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 key real problem for retailers, as it results in the loss of inventory, which ultimately means lost money. 

Understanding Shrinkage

Shrinkage is the difference between recorded inventory and actual inventory, but it's important to understand the difference between book inventory and physical inventory. When a retailer receives a product to sell, for example, it records 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 book inventory and the physical inventory in the store. The difference between these two inventory types is shrinkage. If, for example, the retailer loses $100,000 of inventory due to theft, the shrinkage itself would be $1 million in book inventory less the $900,000 in physical inventory, which equates to $100,000.

The Disadvantages 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 part of every retail company, and many businesses try to cover these potential losses by increasing the price of a product to account for 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.