In 2020, more than 15 percent of U.S. retailers experienced inventory shrinkage — that is, loss of physical inventory — of 3 percent or more. According to the 2019 National Retail Security Survey, shrinkage cost the U.S. retail industry $50.6 billion that year.

A common cause of inventory shrinkage is larceny, defined as the taking of property without the use of force — indicating an inside job. One estimate from 2017 found that 33 percent of retail inventory shrinkage resulted from internal or employee theft.

Regardless of the cause, inventory shrinkage is problematic because lost inventory is corporate money gone down the drain: funds spent to acquire an asset, which then disappears so it can’t be sold.

Hence it’s vital to prevent (or at least reduce) inventory shrinkage. To do that, robust internal controls are critical.

The Impact of Inventory Shrinkage

Inventory shrinkage is a loss of inventory. It is the difference between the inventory recorded on a company’s balance sheet and the actual inventory stored and available for use.

Many factors can lead to such losses, including:

  • Vendor fraud or error;
  • Shoplifting or external theft;
  • Employee theft;
  • Administrative errors or improper documentation;
  • Damage.

Shrinkage cuts into profits. It is an especially serious risk in the retail industry and among small businesses that have to sell a large amount of products to make a profit.

To make up for physical inventory loss and the resulting decrease in profits, companies may need to increase the selling price of their products. That, however, can alienate customers and further exacerbate the harm to a company’s bottom line.

Shrinkage can also increase costs in other areas, such as investments in security technologies and personnel. These costs also hit the bottom line and may result in increased prices for customers.

Internal Controls for Inventory Shrinkage and Inventory Loss

Inventory shrinkage is unavoidable. The problem, however, can be lowered to an acceptable level where it doesn’t materially harm profits. For this, it’s crucial to identify absent or weak internal controls and implement robust internal controls to protect your business.

Segregate Duties

Segregation of duties means that different people are in charge of ordering, recording, reconciling, and safeguarding inventory. Dividing responsibilities in that way can minimize the chance of a particular employee stealing inventory stocks and covering up the theft.

Segregation of duties also assures that one employee’s actions are verified and approved by another. One employee may retrieve the stock for processing, while another counts the inventory and updates the records. It’s difficult for either one of them to steal inventory unless the two employees are scheming together.

Regular Inventory Counts

New inventory from a vendor must be immediately counted and reconciled with the packing list to confirm that there are no mismatches, clerical errors, or vendor fraud. If the amount is incorrect, the vendor must be notified immediately. It’s also essential to do a regular physical count of inventory levels to detect and address errors and fraudulent activities quickly.

Calculate and Compare Shrinkage Rates

In 2018, the median shrinkage rate in retail was 1 percent. Generally, an acceptable level of inventory shrinkage is less than 1 percent, but it depends on your industry. The rate itself can be calculated as follows:

Shrinkage Rate = (Recorded Inventory – Actual Inventory) / Recorded Inventory

Periodically calculating the shrinkage rate is an excellent way to monitor inventory and compare shrinkage rates throughout different periods. An unexpected increase in your shrinkage rate indicates that you need to investigate possible causes and take a look at your controls.

Rotate Duties and Job Assignments

Rotating job assignments is one way to prevent employees from engaging in long-term schemes to steal inventory. If one employee is stealing, the next employee assigned to their role may discover the theft and report it to the organization.

Mandatory vacations can also discourage theft because many dishonest schemes require the employee to attend to them daily. The scam may collapse or be detected if the employee is unable to execute it personally.

Implement Strong Security

Strong physical security measures can deter inventory shrinkage, particularly due to theft. For example, video cameras provide surveillance of inventory receiving areas and function as a visual recording system.

Other security measures to control inventory shrinkage include:

  • Restrict deliveries to loading docks;
  • Limit access to interior areas such as storage areas to authorized personnel only;
  • Segregate high-demand or expensive items in a separate storage area with more robust fencing, strong locks, and controlled access;
  • Establish a system to document and track any stock taken out of the storage area to another area.

