What Is Inventory Shrinkage?

Inventory shrinkage is the difference between the inventory a business carries on its books and the inventory it can physically count, when the count comes up short. It only becomes visible when someone counts: a full physical inventory or a cycle count compares what is on the shelf with what the system says should be there.

IRS Publication 538 says that a business keeping a perpetual or book inventory must take a physical inventory at reasonable intervals, and the book amount for inventory must be adjusted to agree with the actual inventory.

Federal tax law also addresses estimates of shrinkage. Under 26 U.S.C. 471(b), a method of determining inventories is not treated as failing to clearly reflect income solely because it uses estimates of inventory shrinkage that are confirmed by a physical count only after the last day of the taxable year, if two conditions are met:

• The business normally does a physical count of inventories at each location on a regular and consistent basis.
• It makes proper adjustments to its inventories and its estimating methods to the extent the estimates are greater than or less than the actual shrinkage.

For theft and casualty, Publication 538 says you claim a loss of inventory through the increase in the cost of goods sold by properly reporting your opening and closing inventories, and you cannot claim the loss again as a casualty or theft loss. You can instead choose to claim it separately as a casualty or theft loss; if you do, you adjust opening inventory or purchases to eliminate the loss items so they are not counted twice.

This is general information, not tax or accounting advice.

Shrinkage is simple arithmetic once you have a count:

• Shrinkage in units: units on record minus units counted
• Shrinkage value: recorded inventory value minus counted inventory value, both at the same unit cost
• Shrinkage rate: shrinkage value divided by recorded inventory value, times 100

A distributor's records show 1,200 cases of nitrile gloves at a cost of $18.00 a case, or 1,200 x $18.00 = $21,600.00. A cycle count finds 1,176 cases.

• Shrinkage in units: 1,200 - 1,176 = 24 cases
• Shrinkage value: 24 x $18.00 = $432.00
• Shrinkage rate: $432.00 / $21,600.00 x 100 = 2%

The distributor adjusts the on-hand quantity to 1,176 cases to match the count.

In Shopify's inventory model, the on hand quantity represents the total number of units that are physically stocked at a location. Shopify's developer documentation lists a completed stocktake as one scenario for setting the on-hand quantity, and the mutation that sets it takes a reason for the adjustment. The reasons include:

• shrinkage: used when actual inventory levels are less than recorded due to theft or loss
• damaged: used to remove units from inventory count due to damage
• cycle_count_available: used to specify an adjusted inventory count due to a discrepancy between the actual inventory quantity and the previously recorded quantity
• correction: used to correct an inventory error or as a general adjustment reason

Shopify's Help Center adds that every adjustment is recorded, so you can review who changed a quantity, when, and why, and use that history to trace a discrepancy back to the change that caused it.

Uncap's guide to available to promise vs on hand separates two numbers: on hand is what the warehouse has, and available to promise is what the business can still sell. It explains that B2B storefronts oversell because the integration feeding them was built around the first number when the buyer was asking about the second.

• Cycle counting
• Safety stock
• Cost of goods sold
• Three-way match
• Dead stock
• Inventory turnover ratio

• IRS Publication 538: Accounting Periods and Methods
• 26 U.S.C. 471, General rule for inventories (Cornell LII)
• Shopify.dev: Manage inventory quantities and states