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Inventory Shrinkage and How You Can Stop It

Posted by inFlow InventoryLast Updated December 20th, 2022
— 7 minutes reading

Inventory loss (also known as inventory shrinkage or shrink) is a big problem for any business that carries physical goods. Without controls and monitors in place there is no way to trace the root causes that created the shrinkage in your business. It is estimated that companies lose 6% of their total annual revenue due to employee fraud and abuse. To help with this problem, we will look at techniques to combat inventory shrink. We’ll also take a look at the internal and external forces that may be perpetuating the losses.

What is Inventory Shrinkage?

Inventory shrink is a loss of goods either due to theft, damages/spoilage or administrative errors on items moving from a manufacturing site to an end customer.

The shrinkage can be referred to as a hit to the margin or loss in profit.

How do we Record Inventory Shrink?

Somewhere between your last cycle count to the current recording period, your business may have experienced some inventory losses. In other words, the physical inventory you have on hand today is less than what was recorded on your books. To account for this loss of inventory via the perpetual accounting method, you would: increase the cost of goods sold and decrease the inventory by the difference for the recording period.

Your balance sheet would show a credit to the inventory line item for the value that was lost. Showing that you have incurred higher expenses (cost of goods) and a lower gross profit will lower your taxable income. However, you might choose to record your shrinkage separately instead of including it into your costs of good sold. If so, you would need to file a claim with the Internal Revenue Service (IRS) using Form 4684 if you are located in the United States.

What Causes Inventory Shrinkage?

Inventory shrinkage is inevitable. However, the rate can be controlled through proper inventory management best practices. Shrink can occur due to fraudulent behavior, such as:

  • Employee theft and fake sales
  • Retail theft i.e., petty theft, shoplifting, breaking and entering and fake coupons

However, shrink isn’t always attributed to a hurtful scam. It can also be caused by having poorly defined operational procedures and standards which leads to higher administrative errors. This has a trickle down effect to the rest of the business including the warehouse and financial operations.

What Can Be Done To Prevent Employee Theft?

You can manage your inventory shrink by implementing internal controls first. This starts right from the hiring process. Conduct a thorough background and reference check on your candidates. Once a new hire has been on-boarded, educate them on your policies and your stance on employee theft.

Here are some prevention steps to combat internal causes:

  • Surveillance – install cameras throughout your facility
  • Reduce Temptation – store valuable items in secure areas that require higher authorization levels for access
  • Monitor Trash Removal Process – use clear garbage bags so items can’t be masked
  • Separation of Duties – don’t have the same person processing the receipts be responsible for recording them as well
  • Education – show your employees how shrink affects them directly, i.e, limited pay increases, minimal opportunities for job promotions and risk to the company’s financial stability which can lead to lay offs
  • Anonymous Reporting – provide an easy way for employees to report an issue via a web portal and phone hotline
  • Audits – conduct spot inventory audits to catch infiltrators off guard

Fake Sales

Any discount over a certain threshold should require an additional layer of authorization. If a fake sale was to take place, the transaction would be flagged. For instance, a customer buys an item for $1000. During the check out process the cashier fakes a 20% discount; however, the consumer is unaware of this and pays the full rate. The cashier would pocket the $200; or the original transaction goes through as usual,  but later, the transaction gets voided and re-keyed in at $800. Regardless how it is done, the company takes a hit.

Photo of a US dollar bill (credit to neonbrand from Unsplash)

To avoid fake sale scams, set discount thresholds to a lower amount. This way if a higher discount was being attempted the transaction would be prevented. Plus, it doesn’t hurt to review all your sales transactions regularly. If a scam was being pulled, the anomalies would show up in the data.

Returned Goods

This scam consists of one person working inside for the company and with an external accomplice. The external person would return an item to the store. With the help of their cashier friend, he/she would refund the item at a higher price than what was initially paid.

Original receipts should be scanned during a return procedure. If a receipt isn’t available because the item was purchased as a “gift”, then implement a restocking policy. Items being returned without a receipt automatically incur a 20% restocking fee. Have this posted at the cash register and this might help deter fictitious returns.

Purchasing Fraud

Requisition schemes can take on many forms from skimming excess inventory off the top to paying fictitious vendor bills. Here are some examples:

  • A manager inflates the demand with the plan to steal the surplus inventory
  • Phantom vendor accounts set up by an internal Purchasing employee – then pays fraudulent bills even though items were never shipped
  • Phantom customer accounts – places a sales order and has the items shipped to a fake address where payment can never be recuperated and the bill ends up sitting with collections
  • Vendor kickback scheme where the buying company overpays for goods and the vendor pays a percentage to the inside perpetrator for keeping the scam alive

Photo of forms, glasses, and laptop (credit to rawpixel from Unsplash)

To mitigate the severity of purchasing fraud, perform periodic audits on your operational procedures. Make sure that there aren’t any hidden relationships between your staff and the vendors you are buying from. Keep a close eye on your dead accounts, too. If a business hasn’t done an order with you in the past year, then do a proper follow up. Verify that the order is legitimate.

Shipping Fraud

Since there is a ton of activity at a warehouse receiving area, scams can be easily missed.  Always validate all your shipping slips and shipments that claim to be spoiled or damaged. For spoiled goods, always have them inspected before they get disposed. Another scheme consists of marking a shipment as “short” even though the right amount of stock was delivered. Have all your inspections performed by someone outside of receiving and keep a paper trail of the inspection reports.

What Can Be Done to Prevent Retail Theft?

Use security cameras and mirrors throughout the retail space. This way suspicious behavior can be spotted more easily. However, petty theft isn’t the only way a retailer can get scammed.

Photo of a security camera (credit to Bernard Hermant from Unsplash)

Bad Promotion Codes and Fake Coupons

Online discount sites have increased the amount of fake manufacturer coupons circulating on the net. Bad coupons and promotion codes affects the margin of retailers. If a manufacturer decides to audit the store and determines the coupons invalid or that the discounts were issued to the wrong items, then the reimbursement can be revoked.

To avoid this problem, stay up to date with coupon scams. Also keep a watch for large quantities of coupons being redeemed or a larger than average shopping cart value. These are indicators that something fishy might be going on.

What Can Be Done to Prevent Administration Errors?

Automating and managing your inventory through a software solution will help eliminate administration errors. First, it will provide a standardized and repeatable process to track your entire inventory and its movement accurately. So pulling a fraudulent scheme will be pretty tough to do.  Second, it makes doing inventory adjustments easier in a software that solely focuses on managing inventory versus in an accounting system.

Solutions like inFlow Inventory will provide you with a complete view into your inventory processes. Plus, you’ll also get an audit trail of all your transactions so you can catch abnormal behaviors and monitor inventory shrinkage better. For example, you can create unlimited user accounts and know who processed which transactions and when.

Take control of your inventory by trying inFlow today!

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