What Is Inventory Shrinkage and How to Reduce Inventory Shrinkage?

Small Business

March 21, 2023

Inventory shrinkage is a massive problem in the retail industry. In 2021, shrinkage accounted for about $94.5 billion in losses—an unconscionable amount.

No matter what kind of retail business you run, it is crucial to know your shrinkage rate and take steps to minimize it.

This comprehensive guide delves into calculating inventory shrinkage and what you can do to bring it down.

Let’s start with some basics.

What Is Inventory Shrinkage?

Inventory shrinkage is the difference between recorded inventory and the actual number of items available. It is inventory purchased from the manufacturer or supplier but is not sold to customers, leading to considerable losses in profit.

Businesses try to employ various methods to prevent shrinkage. But before you can solve the problem, you must first understand why it happens.

What Can Cause Inventory Shrinkage?

Once you understand the cause of shrinkage in your store, you can take the necessary steps to reduce it.

Here are the most common reasons for discrepancies in your inventory:

Shoplifting

Malicious parties have developed sophisticated tactics to swipe and hide inventory of all shapes and sizes, switch price tags or use tools to remove anti-theft devices. Shoplifting is still one of the biggest problems that brick-and-mortar stores face. In the US, shoplifting accounts for about 36% of all retail inventory shrinkage.

Employee Theft

Employees have direct contact with store inventory, and this easy access provides plenty of opportunities to nick some items and take them home. It is estimated that employee theft in the restaurant industry accounts for about 75% of all inventory shrinkage.

Administrative or Paperwork Error

Manual inventory management can often result in errors in data entry, cash counting, sales records, etc. Industry estimates put administrative errors at about 20% of all inventory shrinkage losses.

Vendor Fraud

You may also encounter differences in inventory stocked and inventory ordered because of vendor fraud. This can mean your vendor has delivered fewer products than what you ordered (a short shipment), overpriced one or more products compared to the agreed upon contract price or substituted a product with a lower quality product.

Now, this can be an administrative error on their part, or you might be dealing with a dishonest supplier.

Either way, this problem can only be resolved by communicating with your vendor and monitoring their deliveries closely.

Industry estimates suggest that about 5-10% of inventory shrinkage is due to vendor fraud.

Damaged Products

Poor inventory handling can lead to damaged items that you can’t sell to customers. Perishable goods that remain unsold beyond their expiry date can also be considered damaged products.

All such items must be taken off the shelves and disposed of, leading to shrinkage and loss in profits.

While retail businesses can mitigate most issues causing inventory shrinkage, preventing all of them at once isn’t easy. The best strategy is to tackle each issue separately until most potential avenues for lost inventory are minimized or eliminated.

So how do you tell if your efforts are making a difference?

You must learn how to calculate inventory shrinkage rate.

How To Calculate Inventory Shrinkage Rate

Inventory shrinkage rate is the difference between recorded and actual inventory. The successful implementation of shrinkage reduction strategies should lower your shrinkage rate.

Here’s the formula to calculate shrinkage:

Inventory in books (number or value) – inventory in physical stock (number or value)

Let’s take a look at this equation in practice.

Your business records an inventory book value worth $80,000. But when you count actual physical inventory, the items are only worth $75,000. Here’s what your shrinkage is worth:

80,000 – 75,000 = 5,000

Your business has shrinkage of goods worth $5,000, which you can convert into a percentage using the inventory shrinkage rate formula.

Inventory shrinkage rate = inventory shrinkage inventory value 100

Inventory shrinkage rate = 5,000 80,000 100 = 6.25%

The acceptable inventory shrinkage rate for retail businesses varies depending on several factors such as store size, product type, and location but is generally between 1% and 2%.

Here are estimated inventory shrinkage rates for various industries:

Apparel and fashion retail: 1.5% – 2%
Electronics retail: 1% – 1.5%
Grocery stores: 1% – 2%
Hardware and home improvement: 1% – 1.5%
Luxury retail: 0.5% – 2%
Pharmacies and drugstores: 0.5% – 1.5%
Restaurants: 2% – 4%
Sporting goods retail: 1% – 2%

If your shrinkage rate is higher compared to your industry, you must develop strategies to bring it within this acceptable range or even lower.

