What Is Inventory Shrinkage?

forklift in a warehouse picking up a pallet

While taking a look at your inventory, you may occasionally notice that your numbers aren’t quite matching up. If you’ve ever found a discrepancy between the excess amount of inventory listed in your accounting records and the amount you actually have on hand, then you’ve already experienced the effects of inventory shrinkage. Retailers lose 1.33% of sales to inventory shrink annually, costing them a collective $46.8 billion each year.

The term “inventory shrinkage” refers to the loss of inventory. There are many different causes of shrinkage in retail. Theft (from employees or customers), supplier fraud, damaged goods, spoilage, even simple human error — experiencing one or more of these can quickly lead to substantial discrepancies that you’ll discover while managing your inventory.

This guide will help you understand how inventory shrinkage ultimately impacts your business, as well as best practices when it comes to mitigating its effects. Read on for a comprehensive view of this subject.

Understanding Inventory Shrinkage

A loss of inventory ultimately means a loss in the bottom line. Any business that sells physical products must take efforts to understand and prevent shrinkage. If you are in an industry that has tight margins, then you need to be especially diligent to stay profitable.

Your book inventory represents the number of units your accounting records show you should have, while your physical inventory represents the number you actually have. For example, if your accounting records indicate that you should have 1,050 units of a specific item, but you actually only have 980 units, then you’ve experienced an inventory shrinkage of 70 units.

Negative Impacts of Inventory Shrinkage

There are several negative impacts that can result from a loss of inventory. As noted above, inventory shrinkage is essentially a loss of profit. This loss can be small and mostly recoupable, or it can be large and difficult to resolve. In either case, note that inventory loss hits your bottom line twice: once for the cost of the purchase, and once for the loss of profit.

Other negative effects of shrinkage in retail include:

  • Operating problems, such as inventory shortages
  • Lower purchasing capacity
  • Decreased capital for wages, leading to wage stagnation and reduced employee retention
  • Increased cost for security measures to prevent further shrinkage

One potential solution to maintaining your margins is to increase prices, but this can result in its own negative impacts. Depending on your niche and positioning in the market, your customers may be sensitive to price increases. Goods or services with inelastic demand can experience a dramatic decrease in demand at even a marginal increase in price. In this case, attempting to recoup losses due to inventory shrinkage in this manner can actually result in further diminished profits.

Shrinkage Accounting Formula

Shrinkage accounting requires the use of a basic formula. Calculating inventory shrinkage involves a fairly straightforward formula. All you need to do is perform a physical count of your inventory, then deduct this number from your book inventory. Follow this formula:

(Book inventory units) - (physical inventory units) = (number of units lost)

Then, you can divide this result by your inventory value to determine your shrinkage percentage:

(Number of units lost) / (book inventory units) = (shrinkage rate)

Here’s an example of how the shrinkage accounting formula can help you calculate your shrinkage rate:

900 book inventory units - 882 physical inventory units = 18 units lost 18 / 900 = 0.02, or a 2% shrinkage rate

Once you’ve completed the formula above, you have your business’s shrinkage rate. But, devoid of further information, there’s not much you can do with that statistic to improve matters. However, this figure should spur you to discover potential sources of shrinkage, then take action to decrease your shrinkage percentage over time.

Shrinkage Example

As discussed earlier in this article, there are many potential sources of inventory shrinkage. Using the example from the formula above, let’s take a look at some hypothetical sources of shrinkage. Where did those 18 physical inventory units go?

  • A warehouse employee hired one week ago has been taking company-owned goods home with him and reselling them online, leading to 4 lost units
  • You never received some of them, as one of your suppliers shorted you 6 units
  • Due to a warehouse error or accident, 3 units were damaged beyond use
  • The employee managing your inventory misreported how many items were actually ordered — while your software shows that 900 were ordered, the employee only ordered 895

This accounts for the 18 missing units. As you can see, diagnosing the reasons for these missing units can take a considerable amount of time and effort, and there are many potential causes. Accordingly, the corrective action required to reduce the shrinkage will vary as well.

Preventing and Reducing Inventory Shrinkage

In addition to adopting cutting-edge strategies for improving warehouse efficiency, a key part of increasing profit and maintaining a stable business is to manage inventory shrinkage. The following strategies can help you control shrinkage, reducing its negative impacts and ensuring improved opportunities for growth.

Create a Double-Check System

Sometimes the solution to inventory management woes simply involves a second set of eyes. In cases involving supplier fraud or human error, a double-check system can be invaluable for confirming discrepancies.

This strategy involves having another employee oversee orders and other regular inventory management procedures in order to ensure that the correct number of units are being ordered, in stock, and so on. While a double-check system won’t eliminate inventory shrinkage entirely, it can play a vital part in your shrinkage reduction plan.

Give Products SKUs and UPCs

An acronym for “stock-keeping unit,” SKUs are essential to effective inventory management. These unique identifiers can help you quickly identify and count physical stock — essential tasks for discovering potential shrinkage. Likewise UPCs, short for “universal product code,” can help you quickly scan products to tabulate your current stock levels.

If you haven’t yet assigned SKUs and UPCs to your existing stock, now is the time. This involves designing a number sequence structure for creating SKUs and obtaining a GS1 Company Prefix, then integrating these codes into your inventory management software.

Use Inventory Management Software

If you’re still managing your inventory with simple spreadsheets — or, worse, paper forms — you’re behind the curve. Inventory management software can simplify matters while giving you valuable insights into potential sources of inventory loss. When you use inventory management software that integrates with your checkout software, your inventory receives real-time updates with each sale, providing you up-to-date data on a moment’s notice.

There are multiple benefits of inventory management software when it comes to managing shrinkage. Inventory management software allows users to easily review transactions and physical activity in order to watch for signs of inventory loss. Further, such software can enhance security by providing data on goods entering and leaving the warehouse. Any signs of shrinkage can be detected as early as possible, helping business owners address causes of shrinkage before they get out of hand.

Track Inventory Shrinkage Over Time

To gain a fuller understanding of the causes of shrinkage, it’s essential to track inventory statistics over time. To effectively track this data over time, you should integrate versatile tools into your workflow.

Again, inventory management software can help in this regard. Software like Fishbowl Anywhere can grant you complete access to inventory data, and utilizing software with versatile plug-ins can help you integrate other programs and create a comprehensive picture. With these tools, you’ll be well on your way to tracking your inventory and gleaning a fuller understanding of your business’s inventory management needs.

Plan for Busy Periods

With the holidays come surges in demand. You can anticipate such increases, so why not plan ahead accordingly in terms of inventory management? Once you know your typical inventory shrinkage rate, you can order a number of goods that will prevent shortages and leave each customer satisfied.

While this is but one example, you can use this strategy to prepare for any period in which you anticipate higher-than-usual sales. Such periods may also be the perfect time for increased security measures to reduce shrinkage. After all, when you are working with more goods, your shrinkage rate will reflect a larger net loss in profits.

These strategies, when used in conjunction with other measures to protect your company assets, can help your business remain stable and profitable in the years to come. Platforms like Fishbowl Manufacturing can give you the data and insights you need to effectively leverage these strategies. Assess your shrinkage rate and then initiate corrective action to take your approach to inventory management to the next level.

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