Quick answer: Retail shrinkage is the gap between the inventory your records show and what a physical count finds. At year-end, count every location, investigate large variances, then reduce inventory to the counted value and record the difference to cost of goods or a shrinkage account, tagged by store. NRF’s latest survey put average shrink at 1.6% of sales.
Key takeaways
- Shrinkage comes from theft, damage, vendor errors and paperwork mistakes.
- Measure it as a percentage of sales, by location.
- Record the adjustment so inventory equals the count and COGS rises by the difference.
- Value slow-moving and obsolete stock at the lower of cost and net realizable value.
- Cycle counts during the year catch shrinkage before year-end.
Your POS says you have $250,000 of stock. Your year-end count says $244,000. That $6,000 gap is shrinkage: product you paid for and can’t sell, because it was stolen, damaged, miscounted or never received.
Every retailer has some. The question is whether your books know about it. If they don’t, your inventory is overstated, your cost of goods is understated and your margins look better than they are. This guide covers how to run a year-end count, measure shrinkage and book it properly.
What is retail shrinkage?
Retail shrinkage is the difference between the inventory your records say you have and the inventory you actually have. It’s usually measured as a percentage of sales. Shrinkage comes from external theft, employee theft, damage, vendor errors and paperwork mistakes such as receiving errors or mis-scanned items.
It adds up. The National Retail Federation’s 2023 National Retail Security Survey put the average shrink rate at 1.6% of sales in fiscal 2022, about $112.1 billion in losses. On thin retail margins, 1.6% of sales can be a large share of profit.
Why count inventory at year-end?
A physical count is the only way to know what’s really on your shelves. It matters at year-end for three reasons:
- Your balance sheet. Inventory is often a retailer’s biggest asset. It should reflect what you own, not what the system thinks you own.
- Your cost of goods. Any shrinkage you find increases COGS for the year. Without it, gross margin is overstated.
- Your tax return. Ending inventory feeds directly into cost of goods sold, so your CPA will want a count-based figure.
If your inventory system is reliable, cycle counts during the year can reduce how much you need to count at once. But most small and mid-sized retailers still do a full count at year-end.
How do you plan a year-end count?
Before the count
- Pick a date close to year-end, ideally after close of business when no sales are happening.
- Process every receipt, transfer and return in the system before you start.
- Organize each location by zone and print or load count sheets for each zone.
- Assign counters in pairs, with one counting and one recording.
- Set aside damaged, returned and consignment items so they’re counted separately.
During the count
- Count each zone once, then spot check a sample with a second team.
- Freeze receiving and transfers until the count is complete.
- Note anything unusual, like items with no barcode or large differences, while you’re still on the floor.
After the count
- Enter counts into your POS or inventory system.
- Investigate large variances before you accept them. A missing case may be in the back room or still on a vendor’s truck.
- Approve the final count and save the report as your record.
How do you calculate shrinkage?
Compare the value of inventory in your records with the value counted, then express the difference as a percentage of sales. Here’s an illustrative example for one store.
| Item | Amount |
|---|---|
| Inventory per records, at cost | $250,000 |
| Inventory counted, at cost | $244,000 |
| Shrinkage | $6,000 |
| Annual net sales | $400,000 |
| Shrink rate | 1.5% of sales |
Run this by location if you have more than one store. A company-wide rate of 1.5% can hide one store at 0.8% and another at 3%.
How should shrinkage be recorded?
Once the count is approved, adjust your books so inventory equals the count.
- Reduce inventory by the shrinkage amount, at cost.
- Record the other side to cost of goods sold or to a dedicated inventory shrinkage account that rolls up into COGS. A separate account makes the cost easy to track year over year.
- Record damaged goods separately if you can, so you can tell theft and errors apart from breakage.
- Tag the entry to each location so every store’s P&L carries its own shrinkage.
- Keep the count sheets and the variance report with your year-end records.
