What Is Inventory Shrinkage and How Can You Prevent It?

Inventory loss (also known as inventory shrinkage or shrink) is a big problem for any business that carries physical goods. Inventory shrinkage is a common occurrence, and it can be highly damaging to an organization’s profit margins if it isn’t properly managed. Without controls and monitors in place, there is no way to trace the root causes that created the shrinkage in your business.  

Inventory shrinkage accounted for $112.1 billion in losses for retailers in 2022, up from $93.9 billion in 2021. To help organizations deal with this growing problem, we will examine the various internal and external forces that may be contributing to inventory shrinkage. We’ll also look at effective techniques for combatting the various causes of inventory loss. 

What is inventory shrinkage? 

Inventory shrinkage is a loss of goods caused by theft, damage, or administrative error. The shrinkage can be referred to as a hit to the margin or loss in profit. When inventory shrinkage occurs, the amount of inventory recorded on a company’s balance will differ from the actual account of inventory they have in stock.  

Inventory shrinkage is an unavoidable reality for many businesses, and there are a variety of ways to handle it. Some organizations may deal with excessive inventory loss by raising the prices of their products, but this simply passes the burden on to consumers. Fortunately, there are other effective ways to combat the impact of shrinkage. 

How is inventory shrinkage calculated?  

Calculating inventory shrinkage is generally a fairly simple process. To calculate shrinkage for your business, subtract the actual amount of inventory in your store from the estimated amount or ‘book inventory’ that you should have. For example, if you record a shipment of $100,000 worth of goods, but you only have $90,000 worth of goods in stock, then you must record $10,000 in losses.  

If you divide the losses by the total book value of your inventory, you can determine the percentage of shrinkage. For example, $10,000 in losses from a total inventory of $100,000 would indicate a shrinkage rate of 10%. Studying shrinkage percentages can help you identify trends, patterns, and areas for improvement in your inventory management.

Accounting for inventory shrinkage: How is inventory shrinkage recorded? 

Somewhere between your last cycle count and the current recording period, your business may have experienced some inventory losses. In other words, the physical inventory you have on hand today is less than what was recorded in your books. 

To account for this loss of inventory via the perpetual accounting method, you would increase the cost of goods sold and decrease the inventory by the difference for the recording period.

Your balance sheet would show a credit to the inventory line item for the value that was lost. Showing that you have incurred higher expenses (cost of goods) and a lower gross profit will lower your taxable income. 

However, you might choose to record your shrinkage separately instead of including it in your costs of goods sold. If so, you would need to file a claim with the Internal Revenue Service (IRS) using Form 4684 if you are located in the United States. 

What causes inventory shrinkage?

Inventory shrinkage can be significantly reduced through proper inventory control practices, but the optimal prevention method(s) for you can vary depending on your organization’s unique needs. It is critical for organizations to recognize the root causes of inventory shrink and take proper steps to address these causes. Commonly, inventory shrink can occur due to fraudulent behavior, such as: 

• Employee theft and fake sales; 
• Retail theft such as petty theft, shoplifting, breaking and entering, and fake coupons; 
• Purchasing fraud;
• Return fraud;
• Shipping fraud.

While inventory shrink is often associated with theft and fraud, it isn’t always attributed to a hurtful scam. It can also be caused by poorly defined operational procedures and standards which lead to administrative errors. These errors can have a “trickle-down effect” that impacts other areas of the business, including the warehouse and financial operations. 

Inventory loss can also occur when items are broken, damaged, or contaminated. This is often the result of unexpected accidents in the workplace, and can be difficult to predict. However, this risk can be reduced through employee oversight and the enforcement of proper safety protocols. 

What can be done to prevent employee theft? 

You can manage your inventory shrink by implementing internal controls first. This starts right from the hiring process. Conduct a thorough background and reference check on your candidates. Once a new hire has been on-boarded, educate them on your policies and your stance on employee theft. Here are some steps for preventing internal theft: 

• Surveillance: Install cameras throughout your facility. When equipped with AI-powered computer vision systems, they can allow you to monitor employee activities and track the movement of inventory in real time. 
• Reduce temptation: Store valuable items in secure areas that require higher authorization levels for access.
• Monitor trash removal process: Use clear garbage bags so valuable items can’t be disguised as trash and discreetly removed from the premises. 

• Separation of duties: Avoid giving any individual employee too many sensitive assignments. For example, don’t have the same person processing the receipts be responsible for recording them as well.

• Education: Show your employees how shrinkage affects them directly, such as limited pay increases, minimal opportunities for job promotions, and risk to the company’s financial stability, which can lead to layoffs.

• Anonymous reporting: Give employees an easy way to report concerns or suspicious activities discreetly, such as a web portal or phone hotline. 

• Audits: Conduct spot audits to catch infiltrators off guard. Regular inventory audits can also help you create more accurate budgets and identify inefficiencies in your inventory management operations.  