Ways to Reduce Inventory Shrinkage

Here are some actionable ways to bring down shrinkage, whatever your business type:

1. Track Inventory and Shrinkage

The first step to reducing inventory shrinkage is tracking your inventory and shrinkage.

This involves regularly monitoring recorded inventory levels and comparing them against physical inventory counts. There are many ways to do this, depending on your industry, the product you’re working with, and the size of your operations.

Manual tracking may seem easier for small businesses, but it is quite time-consuming, requires a lot of effort, and, most importantly, is very prone to human errors. It is well-understood that automated systems are ideal for larger inventories—they are much more practical and efficient—but they can also benefit micro or small businesses.

Another benefit of using automated systems for inventory tracking is that it frees up your employees’ time so they can focus on more complex tasks that will grow your business.

Tracking inventory and shrinkage will demonstrate whether your physical counts or recorded accounts are to blame for the discrepancies. And when you closely monitor these numbers, you can evaluate if your shrinkage-minimizing strategies are making a difference.

2. Conduct Regular Inventory Level Checks

Regular counting at consistent intervals can mitigate most of your shrinkage issues. When conducted frequently, these checks will help you root out the problem more quickly and prevent shrinkage from turning into huge losses.

You also gain better insights into the duration and periods where you experience high shrinkage. This can help you narrow down the likely factors causing it and employ more effective preventive measures.

3. Introduce a Cross-Checking System

A cross-checking system is where two or more employees check the inventory separately. Comparing counts by different people will give you an idea of your inventory levels and rectify errors immediately.

4. Conduct Surprise Audits

If your shrinkage issue is difficult to narrow down, you will benefit from conducting surprise audits. You can keep a close eye on operations while reducing the opportunities for employee fraud.

5. Automate Inventory Management

Manual errors are hard to avoid. They’re also difficult to investigate.

An easy solution is incorporating automated inventory management systems. These speed up operations and significantly reduce errors and losses. They will also give you insights into inventory levels, demand and supply changes, etc.

6. Use an Integrated System

When automating inventory management, make sure your system can integrate with the rest of your operations. An integrated system will ensure seamless data tracking from cycle counts to payment systems. Also, you will minimize the potential for errors that manual data transfer might produce.

Your inventory management system will collect data from multiple sources and provide better insights into what’s affecting your shrinkage.

7. Implement Thorough Employee Vetting and Training

Hiring responsible employees and training them right is critical to reducing shrinkage and running a successful business.

Reliable employees with good work histories will minimize or eliminate sabotage or theft in your workplace. And when you promote employees based on integrity, you will motivate the rest of your team to do better.

Proper training of all employees can also ensure fewer errors when managing inventory. Train all of your recruits such that they know all the ins and outs of the job they’re tasked with.

8. Create Barcode Numbers and SKUs for Each Item

Giving each product a unique identity will make it easier for your employees to track its movement from the moment of delivery to its sale.

And when you have a robust labeling system, you can seamlessly integrate it with your inventory management system and barcode scanners.

9. Invest in a Security System

A security system is essential if you’re working with valuable items or goods that are easily damaged when improperly stored. And when you have an eye on your inventory at all times, you can deter shoplifters and employee theft.

A security system can also track errors when human eyes and manual processes fail.

Incorporate the best tools and technologies to secure all loopholes in your operations center or retail store. You can install CCTV cameras, tracking devices, alarms, or all of the above.

If you’re storing goods in digital lockers, restrict access to only those directly responsible for the inventory. You may also consider investing in an electronic article surveillance (EAS) system.

10. Rotate Products

Businesses struggling with damaged or expired inventory will find rotating products quite useful.

First, you must label all your products with their best-by or sell-by dates. First-in, first-out stock rotation involves selling the items that first arrived at your store—the ones that will go bad imminently. Put the older products in front so customers will grab them first, and keep the newer, more long-lasting items at the back.

This practice is much easier to employ with the help of an inventory tracking system that can alert you about product shelf life. And when you are aware of such soon-to-expire products, you can employ various sales and marketing strategies to get them off the shelves as quickly as possible.