A Small Business Guide to Inventory Shrinkage

Running a business is hard enough, but it’s even harder when your inventory is disappearing into the ether. When the Widget Fairies carry off your widgets in the middle of the night, that’s called inventory shrinkage, and it can cost your company a lot of money.

Discrepancies between what’s on your factory floor and what’s in your accounting records are a frustrating problem, but a totally solvable one with a few adjustments. However, it may require a complete overhaul of your current inventory management processes. You’ll need to diagnose the problem before you solve it, so it’s important to approach the problem with care and deliberation.

Limiting shrinkage is a vital part of inventory control, and it all comes down to being better organized as a business. Here’s what inventory shrinkage refers to and how to get it under control.

Overview: What is inventory shrinkage?

Inventory shrinkage is when the amount of product a business actually has available is less than what is shown in the accounting records. This discrepancy indicates that there has been theft, miscounting of products, damage, or other issues.

Inventory shrinkage is a problem for businesses that run into problems filling orders and accounting for the missing inventory. Inventory shrinkage costs can be significant and may cost a business thousands of dollars per month or more, depending on how much product the company moves.

4 reasons your business can experience inventory shrinkage

So what’s causing your inventory shrinkage problem? The first step is to diagnose so you can come up with a solution. Generally, the reasons for inventory shrinkage fall under four main categories.

Theft

If products are going missing, inventory theft is a strong possibility. That means employees are stealing products, or customers are shoplifting, or burglars are finding a way in. According to one study, theft is by far the most common cause of inventory shrinkage, with employee theft and shoplifting making up 78.3% of inventory shrinkage cases.

Miscounting and administrative errors

The next most common reason for inventory shrinkage is administrative, at 15.4%. This includes simple errors on the part of your staff such as miscounting, paperwork mistakes, or not factoring in things like inventory turnover ratio.

This may indicate that you need more staff to double-check totals or a better process for double-checking. It could also mean your processes need help in other areas. For example, if inventory is damaged or expires and gets thrown out, is it recorded by your staff?

Vendor fraud

Vendor or supplier fraud is less common -- comprising 3.7% of inventory shrinkage cases -- but it does happen. If you've ruled out theft and administrative errors, investigate whether your supplier is abiding by your contract and that your numbers match up.

Unknown causes

Sometimes all of your investigative work comes up with nothing, and you just chalk it up to "unknown" -- which is the case 3.9% of the time. Inventory is complicated to manage, so it's not surprising that units get lost in the shuffle. Some adjustment for inventory shrinkage is unavoidable, particularly in larger operations. However, improving your administrative processes should help prevent some products from disappearing.

How to calculate your inventory shrinkage rate

Inventory shrinkage rate is calculated by dividing inventory losses by the amount of inventory listed in your accounting records. Here's an example:

ACME Inc.'s accounting records show $1,500,000 in inventory. After doing a physical inventory count, the company determines it has $1,470,000 in inventory on hand; therefore, the inventory shrank by $30,000. To determine the shrinkage rate, divide the total shrinkage by the total recorded inventory amount. Then multiply that figure by 100 to get a percentage.

$30,000 ÷ $1,500,000 x 100 = 2% Shrinkage Rate

5 tips and tricks to prevent inventory shrinkage

Inventory shrinkage is a major drain on business finances. Use these five simple inventory management methods to get it under control as soon as possible.

1. Increase security measures

If you believe that theft is an issue at your warehouse, a few security measures may be all that is necessary to slash your inventory shrinkage rate. New fencing to prevent intruders, better locks, security cameras, and other methods will make it more difficult for scofflaws to make off with your goods.

On the shoplifting side, install security cameras in the store or train your staff to spot suspicious behavior to reduce shoplifting. Change stocking procedures by putting higher-priced or frequently stolen goods behind the counter.

2. Restrict access to certain employees

The more employees you have, the more potential for employee theft -- and the harder it is to identify the culprit. Restrict access to certain parts of the warehouse to only those employees who need it, making it easier to narrow down the suspects if you do have an issue.

For example, certain doors could require a keycard that only some employees have so others -- such as those doing general warehouse maintenance -- would not have access.

3. Improve inventory tracking

A lot of inventory shrinkage comes from poor tracking processes. If you don't think theft is an issue, but you just don't have a good handle on the goods coming in and out of your warehouse, review your inventory tracking processes and talk over with your employees what could be improved.

The fix may be simple, such as monitoring the movement of goods at multiple points instead of just one, or it may require a total overhaul. Conduct a deep dive with your team to determine what is required.

4. Task multiple employees with inventory tracking

Having multiple employees double-checking inventory prevents both fraud and mistakes, so it's one of the most effective ways to limit inventory shrinkage.

Large airlines can't afford to have even one crash, yet they make thousands of flights each day. How do they do it? They follow a rigorous safety process that involves many employees checking and double-checking to make sure basic tasks are done. If one employee makes a mistake, plenty more follow up behind to catch it and make sure, for example, that a part was replaced at a certain milestone.

You can use this same method to reduce mistakes in the warehouse. Additionally, it makes it nearly impossible for employees to commit fraud or theft when other employees are checking up after them.

5. Train employees better

If you're losing track of inventory, it may be nothing nefarious at all -- just employees who aren't properly trained. Meet with employees responsible for tracking inventory and review the processes they follow. If you find they have knowledge gaps, institute a training program.

Explore a mentorship program if you have both experienced inventory workers and newer unskilled staff members. The latter can learn from their more experienced colleagues how to properly track and inventory items to reduce mistakes.

Software will help reduce inventory shrinkage

A powerful inventory management software platform with the latest features and tools will help you get more organized and less likely to lose track of inventory. Additionally, this software will track data and metrics -- such as carrying costs and cycle time -- to help you identify opportunities to improve inventory management.

Explore some software options to determine which best suit your business and then try a few of them out. Once you've settled on a new platform, run a pilot program to see how your inventory shrinkage rate changes over time.