Inventory Shrinkage: Definition, Causes, Journal Entry

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Although it’s normal for product-based businesses to have some level of inventory shrinkage, it must be kept under control. The more shrinkage in a business, the smaller its profits.

We’ll discuss everything you need to know about inventory shrinkage, how it pertains to inventory accounting, and 10 effective strategies for preventing or reducing inventory shrinkage.

In this guide to inventory shrinkage:

Key takeaways

  • Inventory shrinkage is always going to occur in product-based businesses, but the less it happens the less money you lose. Implement processes to minimise how frequently stock disappears.
  • Inventory management software is critical in tracking up-to-the-minute stock levels and maintaining accurate records. Implement a system that helps with stocktaking and offers reporting features to identify the trends that lead to inventory shrinkage.
  • Always account for inventory shrinkage in your journal entries. An inventory write-off is obligatory and will ensure your financial statements are accurate and up to date.

What is inventory shrinkage?

Inventory shrinkage refers to the discrepancies between the recorded inventory levels and the actual physical inventory in a business. If there is a difference, that means there has been a loss of inventory at some point, and it’s currently unaccounted for.

Let’s say you own a furniture store.

Your computer system says you have 35 chairs, valued at $200 each, in stock. But on a physical count, you only locate 32 chairs. The three missing chairs (and $600) are recorded as inventory shrinkage.

Inventory shrinkage is most common in the retail industry. However, any business or organisation that holds stock – whether that be raw materials, wholesale products, or finished goods – needs to have processes in place to identify inventory shrinkage.

Understanding how to calculate, track, and monitor inventory shrinkage is critical. Left unchecked, shrinkage can negatively affect your business’s annual revenue and profitability.

inventory shrinkage

Inventory shrinkage creates bottlenecks as the quantity on your shelves doesn’t match the recorded quantity in your inventory system.

6 common causes of inventory shrinkage

Inventory shrinkage happens all the time. It’s rare for a business holding stock to never lose track of a single item, even with sophisticated inventory management software in place.

Let’s quickly go over some of the biggest culprits:

  • External theft (shoplifting). More commonly called shoplifting, external theft is a common cause of inventory shrinkage for retailers. This is when someone physically takes a product without paying for it.
  • Administration error. Even with digital systems and software, mistakes can be made when it comes to recording data. If a decimal point is in the wrong place, there are too many zeros, or an employee at the storefront missed scanning an item for purchase then your inventory data will be incorrect.
  • Internal theft. Employee theft is an unfortunate occurrence, but it happens. Minor roles in a product business, such as pick-packer or retail assistant, are often minimum-wage positions. Low pay can impact employee loyalty and create financial hardship that leads to desperation.
  • Supplier fraud. For businesses with complex supply chains, inconsistencies between what was ordered and what was delivered can occur at every link. While most are harmless mistakes, some suppliers will attempt to fraudulently ship a lower quantity than was ordered with the expectation that the purchasing business won’t count the products upon receipt.
  • Lost or damaged goods. From ripped clothing to spoiled food, there are plenty of ways in which stock can be damaged and unable to be sold. In some cases, stock can simply be lost in transit or a storage facility.
  • Unknown cause. In some cases, it’s impossible to determine the cause of inventory shrinkage. The more closely you monitor your inventory, the more likely you are to be able to uncover the root cause of any shrinkages that occur.

How does inventory shrinkage impact a business?

The consequences of inventory shrinkage can be significant for businesses of all sizes. The most obvious problem is that your business loses money.

But it doesn’t end there.

The accuracy of your inventory directly affects customer relationships and brand reputation. If your records say a product is in stock, a customer can purchase it. But if those records were wrong and the inventory has shrunk to zero, you’ll have to apologise for the mistake and refund their order.

For one-off sales, this is only a minor loss. But if you get a significant portion of your review from loyal, long-term customers who regularly place large orders, losing them can put your business in serious jeopardy.

Inventory shrinkage also has the potential to devalue your business, increase your cost of goods sold, and stall growth. Rather than investing in marketing and product development, you’re instead having to replace stock.

In addition, inventory shrinkage will mean you have to reconcile accounts, receipts, and other records – consuming time that could be put towards more profitable activities.

inventory shrinkage in food business

Beyond the obvious impact on stock accuracy, inventory shrinkage also hurts a business’s overall efficiency and takes time away from more important tasks.

How to calculate inventory shrinkage

The formula to calculate inventory shrinkage is:

(Recorded Inventory Value – Actual Inventory Value) / Recorded Inventory × 100 = Inventory Shrinkage 

Let’s say that your business has a recorded inventory value of $120,000. Your cost of goods sold (COGS) is $78,000. This means your inventory’s book value should be $42,000.

However, after accounting for inventory shrinkage, your actual inventory value is $90,000.

