What is shrinkage?

In any business that handles physical products, stock changes for many reasons that are not always visible at first glance: a piece of fruit ripens and goes bad, a package breaks during transport, a liquid evaporates, a product expires on the shelf or a box ends up stored in the wrong place. When it is time to do the physical count of the warehouse, a difference almost always appears between what the records say and what is actually there. That difference has a name: shrinkage. Shrinkage is a topic that many companies prefer to ignore until it becomes a serious problem, but ignoring it has a direct cost. Every lost unit was already paid for to the supplier, took up space and was often bought expecting to be sold at a profit, so the loss is doubled: the merchandise is gone and so is the expected profit. This article explains what shrinkage is in inventory, what types exist, how to calculate its percentage, how it should be recorded, how it can be reduced and how it differs from related concepts such as waste, returns or theft.

What is shrinkage in inventory?

In inventory terms, shrinkage is the loss or decrease of stock that a business suffers during its operations. Technically, it is the difference between theoretical stock —the units that according to the records should be in the warehouse— and actual stock, that is, what is found when a physical count is done. If the records say there are 500 units of a product and the count finds 486, there are 14 units of shrinkage that need to be explained. It is important to understand that shrinkage does not always mean theft. The loss can come from the natural deterioration of food, from the expiration of products with a shelf life, from breakage of fragile packaging, from the evaporation of liquids, from errors when recording inflows and outflows, or from losses inherent to the production process, such as wasted raw material. All of these situations reduce the amount of product available for sale or use, which is why they are considered shrinkage. Shrinkage has two effects on a business. The first is quantitative: there are fewer units to sell, which can lead to stockouts in front of customers. The second is economic: every lost unit represents money already invested that will not be recovered, and if shrinkage is not recorded, costs end up miscalculated and prices may not be covering the real losses. That is why, even though shrinkage never disappears completely, it can be measured, controlled and reduced. A simple example makes this clearer. A grocery store receives 100 packages of cookies. At the end of the month, the count finds 96: two packages were expired, one arrived damaged and another was not recorded in the sale because of a cashier error. Those four packages are shrinkage. The store sold less than it could have sold and, on top of that, its inventory information remained distorted until the adjustment was made.

Types of shrinkage: normal and abnormal

To manage shrinkage properly, it is worth classifying it, because not all losses should be treated the same way. The most common classification distinguishes between normal or natural shrinkage and abnormal shrinkage. Normal shrinkage, also called natural or operational shrinkage, is the expected and unavoidable loss that occurs because of the characteristics of the product or the process itself. The evaporation of a stored liquid, the weight loss of some fresh products due to dehydration, a small percentage of breakage during transport or the minimum waste of raw material in a production process are examples of normal shrinkage. This type of shrinkage is known in advance, estimated ahead of time and accepted as a cost of doing business: in fact, many companies include it in their cost margins. Abnormal shrinkage, on the other hand, is the avoidable loss that appears because of control failures or specific events: internal or external theft, damage caused by poor handling or storage, mass expiration due to overbuying or poor rotation, recording errors or misplaced merchandise. Abnormal shrinkage should not exist, and when it shows up in large amounts it is a warning sign: it indicates that something is failing in the business purchasing, storage, dispatch or security processes. The following table summarizes the most common types of shrinkage, with a description and some examples:

Type of shrinkage	What it is	Examples
Expiration or expiry	Products that pass their use-by or best-before date	Food, medicines, cosmetics, cleaning supplies
Natural deterioration	Loss of quality or weight over time and due to environmental conditions	Ripe fruits and vegetables, grains losing moisture, flowers
Breakage or physical damage	Merchandise damaged by bumps, falls or poor storage	Glass containers, bottles, fragile items, electronic devices
Evaporation or volume loss	Natural loss of liquid or weight from a product	Alcohol, fuels, perfumes, liquids stored in bulk
Process loss	Unavoidable loss of raw material during a transformation	Fabric or paper trimmings, weight loss when cooking food
Theft or pilferage	Merchandise taken by outsiders or by people inside the business	Items hidden by customers, employee shortages, warehouse theft
Recording errors	Differences between actual and recorded stock caused by human mistakes	Wrongly keyed sales, miscounted units, unrecorded shipments

Frequent causes of shrinkage in a business

The causes of shrinkage can be grouped into a few categories that are worth knowing so you can tell where to look first:

Purchasing and receiving: receiving merchandise that is expired, damaged or in different quantities than invoiced creates shrinkage before the product even enters the warehouse.
Inadequate storage: incorrect temperatures, humidity, defective stacking or lack of order accelerate deterioration and cause physical damage.
Poor product rotation: selling what arrived last first makes older products expire on the shelf.
Handling and dispatch: bumps during transport, poor packaging and rough treatment of merchandise cause avoidable breakage.
Weak administrative processes: incomplete records, infrequent counts and a lack of clear responsibilities let errors and shortages go unnoticed.
Security failures: the absence of access controls, cameras or inventory procedures makes internal and external theft easier.

