Normal vs abnormal shrinkage: accounting treatment under IAS 2

Normal vs abnormal shrinkage: accounting treatment under IAS 2

Every facility that transforms raw materials loses some of them along the way: a bit of flour sticks to the walls of the mixer, broth evaporates, sheet metal leaves offcuts, a few bottles break while being moved. This loss is so common that almost nobody records it, and that is where the trouble starts. The accounting standard that governs inventories, IAS 2, makes a distinction that sounds simple but changes the numbers of your business: it separates normal shrinkage from abnormal shrinkage. The first becomes part of the cost of your product. The second cannot be capitalized: it goes straight to expense in the period. Understanding where that line sits, and knowing which of your losses falls on each side, is one of the most profitable decisions an owner of an SME in food, beverages, chemicals, pharmacy or manufacturing can make.

Why this distinction matters

If you put every loss into inventory cost without asking where it came from, two distortions follow. First, inventory becomes overstated: the balance sheet shows an asset that will never turn into cash, because those units no longer exist or cannot be sold. Second, the period's profit looks inflated, because the loss is deferred and only shows up on the day the shortage is discovered or the damaged goods are sold. Taxes are paid and profits are distributed on top of that inflated result, and pricing decisions are made with a cost that hides waste. IAS 2, understood at a conceptual level, points the other way: only what is necessary and reasonable to get the product ready for sale belongs in the cost of inventory. What is excessive, avoidable or disproportionate is recognized as an expense of the period in which it occurs. That way the balance sheet shows inventory that can genuinely be sold, and the income statement shows the loss when it happened, not when someone finally admitted it.

What normal shrinkage is

Normal shrinkage is the loss of material that is inherent to the production process and unavoidable when the operation is run efficiently and under control. It is not anyone's fault in particular: it is the physical price of transformation. It is expected, repetitive and, above all, measurable: with your own history you can forecast next month's loss with good accuracy. Typical examples:

• Evaporation, splashing and settling of liquids in tanks and filling lines.
• Loss of weight from cooking, baking, frying or drying.
• Flour or powders that stick to equipment, hoppers and conveyor belts, or that are lost when the line starts up.
• Expected trimmings and offcuts when cutting sheet metal, fabric, cardboard or plastic.
• Minimum breakage of containers during internal handling and plant transport.
• Stems, roots and peels removed when cleaning vegetables or fruit in industrial kitchens.

Because it is unavoidable and expected, normal shrinkage is treated as part of the cost of production. In practice this means one very concrete thing: the total cost of the period is spread over the good units that actually came out of the process, not over the units that were started. If you began the month with one thousand units of material and fifty were lost in a normal way, the nine hundred and fifty good units absorb the full cost. The unit cost rises slightly, and that is correct: it reflects that producing one saleable unit requires more raw material than the theoretical recipe says. This shrinkage does not hit the month's profit directly; it travels inside inventory and is recovered through price when the product is sold.

What abnormal shrinkage is

Abnormal shrinkage is the opposite: it exceeds what is reasonable or could have been avoided. It happens because of errors, carelessness, preventable failures or poor decisions, and it is not part of the cost of producing well. Examples every owner recognizes:

• A whole batch burned or contaminated by a mistake in temperature or dosing.
• Raw material or finished goods spilled through carelessness or bad handling.
• Theft, internal pilferage or shortages with no technical explanation.
• Damage from poor storage: moisture, wrong temperature, crushed boxes.
• Expiry of products because of poor rotation or excessive purchases.
• Customer returns for defects that should have been caught in the plant.

The accounting treatment of abnormal shrinkage is the opposite of the normal one: it is not capitalized. It is charged to expense in the period in which it is detected. The logic is simple and consistent with IAS 2: the cost of inventory only includes what is necessary to get the product ready for sale; abnormal amounts of wasted materials, labor and other costs are not part of that cost. If you hid them inside inventory, you would be saying that those damaged units are still worth money and that future customers will pay for the loss. They will not: the money is already spent and will generate no benefit. The period's profit must feel that blow now, and inventory must stay clean, holding only the good units.

Reference percentages: every process has its own

There is no universal table of normal shrinkage, and be wary of anyone who tries to sell you one. Every process, piece of equipment, climate and raw material has its own. What does help is reference bands to start the conversation with your team and to sanity-check your own numbers, always measured against the material that enters the relevant stage:

• Bakery and pastry: between 3 and 5 percent of flour between weighing, mixing and baking when processes are standardized.
• Restaurants and prepared food: cleaning and trimming vegetables can leave between 10 and 20 percent of purchased weight, depending on the product and the quality of the raw material received.
• Pharmacy and laboratories: with FEFO rotation, first expired, first out, expiries usually stay below 1 percent; without that discipline they climb quickly.
• Sheet metal, plastic and packaging manufacturing: trimmings, start-up scrap and line trials usually run between 2 and 4 percent of the material.
• Beverages and liquids: evaporation, splashing and settling can sit below 2 percent in well-maintained tanks and rise in warm climates or with older equipment.

