What is Inventory Shrinkage and How to Calculate It?

keyKey Takeaways:
  • Inventory shrinkage occurs when the real inventory levels are lower than reported, usually as a result of theft, human errors, or damage.
  • Some of the common reasons for inventory shrinkage include shoplifting, supplier fraud, broken items, employee theft, and administrative mistakes.
  • Inventory shrinkage causes monetary losses, operational hiccups, reputational harm, and decreased profit margins, emphasizing the importance of prevention.
  • Conducting frequent audits and inventory checks helps to detect and address shrinkage proactively, ensuring inventory accuracy and minimizing losses.

Have you ever noticed items mysteriously disappearing from your store’s shelves or inventory counts not matching up? 

If so, you have experienced inventory shrinkage firsthand. 

In fact, more than 13% of U.S. retail brands reported inventory shrinkage rates of 3% or higher in 2022, making it a prevalent issue that impacts businesses of all sizes. This hidden loss can have a big impact on your revenue and make it harder for you to stay profitable and fight successfully in the market.

Therefore, understanding what inventory shrinkage is and how to address it is essential if you want to protect your business’s financial health and long-term success. So, let’s explore the concept of inventory shrinkage and learn how to calculate it accurately.

What Do You Mean by Inventory Shrinkage?

The difference between reported stock counts and the actual inventory value on hand is known as inventory shrinkage. It occurs when a company’s actual inventory levels are lower than those that are officially documented. 

Several factors, including theft, human mistakes, shipping damage, and accounting problems, may contribute to inventory shortages. Also known as “wastage,” raw materials are removed from inventory but not used in production. 

Since inventory loss directly affects profitability, businesses need to monitor it closely. Shrinkage prevention is crucial for maintaining profit, as unexplained inventory results in company losses or inefficient product use.

How is Shrinkage Calculated?

Calculating inventory shrinkage requires a little bit of mathematics. To find the shrinkage, you will need to subtract the total inventory value reported by accounting from the actual inventory value. This gives you the inventory shrinkage value.

Here’s the shrinkage formula:

Inventory Shrinkage Value = Actual Inventory Value – Total Value of Inventory Recorded by Accounting

Furthermore, the inventory shrinkage value can also be converted into a percentage, usually known as the “inventory shrinkage rate percentage.”

To convert this into a percentage, divide the shrinkage value by the actual inventory number, then multiply by 100.

Here’s the formula for inventory shrinkage percentage:

Inventory Shrinkage Rate Percentage = Inventory Shrinkage Value / Actual Inventory Number x 100

Consider the example below to learn how to calculate shrinkage.

Let’s say you have $1,000 worth of inventory recorded. Your cost of goods sold (COGS) amounts to $300. Therefore, your inventory’s expected value should be $700 ($1,000 – $300).

However, due to shrinkage, your actual inventory value is $600.

To find the inventory shrinkage rate:

Inventory Shrinkage Rate = ($1,000 – $600) / $1,000 = $400 / $1000 = 0.40

Then multiply 0.40 by 100 to express inventory shrinkage as a percentage: 40%.

Your inventory shrinkage rate is 40%, indicating that you lost 40% of your inventory value to shrinkage.

This summarizes how to calculate the shrinkage percentage. Now let us discover what causes inventory loss and how to fix inventory shrinkage.

Causes of Inventory Shrinkage

Inventory shrinkage is an issue for businesses looking to protect their assets since it can lead to financial losses. Some of the common factors that contribute to inventory shrinkage are:

1. Employee theft

One of the major causes of shrinkage is employee theft, which can be either direct theft or fraudulent activities. This impacts inventory levels and profits. Hence, implementing security measures and employee training will help discourage theft and secure inventory.

2. Administrative errors

The discrepancy between reported and actual inventories may result from errors made in inventory records. Therefore, implementing automated systems and strict inventory management protocols can minimize the chances of administrative errors. 

3. Damaged or spoiled goods

Inventory shrinkage results in direct losses for businesses due to product expiration and any sort of damage during handling, storage, or transportation. However, following the right handling and storage guidelines and keeping an eye on expiration dates can reduce this risk.

4. Shoplifting

External theft, particularly shoplifting, reduces inventory levels and profits, even with security precautions in place. So, implementing surveillance systems, training staff, and optimizing store layouts can prevent theft and lower inventory shrinkage.

5. Supplier fraud

Supplier fraud, like billing for undelivered goods or providing low-quality products, causes discrepancies between ordered and received inventory. Thus, performing thorough research when selecting suppliers and maintaining open communication can prevent significant inventory shrinkage and financial losses. 

Thus, businesses must recognize and address these factors to successfully prevent inventory loss and protect their bottom line.

Impacts of Inventory Shrinkage

Inventory shrinkage can result in more than just missing stock. Below are some of the impacts inventory shrinkage can have on the business:

1. Financial Losses

Businesses suffer huge financial losses due to inventory shrinkage, which occurs when goods disappear without a clear indication. These losses affect profits and the ability to plan budgets and forecasts, making resource allocation difficult.

