No matter how carefully businesses account for sales, storage, and replenishment, products will inevitably fall through the cracks in the system. Regardless of whether the problem is in inventory management, warehousing strategies, or accounting, the result is the same: inventory shrinkage.
The consequences of inventory shrinkage reach far into a business’s profit margins, though many businesses suffer them silently. When things don’t add up and you don’t know why, you may be tempted to raise prices or cut labor to make up the deficit. Yet, these options often keep the snowball rolling toward lower customer retention, lower employee retention, and inventory management inconsistencies.
Identifying and learning how to reduce shrinkage is a pivotal process in learning effective inventory management. Proactive warehousing, replenishment, and even software management measures can ensure that your business safeguards its assets and stops shrinkage from cutting into your profits.
In simple terms, inventory shrinkage is the discrepancy between the inventory a business has recorded and the inventory it actually has. When inventory is sold, these numbers update to new totals, so the discrepancy is not a result of sales. The shrinkage comes from other sources.
Inventory shrinkage is a loss in viable inventory. Since that inventory was already bought by your business, shrinkage always results in a loss in profits. But what is shrinkage in inventory? How does it happen? The causes of inventory shrinkage can be broadly defined by who is responsible for the shrinkage.
Manufacturer: When the manufacturer is responsible, the shrinkage could be due to manufacturing defects in products that are spotted at the warehouse. Another example is running out of raw materials for product production due to a clerical error or damage, such as an infestation of termites in wood storage. Manufacturing, even when successful, often leads to waste or spoilage, both in raw materials and defective products. When these can’t be recycled, they often result in inventory shrinkage.
Retail: Retailers can cause inventory to shrink by losing or miscounting products, but the most common cause is shoplifting. In fact, the last five-year average for inventory shrink in retail across all industries was 1.5%, which equates to almost $100 billion in lost profits annually, with theft making up the largest portion of the losses. Note that this includes shoplifting and employee theft. Other retail-related causes of inventory shrinkage include cashier errors, inventory counting errors, pricing errors, and employees abusing their store discounts.
Vendor: Vendors can cause inventory shrinkage primarily in the process of shipping and distributing products. If an employee breaks a product in transit, that may not be accounted for in the inventory records, so the warehouse may have paid for a larger supply than it has on hand. As with other instances of inventory loss, they likely won’t discover the discrepancy until an outstanding order can’t be fulfilled.
Restaurant and hospitality: Businesses in food & beverage and related industries must face inventory shrinkage resulting from spoilage. This occurs when ingredients or finished products expire on the shelves or in transit, causing an inventory loss. Examples of this type of shrinkage include a refrigerator breaking down in transit and spoiling the products inside. Restaurants face this shrinkage daily due to customers sending back food in exchange for something else: the meal they sent back represents inventory that was accounted for yet never sold for a profit, resulting in shrinkage.
The causes of inventory shrinkage can be boiled down even further to get to the root cause of the issue and answer the question, “What is shrinkage in inventory?” There are 5 main causes of shrinkage:
- Theft (external, internal, or fraud)
- Lost or damaged goods
- Employee errors (including administrative)
- Spoilage
- Accidents
These can occur at any stage of the product development and fulfillment process and be the fault of any party during that process, from the manufacturer and vendor to the retailer. Here are a few additional examples on top of those discussed above.
- Fraud can occur when a vendor “double bills” for products that were never received. Companies may also pose as vendors, fabricating invoices to commit vendor fraud.
- Employees can cause shrinkage in many ways, from a waiter who drops a dish to a cashier who rings up a product for the wrong amount. Manual tasks increase the risk of human error by default, which is why many companies are turning to inventory management software to reduce shrinkage.
- Customers can cause inventory shrinkage as well, such as by trying products in a store and damaging them.
- Theft is not limited to shoplifting. When employees misplace products in the warehouse or label them incorrectly, they create a problem where more units are thought to be available to sell than are actually in stock or findable.
- Spoilage isn’t the only thing that causes products to become unusable. If you sell products such as clothes that were purchased when they were in fashion but are now out of style, that inventory may be seen as obsolete and then sold at a discount or written off entirely.
Inventory shrinkage to some degree is an inevitable part of inventory control. The risks of shrinkage go up in certain industries, such as those more susceptible to product spoilage or in businesses that rely on outdated inventory management methods.
