What is inventory shrinkage?

Inventory shrinkage is a huge issue for many businesses. It can cost companies a lot of money in terms of lost product, damaged goods, and increased labor costs. Worst of all, many businesses don’t even know they have an inventory shrinkage issue as they don’t have the internal processes to be able to identify stock loss.

In this blog post, we will discuss ways that you can firstly identify, then reduce your inventory shrinkage and thus improve your inventory management and manufacturing processes.

What is inventory shrinkage?

Inventory shrinkage (otherwise known as “wastage”) can be defined as raw materials that have been removed from your inventory, and have not been used in the production of any of your finished pieces.

There can be many reasons why the material has been removed from your inventory, with each cause requiring a slightly different approach to analyse and improve on. It’s worthwhile to be aware of how much material shrinkage you currently have so you can address the causes where possible and ensure that you are factoring it into your costs of production.

Why is it important to track and analyze your inventory shrinkage?

There are a few key reasons why it’s important to track and analyze your inventory shrinkage:

To identify areas of waste in your manufacturing process

By understanding where and why your raw materials are being removed from your inventory, you can make changes to your process to reduce or eliminate the waste. This can save you money in the long run by reducing the amount of raw materials you need to purchase.

To understand the impact on your bottom line

Inventory shrinkage can have a significant impact on your business’s bottom line. By tracking and analyzing your inventory shrinkage, you can get a better understanding of how much it is costing you and make changes accordingly.

To improve your forecasting

If you know how much inventory shrinkage you typically experience, you can account for it in your forecasting. This will help you avoid overstocking (which can tie up capital and lead to storage costs) or understocking (which can lead to lost sales).

What are some ways to prevent inventory shrinkage?

There are a few key ways that you can reduce inventory shrinkage:

Track your inventory

By tracking your actual inventory on a regular basis, you can catch issues early and prevent them from becoming bigger problems. This can be done manually or through the use of technology, such as barcoding and RFID tagging.

Reduce waste

One of the main causes of inventory shrinkage is waste. By reducing waste in your manufacturing process, you can reduce the amount of raw materials that are removed from your inventory.

Improve security measures

Another common cause of inventory shrinkage is theft. By improving security measures, such as CCTV and access control, you can deter thieves and protect your actual inventory.

Types of inventory shrinkage

There are four main types of inventory shrinkage:

Theft: This is the most common type of inventory shrinkage, and can be caused by employees or outside criminals.

Waste: Waste can occur during the manufacturing process, or when raw materials are damaged or expire before they can be used.

Loss: Loss can occur due to factors such as natural disasters, fires, or accidents.

Administrative error: This type of shrinkage can occur when there are errors in your inventory records. For example, if you miscount the number of products in your inventory, this will lead to inventory shrinkage.

How to calculate inventory shrinkage

There are a few different ways to calculate inventory shrinkage. The most common method is to use the “retail inventory method.” This method estimates shrinkage by comparing the value of your ending inventory to your sales and cost of goods sold (COGS).

To calculate inventory shrinkage using the retail inventory method, you will need to know the following:

Your ending inventory value

This is the value of your inventory at the end of the period you are measuring. This is confirmed via a physical inventory count, usually performed at the end of the financial year.

Your sales

This is the total value of your sales during the period you are measuring.

Your COGS

This is the total cost of the goods sold during the period you are measuring.

Once you have this information, you can calculate your inventory shrinkage using the following formula:

Inventory Shrinkage = (Ending Inventory Value - Sales - COGS) / Sales

For example, let’s say that your ending inventory value is $100,000, your sales are $200,000, and your COGS is $150,000. Using the formula above, we can calculate that your inventory shrinkage percentage is 25%.

How to handle inventory wastage in your bookkeeping process

If you want to avoid overstocking, it’s important to track and manage inventory wastage. Wastage can occur for a number of reasons, such as damage, expiration, or spoilage. When it comes to bookkeeping, there are a few different ways to handle inventory wastage:

Materials removed from inventory that have been damaged

This usually occurs when the material has been somehow damaged whilst stored.

This is normally accounted for via a simple stock “write down” adjustment to your inventory stock on hand. However, if the material has been damaged in the direct production process, it may be better to include this cost into the manufacture materials cost where it will be accounted for as material usage.

Miscounts of materials from prior stocktakes

This can happen when in a previous inventory stocktake the number in available stock was incorrectly recorded, so you now have less of a material than your records currently indicate.

Ideally, the way to rectify this is to review your material purchase records to try and reconcile the difference, then adjust your expense history to ensure the tally is now correct. If you cannot locate the source of the discrepancy, then you should make a stock level adjustment in your inventory bookkeeping program to get your records back in sync with your physical stock.

Underestimating your previous material usage

If you use an inventory materials tracking system and you have under-estimated of the amount of materials required to create your piece, this will result in an inventory deficit when you next do a stocktake. This commonly occurs when the true amount of “scrap” produced is not adequately accounted for: as most scrap cannot be returned to your materials inventory and needs to be discarded, this can lead to a shortfall in your inventory.

In this case, it is better to include a more accurate measurement of the average percentage of “Scrap” that is normally created in the production of your product in your Bill of Materials, than to periodically mark it down via a stock shrinkage adjustment.

Spoilage of materials

Some of your materials may have a shelf life whereby if they haven’t been used by this time then the material is said to be spoiled and can no longer be used. Your inventory amounts, therefore, need periodic adjustment to ensure that only the usable materials are counted in your stock on hand. It is a good idea to create inventory adjustments rather than reduce the quantity on hand number so you can track the percentage of overall wastage from spoilage: if this percentage is quite high, it could indicate that you need to ensure you only keep a minimum of spoilable materials on hand at any one time.

It is often a good idea to invest in an inventory management program to help track your materials.

Craftybase - your solution to managing inventory shrinkage

Craftybase is the perfect solution for managing your inventory and avoiding shrinkage. With our powerful software, you can track your materials, estimate Scrap percentage, and set reorder points to avoid running out of stock. We make it easy to keep your books in order and improve your manufacturing process. Try Craftybase today!