How to calculate the shrinkage percentage

To know whether a business shrinkage is normal or out of control, knowing the value lost is not enough: it must be compared with the total stock handled during the period. The formula is simple: Shrinkage percentage = (value of shrinkage ÷ total value of stock handled) × 100 The total value of stock handled is calculated by adding the opening inventory of the period plus all purchases made during that same period. Let us look at a step-by-step example. A distributor starts the month with inventory valued at 18,000,000 and buys merchandise worth 7,000,000 during the month. The total value of stock handled is 25,000,000. When doing the closing count, it detects shrinkage valued at 750,000: 300,000 in expired products, 250,000 in damaged merchandise and 200,000 in unexplained shortages. The shrinkage percentage is calculated like this: (750,000 ÷ 25,000,000) × 100 = 3% That 3% means that, for every 100 monetary units of stock handled, the business lost 3. There is no single percentage that is valid for every business: it depends on the type of product and the activity. However, as a general reference, many food businesses consider a level close to 1% or 2% acceptable, while higher levels usually indicate control problems worth investigating. What matters is to always measure with the same method so that one period can be compared with another. To calculate the shrinkage percentage of your business, you can follow these steps:

Define the period to analyze: a month, a quarter or a year.
Calculate the total value of stock handled: opening inventory plus purchases for the period.
Value the shrinkage found in the physical count, separating it by cause when possible.
Apply the formula: divide the value of shrinkage by the total value of stock handled and multiply by 100.
Compare the result with previous periods and with the levels expected for your type of business.

How to record shrinkage in inventory

When the count reveals shrinkage, the most common mistake is leaving it written on a piece of paper or simply ignoring it. For the business information to be reliable, shrinkage must be formally recorded in the inventory system as an inventory write-off: an outflow of merchandise that is not a sale or internal consumption, but a loss. The shrinkage record should always include the cause of the loss, because writing off one hundred units is useless if you do not know later whether they expired, were damaged or were lost. Knowing the cause makes it possible to attack the origin of the problem and not just its effect. The basic procedure is as follows: first, identify and separate the affected merchandise; second, determine the cause of the loss and value the merchandise at its cost; third, record the write-off in the product stock record with its reason and date; and finally, review the information periodically to detect patterns. Recording shrinkage also has accounting benefits. When the loss is documented, business costs reflect reality and it becomes possible to decide with better information whether to adjust prices, change suppliers, improve storage or strengthen security. Shrinkage that is not recorded stays hidden inside general costs and distorts the real profitability of the business.

Shrinkage, waste, returns and theft: what is the difference?

Shrinkage is often confused with other terms that are related but not identical. These are the main differences:

Shrinkage and waste: waste is the portion of a product that is discarded because it is no longer useful or because it is left over after a process, such as fruit peels or food that is not sold and is thrown away. Waste can be seen as one of the ways in which shrinkage shows up, but shrinkage is a broader concept that also includes loss of value without physical discarding, such as evaporation.
Shrinkage and returns: a return is merchandise that comes back to the business because a customer rejected it or changed their mind. A return is not a loss in itself, although it can end up as shrinkage if the returned product cannot be sold again because it is damaged or expired. A well-managed return can go back into inventory; shrinkage, on the other hand, always involves a permanent loss.
Shrinkage and theft: theft is a cause of shrinkage, not an opposite concept. When talking about abnormal shrinkage, pilferage is one of its main sources, along with damage and errors. The practical difference lies in the treatment: theft calls for security measures, while other causes of shrinkage call for process improvements.
Shrinkage and accounting shortages: a shortage is the difference that shows up in the count, but it may be due to a recording error rather than a real loss. That is why, before writing off shrinkage, it is worth checking whether the difference corresponds to a sale or a movement that was never recorded.

How to reduce shrinkage in your business

Reducing shrinkage does not require expensive technology: it requires order, discipline and consistency in a few basic habits. These are the most effective measures:

Control expiration dates: check products when you receive them and organize the warehouse so that items closest to expiring stay at the front and are shipped first.
Apply FIFO rotation: the first-in, first-out rule guarantees that the oldest products are sold before they expire or deteriorate.
Handle and store correctly: respect the temperature, humidity and stacking conditions that each product requires, and train staff to handle merchandise carefully.
Run cycle counts: instead of waiting for the annual inventory, count groups of products every week or month to detect differences early.
Strengthen security: control access to the warehouse, assign a person responsible for each zone and review receiving and dispatch procedures to make internal theft harder.
Record every movement: an entry or outflow that is not recorded becomes a shortage sooner or later. Keeping records up to date is the foundation of all control.
Analyze shrinkage reports: periodically review which products and which causes concentrate the losses, and tackle the ones that represent the most money first.

Conclusion

Shrinkage is an unavoidable part of any business that handles physical products: there will always be a minimum percentage of loss from evaporation, deterioration or handling. The difference between a healthy business and one with problems is not whether it has shrinkage, but whether it knows how much it has, why it happens and what it is doing to control it. Normal shrinkage is budgeted and accepted; abnormal shrinkage is investigated and eliminated. The starting point is always the same: measure and record. If every shrinkage write-off is documented with its cause and value, the business gains valuable information to buy better, store better and sell better. To keep that control in an organized way, an inventory system such as Kardex Tauro lets you record merchandise write-offs stating the reason for each outflow, so that business losses always remain visible and backed by a historical report.

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#shrinkage #losses #inventory