By taking these steps to optimize your hiring processes and increase employee oversight, you can reduce the risk of internal theft while streamlining workflows and improving employee well-being. Along with preventing inventory shrinkage, this can increase productivity and establish a more positive culture within your organization. 

What can be done to avoid fake sale scams? 

Any discount over a certain threshold should require an additional layer of authorization. If a fake sale was to take place, the transaction would be flagged. For instance, a customer buys an item for $1,000. During the checkout process, the cashier fakes a 20% discount; however, the consumer is unaware of this and pays the full rate. 

The cashier would pocket the $200, or the original transaction would go through as usual, but later, the transaction gets voided and re-keyed at $800. Regardless of how it is done, the company takes a hit. 

To avoid fake sale scams, set discount thresholds to a lower amount. This way if a higher discount was being attempted the transaction would be prevented. Plus, it doesn’t hurt to review all your sales transactions regularly. If a scam was being pulled, the anomalies would show up in the data.

What can be done to avoid returned goods scams? 

Returns goods scams consist of one person working inside for the company and with an external accomplice. The external person would return an item to the store. With the help of their cashier friend, he/she would refund the item at a higher price than what was initially paid. 

To prevent this, original receipts should be scanned during a return procedure. If a receipt isn’t available because the item was purchased as a “gift,” then implement a restocking policy. Items being returned without a receipt automatically incur a 20% restocking fee. Posting this information at cash registers can help deter would-be scammers. 

What can be done to prevent purchasing fraud? 

Requisition schemes can take on many forms, from skimming excess inventory off the top to paying fictitious vendor bills. Here are some examples of commonly used purchasing fraud techniques:  

• A manager artificially inflates the demand for a product with the plan to steal the surplus inventory. 
• An internal purchasing employee sets up phantom vendor accounts, and then pays fraudulent bills even though items were never shipped. 
• An employee sets up phantom customer accounts, then places sales orders and has the items shipped to a fake address where payment can never be recuperated and the bill ends up sitting with collections.
• An internal purchasing employee has the company deliberately overpay vendors for goods, and then receives a personal kickback from the vendor for their continued cooperation.  

To mitigate the severity of purchasing fraud, perform periodic audits on your operational procedures. Make sure that there aren’t any hidden relationships between your staff and the vendors you are buying from. Keep a close eye on your dead accounts, too. If a business hasn’t done an order with you in the past year, then do a proper follow-up. Verify that the order is legitimate.

What can be done to prevent retail theft? 

Retail theft is a major source of loss for businesses, and shoplifting has continued to increase even as other types of crime have declined. Businesses can reduce and deter theft by using security cameras and mirrors throughout their retail spaces. This way suspicious behavior can be spotted more easily. 

By keeping your store clean and designing your retail space with open sight-lines, you can make it more difficult for thieves to hide. Further, you can improve incident response times by training staff to recognize suspicious behaviors and establishing clear protocols for these situations.  

What can be done to prevent shipping fraud?  

Since there is a ton of activity at a warehouse receiving area, shipping fraud scams can be easily missed. Always validate all your shipping slips and shipments that claim to be spoiled or damaged. For spoiled goods, always have them inspected before they get disposed of. 

Another commonly used shipping fraud scheme consists of marking a shipment as “short” even though the right amount of stock was delivered. Have all your inspections performed by someone outside of receiving and keep a paper trail of the inspection reports.

What can be done to prevent fake coupon scams? 

Online discount sites have increased the amount of fake manufacturer coupons circulating on the internet. Bad coupons and promotion codes affect retailers’ margins. If a manufacturer decides to audit the store and determines the coupons are invalid or that the discounts were issued to the wrong items, then the reimbursement can be revoked. 

To avoid this problem, stay up to date with coupon scams. Additionally, look out for large quantities of coupons being redeemed for a larger-than-average shopping cart value. These are indicators that something fishy might be going on.

What can be done to prevent administrative errors? 

Automating and managing your inventory through a software solution will help eliminate administrative errors. First, it will provide a standardized and repeatable process to track your entire inventory and its movement accurately. So pulling a fraudulent scheme will be pretty tough to do.   

Second, it makes doing inventory adjustments easier with a software tool that solely focuses on managing inventory versus an accounting system. This can help staff members save time and avoid burnout when managing your inventory, which can in turn reduce the risk of employee error.    

Plus, you’ll also get an audit trail of all your transactions, which will enable you to catch abnormal behaviors quickly and monitor inventory shrinkage more effectively. For example, you can create unlimited user accounts and know who processed which transactions and when.

Integrated solutions like inFlow Inventory will provide you with a complete view of your inventory management processes. This will help you identify new ways to prevent shrinkage by optimizing security, increasing employee oversight, and streamlining workflows.