How to Deal with Inventory Shrinkage

Inventory shrinkage, also known as inventory shrink or loss, is an unexplained reduction in stock. It’s usually noticed during audits when business owners discover they have fewer stocked items than in the inventory list.

Without monitoring and control mechanisms, it is impossible to accurately pinpoint the events that cause inventory shrinkage. You need an effective strategy to identify the root cause of your inventory problems and prevent them from recurring.

How to deal with inventory shrinkage

How to calculate inventory shrinkage

At some point between your last cycle assessment and your current record period, it’s likely your business has suffered inventory losses. In simple terms, your current physical inventory is less than initially recorded even after you’ve accounted for sales.

To determine how much your inventory has shrunk, you’ll need to find your inventory shrink rate. This is a percentage that shows how much your business has lost due to error, damage, or theft. 

You’ll need to know the cost of items sold, how much inventory was lost, and how much you have on-hand.

First, deduct the cost of goods sold from your inventory. This will reveal your stock’s book value. Recorded inventory = inventory- the cost of items sold.

After you’ve found the quantity of inventory you should hold, calculate the stock you really have. This will help you determine how much you have lost. i.e.

Inventory Shrinkage Rate = (Recorded inventory – Actual inventory) / Recorded Inventory

Next, multiply the result by 100% to turn it into a percentage.

Example:

Assuming your inventory is valued at $100000, and the cost of the items you’ve sold is $25000. Your stock’s book value should be $75,000 ($100000 – $25000). However, if you find that your existing inventory is $69000 as a result of shrinkage, you may use the shrinkage rate to calculate how much value has been lost.

Inventory Shrinkage Rate = ($75,000 – $69,000)/$75,000.

The inventory shrink rate will be 0.08 * 100%= 8%.

So, you lost 8% of your stock to shrinkage.

How to account for inventory loss

To compensate for this decline (via the perpetual inventory management system), you’ll have to raise the unit cost of your items sold and decrease the inventory level by the missing items for the recording period.

Your balance sheet will display a credit to the inventory line item for the value lost. This approach will show that you incurred more expenses (a higher cost of goods), made a lower gross profit than before the inventory was lost, and decrease your taxable income.

Alternatively, you may record your shrinkage separately instead of combining it with the cost of goods sold. However, doing so will require that you file a claim with the IRS (Internal Revenue Service) if your business is located in the U.S.

Why shrinkage occurs

As mentioned earlier, there are several possible explanations for inventory loss. It may happen when items like perishable goods expire or when more durable products are damaged and are no longer sellable. 

Shrinkage may also occur due to counting mistakes, especially if you are using a manual inventory accounting system. You or your employees may miscount the products. Your vendor may also make mistakes when they supply fresh inventory. In some situations, your stock might shrink from malicious behavior, such as fake promotions or fraud.

How to prevent inventory loss

Some losses are inevitable. Nonetheless, you can control/limit your shrinkage rate through effective management practice

Purchasing fraud

Fraudulent schemes take many forms, from forging vendor bills to skimming excess inventory.  A few examples:

  • One of your managers may overstate demand with the intent to steal excess inventory
  • An internal procurement officer may set up ghost vendor accounts and pay fake bills even though no items were ever shipped.
  • An employee may create fake customer accounts, place a sales order, and have them shipped to a non-existent address where payment can’t be recovered.

To control fraudulent behavior, you should perform frequent audits on your operations. Ensure there aren’t any secret relationships between your suppliers and your employees. You should monitor dead accounts as well. If a business has not purchased from you after a year, follow up on the issue. Verify that it is legitimate.

Returned goods scams

This usually involves an employee working with an accomplice. The accomplice will return an item purchased from the store, and the employee will provide a refund higher than the original price of the product.

Your returns procedure should involve original receipt scanning. If a receipt isn’t available, invoke a restocking policy: “items returned with no receipt will suffer a 25% restocking fee. Posting this on your website will discourage potential fraudsters.

Fake promotions

Any discount that exceeds a specific threshold should require authentication. In this way, if a fake sale were to occur, it would be recorded. Let’s assume a customer buys a product worth $1000, and the cashier invokes a 30% discount without the customer’s knowledge. The cashier will keep $300, and your company will make a loss. 

To prevent fake promotions, you’ll want to set low discount thresholds. So, if someone attempts to make a substantial discount without your permission, it will be prevented. Furthermore, it will help if you regularly review your sales records. If one of your employees attempts a fake sale, it will show in your data.

Whether your company is a brick-and-mortar store or an e-commerce site, the advice discussed here will limit inventory shrinkage.

However, it may prove overwhelming, especially if you process hundreds or thousands of orders a day. By partnering with a third-party logistics company like Nextsmartship, you can eliminate your inventory shrinkage problems all at once.

Order fulfillment companies offer a comprehensive solution to inventory shrinkage. Since customer orders and inventory levels will be handled externally, through a sophisticated inventory management system, there will be a reduced risk of fraud from employees, customers, and suppliers. Your logistics partner will handle all aspects of the inventory accounting process, saving you time, energy, and many other resources.

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