2. Operational disruptions

Inventory shrinkage results in missing necessary items, which slows manufacturing or reduces operational effectiveness. As a result, the supply chain is disrupted, which has an impact on customer satisfaction and delivery schedules.

3. Reputation damage

A company’s reputation may suffer from inventory depletion as clients expect businesses to have the products they require consistently. When inventory discrepancies lead to unfulfilled orders or stockouts, it hampers trust and damages the brand’s image.

4. Reduced profit margins

Inventory shrinkage directly impacts profit margins as businesses pay for lost inventory, lowering the profitability of each sale. Plus, the reduced profit margins might make it difficult for businesses to maintain competitive pricing or reinvest in expansion plans.

Businesses must thus proactively handle inventory shrinkage to protect their bottom line and reputation since it can result in financial losses, operational interruptions, reputational harm, and decreased profit margins.

How to Prevent Inventory Shrinkage?

The loss of inventory may have a big effect on a company’s earnings, but it can be avoided with preventive steps. Here are some effective strategies to reduce inventory shrinkage:

1. Employee training and awareness

  • Educate employees on the significance of inventory management and preventing internal theft.
  • Implement policies for reporting suspicious activity, and provide frequent training sessions to reinforce security precautions. 
  • Encouraging a culture of accountability among staff members can also help prevent theft and illegal access.

2. Inventory management systems

  • To precisely track inventory levels, use sophisticated inventory management software for inventory optimization.
  • Make use of RFID technology, barcode scanning, and real-time monitoring to expedite inventory procedures and quickly identify inconsistencies. 
  • To guarantee inventory accuracy, reconcile recorded inventory with physical inventory counts regularly.

3. Enhanced security measures

  • To prevent theft and illegal entry, install alarm systems, access restrictions, and security cameras. 
  • To improve security even further, make sure storage facilities have enough lighting and visibility.
  • Key cards or security badges can be used to monitor staff movements and limit access to critical places.

4. Supplier relationship management

  • Establish strong relationships with suppliers and carry out thorough investigations to reduce the possibility of supplier fraud.
  • To maintain inventory accuracy and avoid inventory problems, verify shipments and orders with purchase orders. 
  • Clear terms and agreements should be negotiated with suppliers to reduce the possibility of delivery inconsistencies.

5. Regular audits and inventory checks

  • To identify and address shrinkage losses early on, do regular audits and inventory checks. 
  • Examine any differences as soon as possible by comparing the reported inventory levels with the physical inventory count.
  • Implementing random spot checks and cycle counts can help detect irregularities and deter theft effectively. 

Thus, businesses can implement these preventative measures to reduce inventory shrinkage, safeguard their assets, and increase overall profitability.

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Frequently Asked Questions

The main difference between shrinkage and loss lies in their scope. Loss refers specifically to a drop in inventory as a result of identified circumstances, such as theft or damage. Whereas shrinkage encompasses loss, it also includes other factors such as supplier fraud, paperwork mistakes, and administrative errors, resulting in a decline in inventory levels.

To monitor stock levels and reduce shrinkage in inventory management, you must track inventories in real-time, conduct frequent audits and cycle counts, implement security measures, utilize inventory management software, provide training to your staff, and last but not least, apply the Pareto principle or 80/20 rule.

Inventory shrinkage can be calculated through various methods, with the “retail inventory method” being the most prevalent. This approach estimates shrinkage by comparing the value of ending inventory with sales and the cost of goods sold (COGS). Here’s how:

Inventory Shrinkage = (Ending Inventory Value – Sales – COGS) / Sales

The four primary sources of inventory shrinkage include employee theft (42.7%), shoplifting (35.6%), administrative (15.4%), and vendor fraud (3.7%). However, unknown sources have also reported 3.9% of inventory shrinkage.

In retail and other businesses, employee theft often accounts for ranging from 30% to 40% of overall losses, making it a major contributor to inventory shrinkage.

Regular inventory audits, typically conducted monthly or quarterly, are recommended to prevent inventory shrinkage effectively. The frequency may vary depending on business size, industry norms, and historical shrinkage rates.

Take Control of Your Inventories Today

To sum up, for businesses to continue operating profitably and efficiently, they must identify and address inventory losses. Businesses may reduce the risk of shrinkage by identifying their sources, which include shoplifting, supplier fraud, damaged items, staff theft, and administrative mistakes. 

Additionally, to reduce losses and protect assets, companies can implement tactics such as supplier screening, automation, enhanced security, staff training, and proper handling. Prioritizing these strategies is crucial for addressing inventory shrinkage and ensuring long-term success in the cutthroat industry.

Author Bio
Rakesh Patel
Rakesh Patel

Rakesh Patel, author of two defining books on reverse geotagging, is a trusted authority in routing and logistics. His innovative solutions at Upper Route Planner have simplified logistics for businesses across the board. A thought leader in the field, Rakesh's insights are shaping the future of modern-day logistics, making him your go-to expert for all things route optimization. Read more.