How Do You Calculate Inventory Shrinkage?

How Do You Calculate Inventory Shrinkage?

If there’s a simple way to understand most company’s attitude to inventory shrinkage, just google ‘inventory shrinkage’.

70% of the results relate to accounting for shrinkage and only 30% of the relate to correcting it. (Your Google results might differ due to personalized search results.)

In other words, most businesses accept inventory shrinkage as a cost of doing business and are more interested in accounting for it properly instead doing something about it.

What is Inventory Shrinkage?

In simple terms, it is the negative difference between the inventory recorded on your books versus what’s actually in the warehouse. It’s usually spotted when a manual inventory count is done and compared to the recorded inventory levels.

When shrinkage is discovered, it must be accounted for on the company’s books, as an expense under cost of goods sold.

What are the Causes of Inventory Shrinkage?

One of the reasons that shrinkage is so universally accepted is because many of its causes seem to be inevitable. Shrinkage happens due to the following:

Clerical Errors

Administrative errors in paperwork, data entry, lost documents, etc., are one of the leading causes of shrinkage. These include errors that happen in your company and with your suppliers.

Damage & Spoilage

Anything that gets handled can get mishandled. Spoilage can happen when inventory becomes obsolete before it is solid. Lost inventory due to production/manufacturing issues are also considered spoilage.

Lost Inventory

Inventory that is misplaced in a warehouse or misdelivered, is considered shrinkage.

Employee Theft

Easy access to inventory can prove too tempting for some employees.

Supplier and Customer Fraud

Especially when suppliers deliver lots of inventory units, it’s easy to hide a shortage in a shipment. Customers can also claim to have not received what they ordered.

Unknown Causes

About 6% on inventory shrinkage cannot be attributed to a known cause.

How is Inventory Shrinkage Calculated?

As we said, one of the simplest ways to find and assess inventory shrinkage is to compare manual inventory counts with the stock levels on your books. This is an effective method even if inventory management systems are in place.

To determine inventory shrinkage according to cost, you would evaluate the manual count of inventory and subtract it from the inventory cost listed in your books.

To determine inventory shrinkage as a percent of inventory cost, you would divide the difference by the amount of stock recorded on the books.

For example, let’s say your company has $100,000 of inventory on the books. You do a manual inventory count and discover that the stock-on-hand is worth $95,000. The dollar amount of shrinkage is $5,000. And the shrinkage percentage is the result of the difference ($5,000) being divided by the stock level on the books ($100,000) to arrive at a percentage (.05 or 5%).

The Cost of Inventory Shrinkage

Once you know how to calculate inventory shrinkage, you can get an idea of its costs. When expressed as percentage of the stock value on the books, the cost of shrinkage might not seem very high. A study reported by Supply Chain Digest found that typical warehouse shrinkage percentages are below .5%.

To show you the benefits of knowing the costs of inventory shrinkage, in the same study, the percentage of shrinkage for ‘Best in Class’ companies is less than .005%.

If that looks like less than a half a percent difference, it’s actually 99% lower. Or the best-in-class cost of inventory shrinkage is one-hundredth that of a typical company’s shrinkage. If the average warehouse lost $100,000 to shrinkage, the best-in-class warehouse would only lose $1,000.

But the way most companies track and account of the costs of inventory shrinkage tells only part of the story. The real costs of shrinkage ripple beyond the inventory costs into other areas of your operation. These costs are more difficult to track than simply counting stock. Some of the costs might never be known and some are unknowable. They are the hidden costs of inventory shrinkage.

The Hidden Costs of Inventory Shrinkage

The hidden costs might not be tracked by most companies and simply unknown to other companies, but they are no less costly than the physical loss of inventory.

In fact, the hidden costs of inventory have the potential to be the largest costs of inventory shrinkage by far. Businesses must begin to realize the real costs of shrinkage by understanding that hidden costs exist, knowing their extent and seeing their direct drain on the company’s profit.  When they do, they will be motivated to stop accepting the costs and find ways of reducing and eliminating them.

You owe it to yourself to learn more about the hidden costs of inventory shrinkage and how they are killing your profits.

Download our free ebook “Quiet Profit Killers – The Hidden Costs of Inventory Management”.

In addition to finding out where costs may be hiding in your inventory shrinkage, you’ll also discover the hidden costs of Inventory Waste and Inventory Replenishment.

Download Your Free Ebook

About the author

Israel Ellis, CEO