What Is Inventory Shrinkage?
Inventory shrinkage is the difference between recorded and actual stock levels. It represents lost product and margin.
Key Takeaways
- Shrinkage = (recorded inventory minus physical inventory) divided by recorded inventory
- Causes: theft, damage, administrative error, and supplier shortfalls
- Industry average shrinkage is 1-2% of retail value — higher rates signal a problem
- Regular cycle counts catch shrinkage early before it compounds
What inventory shrinkage is
Inventory shrinkage is the unexplained difference between the quantity your records show and the quantity you actually have on hand. If your system says you have 500 units but a physical count finds 475, the 25-unit difference is shrinkage. Expressed as a percentage: 25 divided by 500 = 5% shrinkage rate — higher than typical benchmarks and a signal of a problem.
Causes of shrinkage
Shrinkage has four main causes: employee theft or internal fraud (historically the largest single cause in retail, accounting for 35-40% of shrinkage); external theft; administrative or process errors — miscounts, data entry mistakes, wrong products received; and supplier fraud or shortfalls — receiving fewer units than invoiced.
Measuring shrinkage
Shrinkage is measured during physical inventory counts or cycle counts — comparing physical reality to the system record. For high-value or high-velocity SKUs, cycle counts (counting a rotating subset regularly) catch discrepancies early. Track shrinkage by SKU, location, and time period to identify patterns — if it concentrates in one product line or warehouse area, that narrows the investigation.
Financial impact
Shrinkage is a direct hit to gross margin. Every unit that disappears without being sold is a cost you bore with zero associated revenue. A business with £2 million in cost of goods and 2% shrinkage loses £40,000 per year. At a 50% gross margin, that £40,000 requires £80,000 of additional sales to recover.
Reducing shrinkage
For administrative error: improve receiving procedures, invest in barcode scanning, and run regular system reconciliations. For theft: improve access controls, install CCTV in warehouse areas, conduct background checks on warehouse staff, and use cycle counts as a deterrent. For supplier shortfalls: switch from invoice-based to count-based receiving — count everything before accepting the delivery.