In our example, the entry moves $6,000 out of inventory and into shrinkage expense, reducing the year’s gross profit by $6,000.
What causes shrinkage, and how do you tell the sources apart?
A single shrinkage number tells you how much went missing. It doesn’t tell you why, and the fix depends entirely on the cause. Most retail shrinkage falls into five groups.
| Source | What it looks like in the data | First fix to try |
|---|---|---|
| External theft | Losses concentrated in small, high-value items near exits or blind spots | Move high-risk stock, add visibility, tag or lock key items |
| Employee theft | Losses on specific shifts, voids and no-sale drawer openings above normal | Review void and refund reports by employee, tighten approvals |
| Vendor and receiving errors | Shortages on items from particular suppliers, often whole cases | Count deliveries against the purchase order before signing |
| Damage and spoilage | Losses in fragile or dated goods, often visible in a damaged-goods bin | Record damage as it happens, review handling and storage |
| Administrative errors | Gaps that reverse on the next count, wrong costs, items scanned as the wrong SKU | Clean up item setup, train staff on receiving and returns entry |
The last group is easy to overlook. Some of what looks like theft is really paperwork: a delivery entered twice, a return processed to the wrong SKU or a transfer between stores that was sent but never received. Before you treat a variance as lost goods, check whether it reverses when the paperwork is corrected.
Tracking damage separately pays off here. If damaged goods go to their own account as they happen, your year-end shrinkage is mostly theft and errors, which makes the number far more useful.
Does your inventory method change how you book shrinkage?
Yes. Retailers generally track inventory one of two ways, and each one surfaces shrinkage differently.
Perpetual inventory. Your POS or inventory system updates stock with every sale, receipt and return. The system always shows what you should have, so a physical count reveals shrinkage directly as the gap between system and shelf. You record that gap as an adjustment, as described above.
Periodic inventory. You don’t track stock continuously. Instead, you calculate cost of goods sold at the end of the period: beginning inventory plus purchases, minus ending inventory from the count. Shrinkage is buried inside that COGS figure, so you never see it as its own number unless you estimate it separately.
Most retailers with a modern POS run a perpetual system, which makes shrinkage visible and measurable. If you’re on a periodic system, a year-end count still gets your balance sheet right, but you’ll need better records to know how much of your cost of goods was shrinkage.
How do you value inventory at year-end?
The count tells you how many units you have. Valuation tells you what they’re worth on your balance sheet. Three decisions matter.
Your cost method. Most small and mid-sized retailers use either first in, first out (FIFO), where the oldest costs flow to COGS first, or weighted average cost, where every unit carries the average cost of all units on hand. Your POS or inventory system usually applies one of these automatically. Whichever you use, use it consistently from year to year.
Slow-moving and obsolete stock. Under US accounting rules, inventory measured on FIFO or average cost is generally carried at the lower of cost and net realizable value. In plain terms: if you can no longer sell something for what it cost you, its value on the books should come down. Seasonal stock that didn’t sell, discontinued lines and damaged goods are the usual candidates. Your CPA can help you decide how far to write them down.
Landed cost. Your inventory cost should include what it took to get goods onto your shelves, such as inbound freight and duties, not just the supplier invoice. If those costs have been expensed as they arrived, your inventory is undervalued and your margins swing from month to month.
What is cycle counting, and should you use it?
Cycle counting means counting a small part of your inventory on a regular schedule, so every item is counted several times a year without shutting down for a full count. It’s the most practical way to catch shrinkage early.
A common approach is to rank items by value or risk:
- A items: the 10% to 20% of SKUs that make up most of your inventory value, or that are most often stolen. Count them monthly.
- B items: the middle tier. Count them quarterly.
- C items: low-value, slow-moving items. Count them once or twice a year.
Each count is small enough to do in an hour before opening. When a cycle count finds a variance, you investigate it while the trail is still fresh, instead of trying to explain a year-old gap in January.
