What is Inventory Shrinkage?

Shrinkage appears when a physical count shows less inventory than the records say should be there. It is a cost of doing business that can quietly erode margins.

Causes

• Shoplifting and employee theft
• Damaged, expired or spoiled goods
• Receiving errors, such as paying for goods not delivered
• Recording errors in sales or returns
• Vendor fraud

Measuring it

Shrinkage = book inventory − physical inventory count

Expressed as a percentage of sales, it can be tracked over time and compared by location or product category.

Accounting treatment

After a count, adjust inventory down to the counted amount. The adjustment is typically recorded in cost of goods sold or a separate shrinkage expense account, so that inventory on the balance sheet reflects what is actually there. The IRS explains inventory rules in Publication 538, and Publication 334 discusses COGS for small businesses.

Count regularly

Many tax and accounting methods rely on physical counts. A year-end count is a minimum; cycle counts of high-value or high-theft items throughout the year catch problems sooner.

Reducing shrinkage

1. Match receiving reports to purchase orders and invoices
2. Separate duties: the person receiving goods should not approve payment
3. Track discards and damaged goods in the system
4. Investigate unusual adjustments by location or employee

See inventory accounting basics, FIFO and LIFO and our retail bookkeeping page.

Related terms

• Cost of Goods Sold: Cost of goods sold is the direct cost of the products a business sold during a period.
• FIFO and LIFO: FIFO and LIFO are inventory costing methods that decide which purchase costs are assigned to the goods you sold.
• Balance Sheet: A balance sheet shows what a business owns, what it owes and the owners' equity at a specific date.

Browse more definitions in the small business glossary.