What is the Shrinkage Formula?

The shrinkage comes into play when there is a substantial difference in the number of items mentioned in the book of accounts than as present physical. Considering the case of inventory valuationInventory Valuation Inventory Valuation Methods refers to the methodology (LIFO, FIFO, or a weighted average) used to value the company’s inventories, which has an impact on the cost of goods sold as well as ending inventory, and thus has a financial impact on the company’s bottom-line numbers and cash flow situation.read more, shrinkage is defined as the difference between the value of inventory mentioned in the book of accounts and the value of inventory that exists physically.

  • If there is a discrepancy or shrinkage of any item in the book of accounts, it is usually considered an act of fraud, theft, or an accounting error.Inventory shrinkage is very common in retail and manufacturing businesses. Inventory shrinkage can result in business or inventory value loss. The business should be very critical in monitoring how the inventory is managed daily.The inventory shrinkageInventory ShrinkageInventory Shrinkage refers to the excess stock of goods shown in the accounts’ books, although actual inventory is short of it. The reason behind this difference in real and recorded stock can be damage, theft, counting error, etc.read more formula is represented as below:

  • The inventory in the book of accounts formula is represented as follows:

  • Similarly, from the above relationship, it is easy to derive the shrinkage rates observed in the inventory levels. The shrinkage rate formula is represented as below:

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Explanation of Shrinkage Formula

Examples of Shrinkage Formula (with Excel Template)

Let’s see some simple to advanced examples of shrinkage formula to understand it better.

  • Firstly, Determine the value of beginning levels of the inventory. Next, determine the costs of adjustments, if any, on the inventory levels. Next, Determine the purchases made by the business for the financial year. Next, Record the sales made by the business for the financial year. Next, Add the beginning value of inventory and the purchases as recorded by the business. Next, deduct the resulting value in step 5 from the sales achieved by the business and corresponding adjustments in inventory levels to arrive at the book value of inventory. Next, deduct the actual value of the inventory from the book value of the inventory to arrive at the shrinkage value. Next, divide the shrinkage value determined in step 7 by the actual value of inventory to get the shrinkage rate.

Shrinkage Formula Example #1

Let us take the example of a manufacturing business that had reported $30,000 as the final inventory value as per the book of accounts. However, the accountant observed that the business has $28,000 worth of finished products. Help the top management of the business determine the overall shrinkage in the inventory.

Solution:

Use the given data for the calculation of shrinkage value.

Calculation of shrinkage value can be done as follows:

Determine the value of shrinkage as displayed below:

Shrinkage Value = $30,000 – $28,000

Shrinkage Value will be –

Shrinkage Value = $2,000

Therefore, the manufacturing business has an inventory loss of $2,000 due to the shrinkage reported between the book of account and actual value.

Shrinkage Formula Example #2

Let us take the example of a manufacturing business that reported $50,000 as the final inventory value per the book of accounts. However, the accountant observed that the business has $37,000 worth of finished products. Help the top management determine the overall shrinkage and the shrinkage rate in the inventory.

Shrinkage Value = $50,000 – $37,000

Shrinkage Value = $13,000

Calculation of shrinkage rate can be done as follows:

Shrinkage Rate = $13,000 / $37,000

Shrinkage Rate will be –

Shrinkage Rate = 35.14%

Therefore, the manufacturing business has an inventory loss of $13,000 due to the shrinkage reported between the book of account and actual value. It further accounted for a shrinkage rate of 35.14%, which is very high. The management, therefore, has to investigate whether the shrinkage is due to theft or accounting errors.

Shrinkage Formula Example #3

Let us take the example of a manufacturing business that had reported $50,000 as the beginning inventory value as per the book of accounts. The business purchased $20,000 through the financial year and achieved sales of $30,000 for the financial year. It additionally made adjustments in inventory levels by $2,000.

However, the accountant observed that the business has $37,000 worth of finished products. Therefore, help the top management determine the overall shrinkage and the shrinkage rate in the inventory.

Calculation of Inventory on Book can be done as follows:

Inventory in the book of Accounts = $50,000 + $20,000 – $30,000 – $2,000

Inventory in the book of Accounts will be –

Inventory in Book of Accounts = $38,000

Shrinkage Value = $38,000 – $37,000

Shrinkage Value = $1,000

Shrinkage Rate = $1,000 / $37,000

Shrinkage Rate = 2.70%

Therefore, the manufacturing business has an inventory loss of $1,000 due to the shrinkage reported between the book of account and actual value. However, the shrinkage rate is comparatively low at 2.70%, and hence this shrinkage may be due to accounting errors while reporting the values in the book of accounts.

Relevance and Uses

It is critical for the accountants and the audit experts to monitor the physical inventory levels. Further, it has to be compared with the inventory levels, as mentioned in the book of accounts. Once the value is determined, the shrinkage arising out of the comparison should be noted and reported to the top management.

Determining the shrinkage levels helps in better control over the inventoryControl Over The InventoryInventory control is adopted by organizations to properly manage the inventory/stock stored in the course of business to minimize storage & carrying charges for the inventory and satisfy its customer’s demands in the market.read more. For example, an inventory shrinkage may result from direct theft, which may have been done by either employees, vendors, or customers.

This article has been a guide to the shrinkage formula. Here we discuss the calculation of shrinkage value and its rate using a formula along with examples and a downloadable excel template. You can learn more about financial analysis from the following articles –

  • Inflation FormulaDays Payable Outstanding FormulaInventory Financing DefinitionInventory Financing DefinitionInventory financing is a short-term loan or a line of credit that keeps revolving after a pre-decided time period and is used to finance the company’s inventory, with the purchased inventory acting as collateral for the loan. If the firm fails to repay the loan, the lender has full authority to seize and sell the inventory in order to recover the lent capital.read moreInventory AuditInventory AuditInventory audit is a process of checking the inventory methods used by the company to record the inventory using various analytical processes. It ensures that the proper record of the inventory is maintained in the company’s book of accounts and that it matches to the physical inventory count.read moreBadwillBadwillThroughout your career, it will help you take up diverse roles such as a public accountant, financial consultant, tax advisor, CFO, auditor, controller, or federal officer, etc., depending on your skills or experiences. As a result, the license is one of the most coveted ones in accountancy in the world.read more