So, using the formula you would work shrinkage out like this:

($120,000 – $90,000) / $120,000 × 100 = 25%

This means you have lost 25% of your inventory value to shrinkage.

Inventory shrinkage accounting

All inventory shrinkages will need to be accounted for in your books. This section explains how shrinkage impacts accounting and the journal entries you’ll need to record it.

Which accounts are affected by inventory shrinkage?

When inventory shrinkage occurs, it must be reconciled with the records of the physical inventory stock. This process is called an inventory write-off.

You will also be required to document it as an expense in the financial period in which it happened, so it can be balanced against revenue for the same financial period. And a shrinkage expense account is usually kept under the cost of goods sold account, as any inventory shrinkage will directly increase the cost of goods sold.

Inventory shrinkage journal entry

When you experience inventory shrinkage in your business, you need to account for those losses by raising your shrinkage expense debit and reducing your inventory credit. This is done in an inventory accounting journal entry.

Correcting entries

If your business uses accrual accounting, you’ll be familiar with double-entry bookkeeping.

In double-entry bookkeeping, you make an entry into both debit and credit for every transaction. A correcting entry fixes a mistake that has been made in your bookkeeping journals.

Inventory shrinkage qualifies for this. The inventory value recorded does not match the actual value once you reconcile stock. This entry will need to be adjusted.

To ensure your financial records are kept accurate, make correcting journal entries as soon as you discover an error in your records.

inventory shrinkage in a pharmacy

Inventory write-off journal entries are an essential bookkeeping response to inventory shrinkage.

10 strategies to prevent inventory shrinkage

Achieving zero inventory shrinkage is impossible. But there are plenty of ways in which you can minimise your business’s risk. Here are some effective strategies.

1. Install tracking devices

Tracking devices, such as electronic tags, allow you to determine the exact location of your products. This can be useful both in finding lost items and for deterring thieves.

Installing tracking devices in your warehouse, factory, or shop can also improve picking time and, consequently, inventory management efficiency.

2. Carry out regular inventory counts

Regular physical counts of your inventory will flag any shrinkages shortly after they occur. This can make it easier to work out the root cause.

You might notice that a particular shelf is prone to inventory shrinkage. An investigation into that area could result in the discovery that items were falling behind the shelf into a hidden nook.

Look for any trends surrounding inventory shrinkages. Who was working which shifts? Who handled the missing goods? Where are the blind spots in your security system?

3. Conduct surprise audits

It’s not always the right tactic to use, but if you’re experiencing significant inventory shrinkage and you’re unable to link it to anything specific, conducting unexpected audits could help to identify whether there has been internal employee theft or fraud. 

4. Increase security measures

Depending on the type of inventory you have and where it is typically stored, you may wish to add extra security measures to ensure its safekeeping.

Security measures that can help reduce inventory shrinkage include:

  • Install surveillance cameras wherever stock is kept.
  • Track stock in real-time with inventory management software.
  • Hire security staff.
  • Restrict access to storage and production areas to relevant employees.
  • Utilise bin-level tracking of inventory items.
  • Introduce a key card system.
inventory shrinkage in a bakery

When inventory goes missing, products can be promised to a customer that aren’t able to be delivered, ruining their customer experience.

5. Involve employees

Create an environment where employees are educated on what inventory shrinkage means for a business.

Equip them with the knowledge of why inventory shrinkage happens and how they can help.

6. Split inventory tasks

If only one employee is responsible for inventory management, there is an opportunity for records and accounts to be forged. It can be a good idea to split tasks between different people, allowing for discrepancies to be identified and lowering the risk of internal theft.

7. Implement a double-check process

Double-checking inventory counts – including receiving and packing counts – can help to identify issues and spot errors in time to resolve them.

8. Automate inventory management

Minimise the number of manual steps in your inventory management processes to reduce the risk of inventory shrinkage. Errors are more likely to occur when human interference is possible.

Automate your inventory management using smart systems and software. Integrate your inventory management with other areas of the business to ensure an accurate flow of information and end-to-end visibility.

9. Monitor inventory shrinkage

Regular monitoring of inventory shrinkage is key to stopping it from happening again.

If you leave it too long between checks, it can be far more difficult to identify what caused it. You’ll just have to write it off and absorb the loss.

Make it a part of your daily, weekly, or monthly process to identify when and why each shrinkage happened and remedy it immediately.

10. Work closely with your suppliers

Build a close relationship with your suppliers to create a robust process for managing inventory shrinkage. Understand their security measures and the systems they have in place to prevent stock loss.

Before bringing on a new supplier, ensure you thoroughly review their business and perform background checks before signing any agreements.

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Oliver Munro - Unleashed Software
Oliver Munro

Article by Oliver Munro in collaboration with our team of specialists. Oliver's background is in inventory management and content marketing. He's visited over 50 countries, lived aboard a circus ship, and once completed a Sudoku in under 3 minutes (allegedly).

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