back to resources

What Is Shrinkage: How to Calculate Inventory Shrinkage

By
Scott
on
Monday, November 16, 2020
Table of Contents

Here are two simple and indisputable statements:

  1. If inventory shrinkage is large, your profits decrease.
  2. If inventory shrinkage is managed, your profits increase.

As you can tell from the word choice, inventory shrinkage can’t be eradicated.

It can only be successfully managed and lowered. Hopefully to a below-average level.

But 11% of retail businesses report shrinkage rates at or above 3%. That’s three times the industry median shrinkage rate of 1%. So, with money on the line, it’s obviously in your company’s best interest to identify and prevent shrinkage.

But what is shrinkage? What causes shrinkage, and just what kind of numbers, industry-wide, are we looking at in regards to shrinkage in retail? And finally, how on earth can I get a hold of shrinkage control?

Your answers are below. 

Inventory Shrinkage Is Recorded When … 

Inventory shrinkage is recorded when you want to reconcile your sitting inventory with your inventory records. If you find less on your shelves than your accounting reflects you’ve sold, you’ve got shrinkage. 

What Is Inventory Shrinkage?

Inventory shrinkage is when you have less inventory than you should. Something is causing items to go missing before the point of sale. And inventory shrinkage isn’t just a retail problem. It affects every stage of the supply chain from the point of manufacture. And it affects every business's inventory turnover ratios and sell through rates. Because that inventory isn't being turned over or sold.

How to Calculate Inventory Shrinkage

If you’ve got shrinkage, there’s good news: Shrinkage is unavoidable. Every business will run some level of inventory shrinkage. You just need a shrinkage calculation to uncover it and there’s more good news: You can lower it.

Here’s a shrinkage formula for calculating inventory shrinkage:

Shrinkage Rate = (Recorded Inventory - Actual Inventory) / Recorded Inventory

We’ll use a wine bar as an example. Let’s say a wine bar takes bar inventory and counts 71 bottles of wine and that they’ve sold none of those bottles. If they recorded receiving 72 bottles of wine from their supplier, the shrinkage calculation would look like this:

Shrinkage Rate = (72 - 71) / 72 
Shrinkage Rate = .014 or 1.4%

1.4% of the wine bar’s sales of this wine bottle are lost. To be honest, though, 1.4% isn’t so bad. It’s actually right around average and speaks to an industry-standard amount of shrinkage control.

Restaurant Shrinkage: Kitchens

In restaurant kitchens, shrinkage refers to the difference between the amount of food you acquire from suppliers and the amount of food you sell to customers.

Restaurant shrinkage reflects three things:

  • The efficiency of the kitchen. Kitchens that burn steaks, prep incorrectly, or otherwise contribute to waste increase shrinkage.
  • The amount of dead stock expiring. Inaccurate purchase orders that stock storage with sitting inventory that goes bad increases shrinkage.
  • The quality of raw inventory from suppliers. If some portion of raw inventory can’t be used, it’s trimmed and counted as shrinkage. The more unusable material trimmed and discarded, the higher the shrinkage.

Shrinkage at the Manufacturer

Back to our wine. Imagine a small, 5-acre vineyard that produced 600 cases of wine this harvest. They’re the manufacturer. They have a contract with a wine wholesaler who buys every case available to distribute to retail wine shops, bars, and restaurants. But the vineyard only has 598 cases of wine to sell to the wholesaler. The process of bottling, labeling, packing, storing, and shipping the wine cause 2 cases—24 bottles—to disappear. Shrinkage.

Shrinkage at the Vendor

Those 598 cases of wine are loaded onto a truck, driven to the wholesaler’s warehouse, and unloaded. The wholesaler stocks it, scans it, inventories it, sells it, and ships it to hundreds of individual retailers. But throughout that process, they’ve lost 5 cases. That’s 60 bottles. Shrinkage again.

Shrinkage in Retail & Hospitality

And finally, a medium-sized wine bar receives their shipment of 6 cases from the wholesaler. That’s 72 bottles. They put the wine in their cellar, open the first case, and begin selling it to guests. At some point the wine bar takes beverage inventory and finds they’ve sold 40 bottles and have 31 left. That’s only 71 bottles. Where’d the other one go? Shrin-kage.

