What is 'Shrinkage'

Shrinkage is the loss of inventory that can be attributed to factors such as employee theft, shoplifting, administrative error, vendor fraud, damage in transit or in store, and cashier errors that benefit the customer. Shrinkage is the difference between recorded inventory on a company's balance sheet and its actual inventory. This concept is a very real problem for retailers, and it works to quickly reduce retail sales, resulting in billions of dollars of lost inventory each year for U.S. retailers.

BREAKING DOWN 'Shrinkage'

To understand shrinkage, it is first important to discuss the difference between book inventory and physical inventory. When a retailer receives product to sell, for example, accountants record the dollar value of the inventory on its balance sheet as a current asset. If the retailer accepts $1 million of product, the inventory account increases by $1 million. Every time an item is sold, the inventory account is reduced by the cost of the product, and revenue is recorded for the amount of the sale.

For book inventory, the dollar amount tracks the exact amount of inventory that should be on hand for a retailer. However, inventory is often lost due to any number of reasons, causing a discrepancy between recorded inventory and the physical inventory in the store. The difference between these two inventory types is shrinkage. If, for example, the retailer loses $1,000 of inventory due to theft, the shrinkage itself would be: $1,000,000 - $900,000, which equates to $1,000.

However, the problem of shrinkage is often much larger. Walmart, for example, has consistently dealt with annual shrinkage losses of $3 billion, equal to roughly 1% of its U.S. revenue, mainly due to theft.

Negative Impacts of Shrinkage

The largest impact of shrinkage is a loss of profits. This is especially negative in retail environments, where businesses operate on low margins and high volumes, meaning that retailers have to sell a large amount of product to make a profit. If a retailer loses inventory through shrinkage, it is hit twice over; it cannot recoup the cost of the inventory itself, and it also cannot sell the inventory and make revenue, which trickles down to decrease the bottom line.

Shrinkage is a fact of life, and many businesses try to cover these potential losses by increasing the price of a product to account for small losses in inventory. These prices are passed on to the consumer, who is required to bear the burden for theft and inefficiencies that might cause a loss of product. If a consumer is price sensitive, shrinkage works to decrease a company's consumer base, causing them to look elsewhere for similar goods.

Finally, shrinkage can increase company costs in other areas. Retailers, for example, have to invest heavily in security, whether that investment is in security guards, technology or other essentials. These costs work to further reduce profits, or to increase prices if the expenses are passed on to the consumer.

RELATED TERMS
  1. Average Inventory

    A calculation comparing the value or number of a particular good ...
  2. Days Sales Of Inventory - DSI

    A financial measure of a company's performance that gives investors ...
  3. Perpetual Inventory

    A method of accounting for inventory that records the sale or ...
  4. Ending Inventory

    The value of goods available for sale at the end of the accounting ...
  5. Average Age Of Inventory

    The average number of days it takes for a firm to sell to consumers ...
  6. Carrying Cost Of Inventory

    This is the cost a business incurs over a certain period of time, ...
Related Articles
  1. Investing

    How to Analyze a Company's Inventory

    Discover how to analyze a company's inventory by understanding different types of inventory and doing a quantitative and qualitative assessment of inventory.
  2. Investing

    Days Sales of Inventory

    Days Sales of Inventory, also called Days Inventory Outstanding, is a key financial measurement of a company's performance pertaining to inventory management. In simple terms, it tells how many ...
  3. Investing

    How to Calculate Average Inventory

    Average inventory is the median value of an inventory at a specific time period.
  4. Investing

    What is Involved in Inventory Management?

    Inventory management refers to the theories, functions and management skills involved in controlling an inventory.
  5. Investing

    Explaining Carrying Cost of Inventory

    The carrying cost of inventory is the cost a business pays for holding goods in stock.
  6. Investing

    Understanding Periodic Vs. Perpetual Inventory

    An overview of the two primary inventory accounting systems.
  7. Investing

    Inventory Valuation For Investors: FIFO And LIFO

    We go over these methods of calculating this component of the balance sheet, and how the choice affects the bottom line.
  8. Small Business

    How Does a Perpetual Inventory System Work?

    Perpetual inventory is a system that continually tracks inventory items for quantity and availability.
  9. Investing

    Reading The Inventory Turnover

    Inventory turnover is a ratio that shows how quickly a company uses up its supply of goods over a given time frame. Inventory turnover may be calculated as the market value of sales divided by ...
  10. Investing

    Measuring Company Efficiency

    Three useful indicators for measuring a retail company's efficiency are its inventory turnaround times, its receivables and its collection period.
RELATED FAQS
  1. Why should investors care about the Days Sales of Inventory (DSI)?

    Learn about days sales of inventory and what it measures; understand why an investor would want to know a company's days ... Read Answer >>
  2. How do you analyze inventory on the balance sheet?

    Learn how to analyze inventory using financial statements and footnotes by doing ratio analysis and performing qualitative ... Read Answer >>
  3. Why is it sometimes better to use an average inventory figure when calculating the ...

    For a couple of key reasons, average inventory can be a better and more accurate measure when calculating the inventory turnover ... Read Answer >>
  4. Does working capital include inventory?

    Learn about inventory that is part of current assets and working capital, which is the difference between current assets ... Read Answer >>
  5. What are the generally accepted accounting principles for inventory reserves?

    As with most matters related to generally accepted accounting principles (GAAP), accountants assigned with the task of applying ... Read Answer >>
  6. How do I calculate the inventory turnover ratio?

    The inventory turnover ratio is a key measure for evaluating how efficient management is at managing company inventory and ... Read Answer >>
Hot Definitions
  1. 403(b) Plan

    A retirement plan for certain employees of public schools, tax-exempt organizations and certain ministers. Generally, retirement ...
  2. Master Of Business Administration - MBA

    A graduate degree achieved at a university or college that provides theoretical and practical training to help graduates ...
  3. Liquidity Event

    An event that allows initial investors in a company to cash out some or all of their ownership shares and is considered an ...
  4. Job Market

    A market in which employers search for employees and employees search for jobs. The job market is not a physical place as ...
  5. Yuppie

    Yuppie is a slang term denoting the market segment of young urban professionals. A yuppie is often characterized by youth, ...
  6. SEC Form 13F

    A filing with the Securities and Exchange Commission (SEC), also known as the Information Required of Institutional Investment ...
Trading Center