Leverage Security Devices and Technologies

Item tracking devices, such as ink-blot tags and magnetic scanners, can deter and detect both internal and external theft. Barcode scanners make it difficult for internal users to steal inventory and alter company records to cover up the theft.

Digital information resources should also be secured with strong passwords or multi-factor authentication (MFA) to prevent theft and records alteration. Access should only be assigned to authorized personnel. Administrative or super-user access should be limited to assure only specific users can modify records for shipping, sales, purchasing, and inventory counts.

Set Up a Confidential Fraud Reporting Hotline

According to the 2018 Global Study on Occupational Fraud and Abuse by the Association of Certified Fraud Examiners (ACFE), more than 50 percent of corruption and fraud cases in organizations were detected by a tip.

Encouraging employees to participate in fraud detection and prevention can go a long way towards minimizing shrinkage. A confidential fraud reporting hotline allows employees safely to report any possible shrinkage events, such as theft, damage, clerical errors, or vendor fraud.

Make Shrinkage Prevention an Enterprise-Wide Initiative

Employee participation cannot happen without the support of the top leadership. The organization’s leaders, managers, and board of directors must demonstrate honesty, accountability, and ethical behavior from the top.

Leadership must demonstrate that good behavior (such as reporting larceny) will be rewarded; and undesirable behavior (such as participating in theft) will be punished. It’s also essential to set zero-tolerance company policies and adhere to them. Inconsistency will result in honest employees feeling demoralized, unappreciated, and potentially afraid of retaliation.

Set Par Levels and Reorder Points

Expired goods can result in inventory shrinkage too. To avoid shrinkage from expired goods, you must manage inventory turnover, rotate the stock, and prevent overstock.

A par level, or safety stock, is the amount of inventory that must be maintained between receiving shipments to meet customer demand. Setting the proper par levels can help the organization avoid stockout, overstock, and keep an eye on expiration dates.

Establish a Robust Documentation Process

It’s crucial that inventory is trackable and auditable. For this, timely, relevant, and up-to-date documentation is vital. All these documents must be part of the control environment to provide an audit trail and control inventory shrinkage:

  • Purchase requisition form. A written request from an employee to the purchasing department to purchase a particular item.
  • Purchase order. Sent by the purchasing department to a supplier requesting that the item be shipped.
  • Invoice. Sent by the supplier to the purchasing party requesting payment for items shipped
  • Receiving report. Prepared by the receiving department, specifying the quantities and descriptions of items received from a supplier.

Adjust Accounting Records

All inventory-related documents should be regularly checked against accounting department records to confirm that there are no discrepancies (deliberate or accidental) between the inventory recorded and the inventory actually available.

If there is shrinkage, inventory losses should be recorded by increasing the shrinkage expense account and decreasing the inventory account. Accurate inventory shrinkage journal entries in the accounting system can help pinpoint errors and identify the steps required to address them.

Automate Inventory Record Keeping

Automating inventory and reporting is the best way for business owners to prevent inaccurate inventory records, malicious dishonesty, and theft. For this, comprehensive inventory management systems are available.

Such software can track the progress of inventory stocks, from the time it is acquired to when it moves into finished goods inventory. The system provides real-time and complete updates on inventory status and possible red flags.

Protect Your Inventory Better with Support from ZenGRC

You may not be able to eliminate shrinkage completely, but you can minimize it and protect your bottom line. This starts with the safeguards we have discussed here, as well as greater visibility into your risk environment.

Explore ZenGRC from Reciprocity to get deeper, real-time insights into the risks affecting your inventory. Identify relevant risks across your business with the single, integrated experience offered by ZenGRC. See where risk is changing, stay ahead of evolving threats, and mitigate business exposure.

To see how ZenGRC can fit into your business, schedule a demo to get started.

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