Inventory doesn't always match what's written in your ledger. Your accounts may show that you have $400,000 worth of goods in the warehouse, but when you count it, it's $398,000 or even $370,000. The accounting term for this situation is inventory shrinkage. You'll have to calculate inventory shrinkage and account for it to keep your ledgers accurate.

Tip

To calculate inventory shrinkage, take a physical count of inventory and subtract the value from the written value in your account books. Divide the result by the inventory value in your ledgers to get the shrinkage percentage.

Why Does Inventory Shrink?

Inventory shrinkage sounds like the result of theft, and sometimes, it is. It can also result from errors and plain bad luck.

  • Somebody dropped and broke a couple of jars but didn't record the loss.

  • One of your employees entered a wrong number somewhere in the system. Putting down the wrong price or reversing 19 to 91 will throw off your inventory. Omitting a decimal point here and there can do the same.

  • Shoplifting from your store.

  • Employee theft.

  • Supplier fraud — this includes truckers removing a few items from the shipment for their own use and suppliers who don't ship as much as the invoice says.

  • Some items have been placed somewhere they shouldn't be put, and now they can't be found.

  • Unknown causes — about 6% of shrinkage has no explanation.

Individual causes of inventory shrinkage may be small and insignificant, but they accumulate over time. One $4 lipstick isn't significant shrinkage, but 100 over a quarter adds up to $400.

Calculating Inventory Shrinkage

Inventory shrinkage is one of the simpler accounting formulas. The toughest part is that you'll need a physical count of the inventory first. You and your staff can make the count, or you can hire an inventory firm to manually count the stock.

Suppose you own an electronics store with a merchandise book value of $245,000. You conduct a physical inventory and find the value to be $237,000. Your total sales between inventories totaled $360,000. Calculating inventory shrinkage is simpler than the physical count.

Subtract the value of the inventory from what's in the books, which in this example gives you a result of $8,000. Divide $8,000 by the book value of $245,000 to get .032, which equals a 3.2% inventory shrinkage rate. Sales don't affect the shrinkage calculation.

Inventory Shrinkage Accounting

Once you have a shrinkage figure, you need to adjust your accounts to reflect it. In the given example, you'd subtract $8,000 from the $245,000 in your inventory account, producing the correct figure of $237,000. Then, you record $8,000 in a shrinkage expense account.

Acceptable Shrinkage Percentage

Shrinkage adds up to billions of dollars in losses for American business, mostly due to shoplifting and employee theft. There is no firm rule for what constitutes an acceptable shrinkage percentage for a given business, but you want the percentage at your stores to be as low as you can make it. If you see inventory shrinkage climbing steadily, that's a danger sign.

The average shrinkage percentage for all American retail is 1.44%.

Shrinking Inventory Shrinkage

If your inventory shrinkage levels are too high, you can attempt to reduce it. There are a variety of steps that can reduce shrinkage depending on what you find to be the cause:

  • Restrict employee access to your warehouse or storage area to those workers who are supposed to be there.

  • Assign one of your employees personal responsibility for inventory accuracy.

  • Make a count of all the items when they arrive at the receiving dock.

  • Use a double-check system so that a second person has to verify records and account for shipments.

  • Automate your inventory system to reduce human error.

  • Train your staff in watching for shoplifters.