker on a box of products or individual, high-priced items. This can help you determine when a product disappears from a warehouse or retail shelf.
Invest in security
Equipping items with magnetic scanners and ink-blot tags can help deter thefts in electronics and clothing stores. You can invest in video security cameras instead of magnetic tags, depending on what might work best for the business for which you work.
Hiring an inventory clerk to keep detailed records and perform regular audits can also help you identify any discrepancies and prevent future inventory-shrinkage.
Count inventory often
Verify inventory counts regularly. This may help you find issues quickly and prevent future errors, and it may discourage employees from considering internal theft. You may also invest in technology that makes counting and recording your inventory more efficient.
Perform unscheduled audits
Consider performing unscheduled or unannounced audits. This may be especially helpful if you suspect internal theft and human error as the primary causes of your shrinkage. These audits may provide a more realistic understanding of the shrinkage problem because employees who are potentially causing problems don’t have time to correct inventory issues.
Split responsibilities
Splitting and changing responsibilities with time can help you identify errors in your financial records. This means that employees can help hold each other accountable for recording and processing receipts, checking and managing inventory and creating policies that prevent shrinkage of all types.
You can let different employees handle the recording and processing of receipts at different times for quality assurance.
FAQ: Inventory Shrinkage
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.
Conclusion
Inventory shrinkage is a common issue for businesses, but understanding its causes and taking steps to prevent it can make a significant difference in your bottom line. By calculating your inventory-shrinkage using the formula we discussed in this blog, you can identify areas of concern and take necessary action to minimize losses.
Remember, prevention is key when it comes to inventory-shrinkage, so implementing effective inventory management practices, conducting regular audits, and training your staff on proper handling and tracking procedures are essential. Don’t let inventory-shrinkage eat away at your profits – take control of your inventory and protect your business today.
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