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The definition of Inventory Shrinkage varies slightly from manufacturing, to distribution centres, to retail. Irrespective of the situation, Inventory Shrinkage is simply the difference between recorded inventory and actual inventory. In other words, shrinkage is the reduction in actual inventory caused by various factors including theft, process failures, and administrative errors. In manufacturing, industry shrinkage is also referred to as the loss of raw materials during a production process.
Causes of Inventory Shrinkage
A more elaborate list of reasons for inventory shrinkage includes:
- Internal theft (employee theft)
- External theft (shoplifting – retail)
- Administrative errors such as shipping errors, receiving errors, and clerical errors in paper work
- Cashier error at the Point of Sale (retail)
- Damaged goods
- Expired goods in case of perishables
- Vendor fraud
Studies have shown that the major cause for inventory shrinkage of finished goods is employee theft. Unfortunately, many organizations underestimate this enemy within. While it is very important to trust the employees, the fact remains that it is the number one reason for inventory shrinkage across industries.
Similarly, in the case of retail businesses, another major reason for inventory shrinkage is shoplifting. Like employee theft, this menace from outside can cause reduction in inventory significantly.
Inventory shrinkage is generally calculated as follows:
- Opening Inventory + Purchases – Sales +/- Adjustments = Booked Inventory
- Booked/Recorded Inventory – Actual (physical count) Inventory = Shrinkage
- Shrinkage / Total Sales x 100 = Shrinkage Percentage
Some industries/businesses, especially distribution operations, calculate shrinkage percentage on their total inventory value instead of total sales.
Bottom Line Impact
At the end of the day, no matter what the cause is, loss of inventory directly impacts your bottom line. If a business operates on a 10 percent profit margin, they need to generate an additional 10% in sales to make up for each 1% loss of inventory. In other words, 1% shrinkage of your inventory will take away 10% of your profit.
As an example:
Sales = $100.00
Margin = 10%
Profit = $10.00
Lost an item of $1.00 = 1% of sales
Percentage of loss from profit = 1 / 10 x 100 = 10%
As you can see, even though the shrinkage % when calculated can be small, its impact on the bottom line can be significant especially in the case of low margin industries.
- Increase security (guards, cameras, etc.) to counter employee theft and shoplifting
- Review security cameras every day without taking things for granted
- Limit the number of entry and exit doors
- Ensure you have a camera near the garbage/card board disposal door
- Ensure all unused doors are alarmed
- Implement strict zero-tolerance internal policies against employee theft
- Review voided/cancelled/deleted sales reports on a regular basis for irregularities
- Examine inventory adjustment reports regularly
- Implement efficient processes to avoid administrative errors
- Check products received against vendor invoices
- Train your staff on products and equipment handling to minimize damages
- In case of perishable goods, ensure that the right quantities are purchased to minimize wastage
- Ensure your insurance policy provides inventory damage coverage protection
- Implement third party cycle counts
As per surveys conducted, roughly 50% of shrinkage is attributed to employee theft and 30% due to shoplifting, while the other causes make up the other 20%. In case of non-retail operations where shoplifting is not a factor, employee theft plays even a much bigger role.
While it is important to send strong signals and messages to employees and customers to the effect that they are being watched, it is of paramount importance that you DO NOT make them feel that you do not trust them. That will be very counter-productive in the long run.
While maintaining trust is a challenge, one humorous way of warning them that they are being watched is to put up lots of fancy signage with something like ‘Smile!! You are on security camera’. Of course, without overdoing it.