Factoring in Inventory Shrinkage

Everyone knows shrinkage exists, though. They don’t often know their shrinkage numbers—which is something inventory management software helps with—but they know they’re losing product. So they adjust their prices to account for it.

The wholesaler pays a bit more for their 598 cases. The wine bar pays a bit more for their 6 cases. Because offsetting the cost of inventory shrinkage is baked into prices. That price increase is ultimately assumed by the last person in the chain: the retail customer.

If you can strengthen your shrinkage control, whether shrinkage in retail or shrinkage on the wholesale and vendor side, you’ll create two money-making opportunities:

  1. You can lower prices and potentially sell more than usual
  2. You can keep prices the same and sell what you were originally supposed to without such high shrinkage

But to lower it, you’ve gotta identify it. So here are the common causes of retail shrinkage.

Causes Of Retail Shrinkage

Just what are the causes of retail shrinkage? There are 6 main reasons for inventory shrinkage.

Theft

Theft affects inventory shrinkage in one of two ways. Either someone external does it and it’s called shoplifting or external theft, or someone internal does it and it’s called employee theft or internal theft.

Of note, what’s known as “POS exceptions” contribute to internal theft and are especially relevant to the hospitality industry. Because POS systems are so integrated into the sales of a bar or restaurant, employees have the ability to use them subtly and to their own benefit. That means ringing in obsolete prices, applying discounts, or otherwise being creative with how things are rung in.

Waste and Spoilage

This one is pretty self-explanatory, but if perishable products aren’t used by their expiration date, they contribute to inventory shrinkage. In our example, the wine bar isn’t able to sell the last half case of wine before the 3-year expiration date. Those 6 bottles, lost to the ravages of time, are shrinkage. 

Waste and spoilage have far a greater impact on the food service industry and retail food sellers. When dealing with products that last a matter of days, spoilage can be a significant cause of retail shrinkage.

Damage

If one of the wine bottles is dropped and shatters, that’s loss of merchandise. It’ll increase shrinkage numbers. Likewise, and it doesn’t have to be a perishable item, if any product is damaged beyond the point of reselling, it will increase your shrinkage percentage. Returns and exchanges contribute to damage-based shrinkage substantially, especially as one of the causes of retail shrinkage in traditional, non-hospitality retail environments.

Human Error

Pouring 6 ounces of wine instead of the standard wine pour is a human error that can compound over time to increase shrinkage numbers. In the food and beverage industry, the same goes for any measuring and portioning done by people.

From a retail shrinkage perspective, think ringing up the wrong item. And from a manufacturer or vendor perspective think loading the wrong cases onto the pallet or commingling different products in storage.

Administrative and Paperwork Errors

When the vineyard sells the cases of wine, the vendor or wholesaler receives and sells the wine. Then the retail-level wine bar receives and sells the wine. There’s a lot of receiving and selling. And a lot of room for error.

If the wine-bar in our example input 10 bottles of wine per case instead of 12, they would have recorded 60 bottles in their inventory instead of 72. Right there, that’s 12 bottles of wine that won’t be accounted for. The POS will eighty-six that wine at 60 bottles and those 12 won’t be sold. That’s a big loss.

Clerical errors like this also lead to premature ordering and, eventually, sitting inventory that takes up shelf space. This type of shrinkage is especially hard to solve because any plan of attack is based on faulty information. Thankfully automation has gotten us pretty far in dealing with both of these problems and we’ll touch on that in a bit. Accurately calculating inventory KPIs like average inventory, inventory days, and carrying cost can all be automated.

Vendor Fraud

Vendor fraud is alternatively known as supplier fraud or wholesaler fraud. It’s as simple as the person or entity who is selling you products not delivering the promised amount. There’s a real risk of this as orders grow in size. The wine bar that orders 6 cases of wine has no problem verifying that 6 cases have been delivered.

But it’s harder for the wholesaler to count the 598 cases of wine they got from the vineyard. And more so for businesses that receive thousands of items. If it’s unrealistic to count, it’s unrealistic to verify that you got the right amount.

Vendors can also deliver different products than were originally agreed on. If, for example, a Grand Cru wine was ordered but the vendor filled the order with a Premier Cru of the same vintage. It’s easy for the vendor to claim it was a mistake, and they still get to roll the dice on nobody noticing or caring enough to do something about it. 

The above is less common. Most often vendor fraud takes advantage of the sheer numbers of commercial ordering and skims a little off the top by shorting the quantity delivered.

