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, and cashier error. Shrinkage is the difference between recorded inventory on a company's balance sheet and its actual inventory. This concept is a key problem for retailers, as it results in the loss of inventory, which ultimately means loss of profits. 

Key Takeaways

  • Shrinkage describes the loss of inventory due to circumstances such as shoplifting, vendor fraud, employee theft, and administrative error.
  • The difference between the recorded inventory and the actual inventory is measured by shrinkage.
  • Shrinkage results in a loss of profits due to inventory bought but not able to be sold.

Understanding Shrinkage

Shrinkage is the difference between the recorded (book) inventory and the actual (physical) inventory. Book inventory uses the dollar value to track the exact amount of inventory that should be on hand for a retailer. When a retailer receives a product to sell, it records the dollar value of the inventory on its balance sheet as a current asset. For example, if a 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.

However, inventory is often lost due to any number of reasons, causing a discrepancy between the book inventory and the physical inventory. The difference between these two inventory types is shrinkage. In the example above, the book inventory is $1 million, but if the retailer checks the physical inventory and realizes it is $900,000, then a certain part of the inventory is lost and the shrinkage is $100,000.

The Impact 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 cannot recoup the cost of the inventory itself as there is no inventory to sell nor inventory to return, which trickles down to decrease the bottom line.

Shrinkage is a part of every retail company's reality, and some businesses try to cover the potential decrease in profits by increasing the price of available products to account for the losses in inventory. These increased 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.

In addition, shrinkage can increase a company's costs in other areas. For example, retailers would have to invest heavily in additional security, whether that investment is in security guards, technology, or other essentials, to prevent shrinkage that was caused by theft. These costs work to further reduce profits, or to increase prices if the expenses are to be passed on to the customer.