The Impact of Shrinkage on Finance in the Retail Industry

The retail industry is unique in many ways. There are several financial and operational concepts which are more relevant to the retail industry than to other industries. Shrinkage is one such concept which has more relevance in accounting for the retail industry.

In this article, we will have a closer look at the concept of retail shrinkage. We will also try to have a closer look at the causes of shrinkage as well as the impact that it has on the retail industry.

Definition of Shrinkage

Retail shrinkage refers to the difference between the physical inventory that a store has as well as the value of the inventory that is present on its books.

For example, the retailer may be assuming that they have $100 worth of inventory in their stores. However, when a physical inventory count is taken, the actual value of inventory is only $95. The balance $5 has been lost and the store now has to write down this value. This is because they cannot sell or return anything to recover the cost of this inventory.

Shrinkage is actually a huge problem in the retail industry. The total amount of inventory lost to shrinkage accounts for over $61 billion in the United States alone. It is for this reason that any student of retail finance must have a basic understanding of the causes as well as the impact of shrinkage.

Shrinkage is a Necessary Evil

Before we discuss any further about retail shrinkage, it is important to know that retail shrinkage is a necessary evil. This means that retail shrinkage cannot be completely avoided. Instead, the impact of retail shrinkage can be minimized.

The retail industry regularly shares benchmarks regarding the acceptable level of shrinkage. At the present moment, the shrinkage of around 1.5% of inventory value is considered to be acceptable. Anything more than that requires further supervision.

It is important to note that it is not financially prudent to try to eliminate shrinkage completely. This is because beyond a certain point the cost of trying to prevent shrinkage actually ends up exceeding the financial damage that shrinkage is likely to cause.

How Inventory Shrinkage is Calculated?

Since the retail industry mentions the acceptable shrinkage rate in percentage terms, it is important to understand how this percentage is calculated. The shrinkage is calculated with the help of the following formulae.

Inventory Shrinkage = Financial Value of Book Inventory – Financial Value of Physical Inventory

The above formula helps us ascertain the financial value of shrinkage. However, in order to convert this absolute value into a percentage, we need to use the following formula.

Shrinkage Rate = Inventory Shrinkage/Financial Value of Physical Inventory * 100

Impact of Shrinkage

It is very important for participants in the retail industry to make attempts to keep the shrinkage value under control. This is because it can have an overall negative impact on the business.

1. Markdown in Profit and Loss Account: Any money lost to shrinkage needs to be straight away expensed via the profit and loss account. This means that uncontrolled shrinkage actually leads to the retailer simply losing money which has earlier been earned by them.

   Inflation and higher interest rates have already created an environment where the margins of retailers are already under pressure. It is for this reason that any further loss due to shrinkage is viewed negatively and brings into question the competence and the ability of the management to effectively run the business.

2. Inventory Planning: Shrinkage also ends up creating multiple problems for inventory planning. This is because of the fact that shrinkage exists because there is a difference between the actual inventory and the inventory which is present on the books of accounts. A lot of the times, this also means that the retailer is not able to order replenishment stock in a timely manner. This eventually causes problems such as excess inventory or stockouts both of which are harmful to the retailer’s financial position.

3. Increased Prices for Consumers: The fact of the matter is that the cost of shrinkage ultimately has to be borne by the consumer.

   It is not the shareholders or the management that foots the bill for shrinkage. Hence, companies which have a high level of shrinkage are compelled to increase their prices in order to make good the losses that they have already suffered. Hence, it has been observed that companies which have higher shrinkage rates also tend to have higher prices.

4. Reduced Sales: Lastly, since the retail business is extremely competitive, even minor increases in the prices of products lead to loss of customer share and decreased sales. Hence, shrinkage can exacerbate an already severe problem which is existing in the retail industry.

The above points explain why shrinkage is such an important concept is retail finance. Shrinkage is present in almost all industries. However, it reaches significant proportions in the retail industry because of various causes which have been outlined in the next article.