Understanding Inventory Shrinkage: Causes, Calculation, and Reporting

The smooth flow of goods from your supplier to your customer depends on effective inventory management. Inventory also ties up a significant amount of capital. Still, if you don’t have enough inventory, you’ll lose sales and customers.

The secret is to find a balance that optimizes inventory holding without risking stockouts. Optimized inventory depends on accurate records and forecasting.

Inventory shrinkage is the difference between recorded inventory and actual inventory. Shrinkage heavily impacts inventory accuracy and can significantly impact your profits.

In this article, we’ll explore the causes of shrinkage and offer best practice ideas to control and optimize your inventory.

What is inventory shrinkage?

Every business has a recorded or theoretical inventory level, but it doesn’t always match reality. Inventory shrinkage refers to the difference between the actual stock and recorded stock. It’s the difference between what you have and what you think you have. This discrepancy can wreak havoc with your operations including sales and production. The consequences can be severe, resulting in sales losses and operational inefficiencies.

Inventory managers must understand stock shrinkage and its causes. They must take action to mitigate the problem. Shrinkage is an inventory loss that comes straight off the bottom line. It can impact production and result in lost sales, affecting profit margins.

To mitigate the risk, businesses must track shrinkage and use the insights gained to improve their inventory systems. Companies that understand shrinkage have more accurate data and better stock control. They can use targeted solutions to reduce and overcome shrinkage.

It is only with accurate data that you can optimize inventories. Optimized inventories release capital tied up in excess stock, enable more efficient ordering and reduce the risk of stockouts.

Causes of inventory shrinkage

There are several reasons for inventory shrinkage. Identify the culprits and target them for improvement. Causes include:

Theft and fraud

Theft and fraud may be either internal or external

• Internal theft: Employees remove inventory for personal gain

• External theft: Customers may shoplift, removing stock from the business premises. Suppliers may bill the company for more stock than they delivered, resulting in stock discrepancies.

Administrative and operational errors

Errors may include:

• Data entry mistakes: Mistakes made when employees capture data, like receipts and sales.

• Mismanaged returns and refunds: The records must accurately record the returns and refunds. If stock returns are not usable, they should not reflect in the usable inventories.

• Poor inventory tracking and auditing practices: Cycle count or annual stock count errors may be incorrect, causing discrepancies. Late transaction data entry is also a cause of many discrepancies.

Damage and storage

The inventory may suffer damage on receipt or in the warehouse. Look out for:

• Perishable goods spoilage: Optimizing inventory makes it easier to control perishable inventories because there is less stock. Order quantities should take account of perishability.

• Handling and transportation damage: Poor handling, inadequate packaging, and transportation can cause damage.

• Poor storage conditions: Unless your store is clean and well-maintained, stored goods may become damaged.

Calculating inventory shrinkage

Inventory shrinkage should form one of your Key Performance Indicators. Here’s how to calculate it.

Basic formula for inventory shrinkage

The formula for inventory shrinkage is as follows:

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

Where :

• Recorded inventory: Inventory in stock according to the accounting records

• Actual inventory: The amount of inventory counted in stock

• Inventory shrinkage: The difference between the recorded inventory and the actual inventory as a percentage of recorded inventory

Companies must strive to reduce shrinkage rates by understanding and controlling the causes. Lower inventory shrinkage indicates better inventory control.

Using technology

Manual inventory management systems are fraught with delays and inaccuracies. These traditional systems are still widely used. The result is often non-current stock records and errors throughout the system. There is no single source of information.

Modern technologies can maintain accurate inventories and reduce shrinkage because updates happen in real-time. Automated transactions remove the human element, so errors are less likely.

Modern order fulfillment software updates stock when an order is placed, picked, packed, or shipped. Accurate, up-to-date data helps businesses optimize inventories. They can avoid overstocking items that aren’t selling well and can prevent lost sales as they quickly restock popular products.

Order fulfillment software will only allocate available inventory to orders. This reduces the risk of incorrect order quantities. The software automatically updates inventories after every order.

Integrated Systems

Integrated fulfillment software aligns with other systems like accounting and point of sales. The systems work from a single source. This improves efficiency and enhances overall accuracy.

Integrated fulfillment software can help to reduce shrinkage in the following ways:

• Reduced Theft: Real-time inventory tracking discourages employee theft as discrepancy detection is easier.
• Minimized Damage: Improved order picking and packing efficiency can reduce product damage.
• Prevention of Administrative Errors: Task automation minimizes the risk of human errors.

Reporting inventory shrinkage

Businesses need regular standard reports and analyses to track inventory shrinkage.

Regular audits and cycle counts

A full inventory audit, conducted at least annually, provides a clear picture of your inventory accuracy. The audit aims to compare the accounting inventory figures with the actual inventory. Discrepancies are identified and investigated to find the cause of the shrinkage.

In recent years, cycle counts have become increasingly more popular. Cycle counts happen more frequently, counting smaller inventory batches. Cycle counts enable ongoing monitoring and can target high-risk or fast-moving items. Use cycle counts to spread the counting over a year and reduce the disruption of a regular full audit.

Utilizing software for reporting

Order fulfillment software can automate shrinkage report generation. Customize the reports to provide insights into categories, locations, and times. Use these to identify trends and patterns. These trends and patterns should help with targeted shrinkage reduction.

Netstock integrates with several major software packages, including Syspro and SAP. Customers attest to the advantages of installing integrated order fulfillment systems.

Analyzing shrinkage reports

The key to reducing your shrinkage rate lies in identifying the trends and patterns and acting on them.

Preventing inventory shrinkage

Actions to reduce shrinkage could include:

Implementing security measures

Security measures should help to reduce inventory shrinkage. Security measures could include:

• Surveillance: Security cameras, access control, and security personnel can reduce theft.

• Employee training: Train employees in inventory principles and stock handling. Training raises awareness and can help to reduce errors and capture delays.

Improving administrative accuracy

You can improve administrative accuracy with a few simple changes.

• Cycle counts: Do more cycle counts on high-risk items and take preventative actions based on the outcomes.
• Real–time automated systems: Install real-time automated inventory and order fulfillment systems to improve accuracy and ensure up-to-date inventory data.

Enhancing storage and handling

Well-maintained storage systems will protect your inventory. Reduce damages with stock management techniques like these:

• Stock rotation: Use inventories in the order in which they were received.

• Inspect incoming goods: Poor handling, inadequate packaging, and transportation can cause damage. Inspect incoming goods to ensure that they are in good condition and specification. Any damage must be identified before the goods are booked in and become part of the stockholding.

• Organization and layout: Store heavier items closer to the ground. Practice good stacking procedures to prevent crushing.

• Access control: Limit store access to personnel.

The role of inventory planning & ordering software

Any business wanting to optimize inventory management must understand and address inventory shrinkage. High shrinkage can significantly impact profits through inventory write-offs and lost sales.

Modern technologies can help address inventory shrinkage problems. Real-time data updates and automatic administration of order fulfillment documents remove the human element, eliminating errors. Automated shrinkage analysis and reports can help identify patterns and trends, allowing you to reduce shrinkage.

A demand and supply planning solution like Netstock provides real-time insights and automated orders.