Say it again: these are starting points for discussion, not rules. Your company's normal percentage is the one your own production history demonstrates as achievable under control. That is why the first step is always to measure, and the second is to measure with a cause attached.

Numerical example: unit cost versus period expense

Let us put numbers on the table. In the month, one thousand units of production are started with a total cost of five million, including raw materials, labor and overhead. If nothing were lost, each unit would cost five thousand. We compare two scenarios: in scenario A, fifty units are lost to expected evaporation and trimmings, normal shrinkage; in scenario B, two hundred units are ruined by an operating error, abnormal shrinkage.

Read the table slowly, because the whole doctrine is in it. In scenario A, inventory keeps the full five million, but over fewer units: unit cost rises from five thousand to five thousand two hundred and sixty-three, and the margin is calculated on that real cost. In scenario B, charging the disaster to the eight hundred good units would be a mistake: the two hundred ruined units are removed from inventory and their cost, one million, is recognized as an expense of the period. The month's profit drops by that million, and it hurts, but it hurts in the right month. The comparison also shows something else important: abnormal shrinkage must not be disguised as a higher unit cost, because then the price would rise to pay for an error that will not repeat if you fix it.

How shrinkage shows up: physical count versus the stock ledger

On paper everything balances; in the warehouse, it does not. Shrinkage becomes evident when you compare two realities: what the records say and what physically exists. The stock ledger records the theoretical ins and outs of each product, and the periodic physical count reveals the shortage. That difference between theoretical stock and counted stock is the shrinkage, and it is the reason why the kardex ledger and actual consumption records are the foundation of the whole system: without a reliable record of what came in, what production consumed and what was dispatched, no difference can be explained or classified.

When a difference appears, the work does not end with adjusting the balance: it must be classified. If the difference matches the volume produced in the period and sits inside the process's historical percentage, it is normal shrinkage and stays capitalized within the cost of the good units. If the difference has an avoidable cause, an owner, an identified batch or a one-off event, it is abnormal shrinkage and is written off with an entry of this kind: debit to period expenses and credit to inventory or to work in process. A stock system that tracks batches, consumption and adjustments, as Kardex Tauro does, turns this exercise into information: by comparing theoretical against counted stock per product and per period, you quantify your real shrinkage percentage and stop arguing opinions to argue data.

Steps to estimate your normal percentage

Estimating normal shrinkage does not require an engineering study; it requires the discipline to record. A practical sequence:

1. Define the unit of measure and the stage: flour in the bakery, vegetable weight at the kitchen door, liters in the mixing tank.
2. Record actual consumption and finished production per batch or per period in the ledger, in the same units.
3. Log incidents separately, with their cause: spill, equipment, storage, theft, expiry.
4. After six to twelve batches or months, calculate the percentage of each type of loss over the material that entered the stage.
5. Use that figure to set a normal operating range and an alert threshold: below the range, suspect that not everything is being recorded; above it, investigate the cause before it becomes a habit.

Review that percentage whenever conditions change: new raw material, different equipment, a seasonal climate, a new supplier. What was normal yesterday may not be normal today.

Costly mistakes to avoid

• Capitalizing all shrinkage into inventory to make profit look better: the adjustment arrives anyway, but later, after taxes have already been paid on fictitious profit.
• Treating theft or expiry as normal shrinkage: hiding an avoidable cause inside cost makes it invisible and permanent.
• Skipping periodic physical counts: shrinkage accumulates, and when it finally shows up it is one large hit in a single month.
• Arguing about who is to blame instead of measuring causes: when the records show the loss always happens at the same stage, the problem is the process, not the people, and that is fixed with standards.

In summary

When any shortage appears, ask yourself two questions. Was it unavoidable in a well-run process? Then it is normal shrinkage: it stays inside the unit cost of the good units and is recovered through price. Could it have been avoided with better control, maintenance, rotation or supervision? Then it is abnormal shrinkage: it leaves inventory and is recognized as an expense of the period in which it occurred. That discipline protects two valuable things: an inventory that tells the truth and a profit that does not deflate later. Keeping the ledger up to date, with actual consumption and periodic counts as Kardex Tauro makes easy, is what turns shrinkage from a monthly headache into a number you control.

This article is for educational purposes only and does not constitute accounting, tax or financial advice. The standards are explained at a conceptual level and may vary by country, tax regime and each company's accounting policies. Consult your accountant or trusted advisor before applying these criteria to your specific case.