No matter the degree, businesses should never be asking “Is shrinkage good?” Shrinkage has several negative effects, including:
- Profit loss: Profit loss occurs because shrinkage causes businesses to replace missing inventory, lose sales, and lose customer loyalty when inventory levels fail to meet demand. Put another way, shrinkage increases your business’s COGS (“Cost of Goods Sold”), which cuts into your profits.
- Price increases: To compensate for shrinkage, many businesses increase their product prices. By passing the buck of your profit losses to the customer, you’re risking losing their loyalty, resulting in an even more serious drain on profits.
- Cost increases: Shrinkage causes cost increases through inventory replenishment. But these are not the only costs a business will face. They may need to invest in new refrigerators, security measures, or accounting software if any of those areas are to blame.
To mitigate these effects, Fishbowl inventory management software automates tasks like replenishment and barcoding to take human error out of the equation, reducing the risks of shrinkage. Fishbowl integrates with QuickBooks to help manage costs and expenses from the accounting side while the software handles inventory tasks.
The good news, if you’re wondering how to calculate shrink, is that the shrinkage formula is relatively simple on paper since it represents an observable discrepancy between the amount of inventory in your records and the amount of value in the inventory you actually have on hand. In other words, it’s the difference between your book inventory and actual inventory.
Shrinkage = Value of recorded inventory – value of on-hand inventory
This can be expressed as a percentage by taking the result, dividing by the book value, and multiplying by 100. It can be applied to dollar amounts or unit counts if your business wants to represent shrinkage based on other metrics.
Knowing the causes of inventory shrinkage, consider these strategies for combating it and reducing the drain on your profit margins:
Utilize automated inventory management software
Inventory management systems like Fishbowl + QuickBooks provide businesses with dedicated software solutions for inventory scheduling, replenishment, barcoding, and more. These systems also track registered system users. So in addition to reducing human error by automating processes, they also give managers a better idea of who could be the source of an inconsistency.
Double-check your inventory records
The double-check method doesn’t need to be applied as rigorously to stock replenishment or barcoding with automated management systems in place. However, invoices still need to be signed and stock still needs to be accepted at your facilities. These are areas where the double-check system can still come in handy to reduce manual errors across your fulfillment process.
Vet your employees
Shrinkage caused by employee misdemeanors can be reduced by instituting stricter background checks on your new employees. Contact their references and past employers to learn whether they have a history of stealing or abusing company resources. As part of this process, make sure you’re training new employees on how to handle stock safely.
Identify and monitor shrinkage
Knowing that no business can eliminate 100% of shrinkage, businesses should track any shrinkage they can observe to try and mitigate it. To do this, inventory counts should be compared to counts from previous quarters to monitor the rate of shrinkage, whether it’s increasing or decreasing, and potentially what measures can be taken to correct it.
Increase security
Signs, security surveillance, and account passwords are examples of security that you can use to increase your employees’ and customers’ accountability when handling your products or systems. If you discover that shoplifting or internal theft is the main cause of shrinkage, increasing security measures could help.
Advise a loss prevention manager
Loss prevention managers can take over training and knowledge processes that free up your higher management for more important tasks like strategizing inventory control. Location-specific policies, emergency training, and customer/employee safety are a few areas that loss prevention managers can take over and optimize for your business. Considering that shrinkage often happens due to employee accidents, safety training could safeguard your profits as well as your workers.
Utilize inventory audits
Audits help your managers confirm how much inventory you have, including its condition and expiration status or any damage it may have sustained. While many tasks can be automated, physical audits are sometimes needed to detect damage, spoilage, theft, and other instances of shrinkage that can slip through the cracks.
Improve internal communication
Shrinkage can result from a communication breakdown, such as when extraneous reorders spoil, products go to the wrong warehouse location, or supplies are damaged in transit. Improving internal communication with an employee management software solution can mitigate these errors.
Inventory shrinkage affects any business with a retail or fulfillment component. Management software like Fishbowl is key to robust inventory management. From real-time tracking to advanced analytics, Fishbowl allows businesses to detect and proactively prevent the factors that cause shrinkage.
Additionally, integration with QuickBooks and Fishbowl allows businesses to achieve maximum efficiency in recording, purchasing, processing, and approving fulfillment actions by automating your most complex systems and reconciling the errors that cause inventory shrinkage before they shrink your profits.