Shrinkage Statistics

According to the shrinkage statistics from the 2019 National Retail Security Survey, inventory shrinkage accounted for 1.38% of all retail “sales.” That’s almost 48 billion dollars. To give you some perspective, the entire wine industry has a market value of 70.5 billion dollars. The “shrinkage industry” is almost 70% of that. There are literally tens of billions of dollars to be recouped.

What Percentage of Shrinkage is Caused by Theft?

In 2017, the NRSS reported that external theft or customer shoplifting were responsible for 37.5% of retail shrinkage. And 33.2% of retail shrinkage was caused by employee or internal theft. That means theft accounts for roughly .98% of all retail sales and a total of almost 34 billion dollars.

To look at the NRSS shrinkage statistics from another angle, the average dollar amount lost per dishonest employee in 2019 was $1,264.10. Another reason to figure out how to hire bar staff that mesh well with your workplace culture. While the average dollar amount lost per shoplifting incident was $546.67. 

“Thanks, real interesting shrinkage statistics. But what should my business be aiming for?” you ask. In the world of inventory shrinkage there are acceptable levels and unacceptable levels. Here’s what you should aim for.

What Are Acceptable Levels of Inventory Shrinkage?

The NRSS reports that in 2018, the average inventory shrinkage rate was 1.38% across all retail sectors. Even though that’s the average, it’s still pretty high because it equally weights even the highest inventory shrinkage rates. Like those at or above 3%, which account for almost 11% of retail businesses.

A better way to look at acceptable levels of retail inventory shrinkage is the median 2018 reported shrinkage. The median is the point in which half the numbers are above it and half below. It makes it a more representative number. The median shrinkage rate for 2018 was 1.00%. If you’re on the short side of that, you’re doing well. An acceptable level of inventory shrinkage is less than 1%.

Ways to Prevent Shrinkage: Controlling Shrinkage in Retail

We talked to everyone we know that runs a business and is concerned with how to stop shrinkage. Here are the 5 most common themes we got when it comes to controlling shrinkage.

Security

Item tracking like ink-blot tags in clothing stores or magnetic scanners in electronics stores do a great job deterring and catching internal and external theft.

Acquiring or upgrading video security systems will also be a great help—especially in cases when fixing ink or magnetic tags to items isn’t reasonable. Maybe someone is taking cash from a drawer or a bottle of liquor from behind the bar.

Of course, hiring loss prevention employees would work too. But that’s a bit of luxury. If you can justify (would you be paying them more than the shrinkage they’d prevent?) and afford the payroll for an employee who is specifically concerned with stopping shrinkage, then great.

Par Levels or Reorder Points

Learning how to set par levels and reorder points is how to stop shrinkage by lessening waste and spoilage. A par level is the amount of inventory you need to have available between receiving shipments to make sure you’re meeting customer demand. If you set the right par levels, you won’t have sitting inventory marching toward its expiry date. And that also means you’ll clear up more shelf space for other, more profitable products.

Train Staff

When staff is operating lockstep with standard operating procedures, it lowers shrinkage significantly. That means profits go up. Train your staff on your inventory pipeline, their role in it, and how to work efficiently. Often that means teaching them to interact with inventory management software and that software's recommendations and analyses.

Take Inventory Often

Each time you take inventory is a chance to detect an inventory discrepancy. And that’s really all inventory shrinkage is. How to prevent shrinkage is an exercise in how often you’re taking inventory. Taking inventory once a week is ideal. Once a month is acceptable. Longer than that, you’re setting yourself to be on the losing end of a shrinkage problem. In a perfect world, though, your inventory is perpetual. Every time product is acquired or sold, your inventory updates in real time.

You need inventory management software for that.

Automate Inventory and Reporting

If you have errors in your inventory counts when manually taking inventory, that screws up your shrinkage rate. To take any action on shrinkage, you need accurate information. It all starts with taking inventory accurately.

The only way to make sure that happens is to automate it.

If you have errors in your accounting records, inventory costing methods, payments, or invoices it will snowball into inaccurate shrinkage rates. Among other problems. Automating your inventory and reporting is the answer. No matter what industry you’re in, there are numerous software solutions for your business.

BlueCart helps wholesalers and suppliers across the country automate and streamline their inventory. Get in touch and we'll show you how.