What is Inventory Shrinkage?

Inventory shrinkage is the excess amount of inventory listed in the accounting records, but which no longer exists in the actual inventory. Excessive shrinkage levels can indicate problems with inventory theft, damage, miscounting, incorrect units of measure, evaporation, or similar issues. It is also possible that shrinkage can be caused by supplier fraud, where a supplier bills a company for a certain quantity of goods shipped, but does not actually ship all of the goods. The recipient therefore records the invoice for the full cost of the goods, but records fewer units in stock; the difference is shrinkage.

How to Calculate Inventory Shrinkage

To measure the amount of inventory shrinkage, conduct a physical count of the inventory and calculate its cost, and then subtract this cost from the cost listed in the accounting records. Divide the difference by the amount in the accounting records to arrive at the inventory shrinkage percentage.

Example of Inventory Shrinkage

ABC International has $1,000,000 of inventory listed in its accounting records. It conducts a physical inventory count, and calculates that the actual amount on hand is $950,000. The amount of inventory shrinkage is therefore $50,000 ($1,000,000 book cost - $950,000 actual cost). The inventory shrinkage percentage is 5% ($50,000 shrinkage / $1,000,000 book cost).

Why Inventory Shrinkage is Important

There are several reasons why inventory shrinkage is important. These reasons are:

Represents a profit reduction. Inventory shrinkage represents the loss of an asset. When the recorded asset total on a company’s balance sheet is reduced, the amount of the reduction is charged to expense through the firm’s income statement. In effect, this means that any reduction in inventory caused by shrinkage is a direct reduction in the reported level of profitability. The situation is actually worse than that, since the business can no longer sell the inventory and earn a profit on the sale.
Causes production to stop. An additional concern is that missing inventory may cause a firm’s manufacturing process to shut down, because it does not have the necessary raw materials or work-in-process that its materials planning staff thought were on the premises. This can trigger substantial additional costs to bring in replacement inventory on short notice. And, if this inventory had been ordered by a customer, the customer must now wait for the replacement parts to be backordered and delivered - which might result in the loss of the customer.

Because of the preceding issues, a business might elect to invest in extra security for its inventory, including fencing, electronic surveillance, and security guards. If so, these are incremental costs that would not have been incurred if the firm had not suffered from persistent inventory shrinkage.

Related AccountingTools Courses

Accounting for Inventory

How to Audit Inventory

Inventory Management

How to Prevent Inventory Shrinkage

There are many techniques available for preventing inventory shrinkage, including the following:

Fencing off and locking the warehouse
Preventing anyone except warehouse staff from entering the warehouse
Instituting bin-level tracking of inventory items
Assigning personal responsibility for inventory accuracy
Improving the accuracy of bill of materials records
Installing an ongoing cycle counting process
Tightly controlling the results of the physical count process, and how adjustments are incorporated into the inventory records
Counting all items when they arrive at the receiving dock
Counting all finished goods when they are shipped from the company