Cycle counting doesn’t always replace the year-end count. Your CPA or lender may still want a full count. But it makes the year-end count faster and far less likely to produce a surprise.
What changes with more than one location?
Multi-location retailers face two extra risks: transfers and averaging.
Transfers between stores are a frequent source of false shrinkage. Stock leaves one store and is never received at the other, so one location shows a shortage and the other an overage. Record transfers as two steps, shipped and received, and reconcile any that are open at count time.
Averaging hides problem stores. A company-wide shrink rate is useful for the board. Store managers need their own number. Track shrinkage by location every time you count, and compare stores side by side. If one store runs at twice the rate of the others, that’s where your time goes next quarter.
Your year-end count checklist
- Choose the count date and tell staff and vendors
- Post every receipt, transfer and return in the system
- Map each store into zones with count sheets
- Separate damaged, returned and consignment goods
- Pause receiving and transfers during the count
- Count in pairs and spot check each zone
- Investigate large variances before approving
- Value the count using your cost method
- Review slow-moving and obsolete stock for write-downs
- Post the shrinkage adjustment by location
- Save count sheets and the variance report with year-end records
Worked example: shrinkage across three stores
A company-wide shrink rate can look healthy while one store needs attention. Here’s an illustrative year-end count for a retailer with three locations.
| Store | Inventory per records | Inventory counted | Shrinkage | Annual net sales | Shrink rate |
|---|---|---|---|---|---|
| Downtown | $180,000 | $177,300 | $2,700 | $520,000 | 0.5% |
| Riverside | $140,000 | $133,700 | $6,300 | $310,000 | 2.0% |
| Airport | $90,000 | $88,200 | $1,800 | $170,000 | 1.1% |
| Total | $410,000 | $399,200 | $10,800 | $1,000,000 | 1.1% |
At 1.1%, the company looks fine. Riverside doesn’t. It accounts for more than half the shrinkage on less than a third of sales.
The next step is to break Riverside’s $6,300 down by category and by cause. In this example, $2,400 traces to a single vendor whose deliveries were consistently short, $1,100 is damaged goods that were never recorded and $1,500 reverses once two unreceived store transfers are corrected. That leaves $1,300 of probable theft concentrated in one small, high-value category.
Each finding has a different fix: a conversation with the vendor and tighter receiving, a damaged-goods process, a transfer procedure and better placement of the high-risk items. None of them would have surfaced from the company-wide number alone.
Record each store’s adjustment to its own class or location so every P&L carries its true cost of goods, and keep the breakdown with your year-end records.
Key terms
- Shrinkage: the gap between inventory per your records and inventory actually counted.
- Shrink rate: shrinkage as a percentage of sales.
- Physical count: a full count of every item on hand at a point in time.
- Cycle count: counting a small part of inventory on a regular schedule.
- Perpetual inventory: a system that updates stock with every transaction.
- Periodic inventory: a system that calculates cost of goods from counts at period end.
- FIFO (first in, first out): a cost method where the oldest costs flow to cost of goods first.
- Net realizable value: what you expect to sell an item for, minus the costs to sell it.
How can you reduce shrinkage next year?
- Receive carefully. Check deliveries against purchase orders before signing. Vendor shortages are a common source of shrink.
- Count more often. Monthly cycle counts of high-value or high-theft items catch problems early.
- Match returns to sales. Returns that don’t tie to an original sale deserve a closer look.
- Review variances by store and by category. Patterns point to the cause.
- Close the books monthly. Shrinkage found every month is easier to explain than shrinkage found once a year.
For the rest of the year-end routine, from reconciling accounts to preparing for your CPA, see our 10-step checklist to get your books ready for year-end.
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FAQs
What is a normal retail shrink rate?
NRF’s 2023 National Retail Security Survey reported an average of 1.6% of sales for fiscal 2022. Your rate depends on your category, location and controls.
Is shrinkage part of cost of goods sold?
Yes. The adjustment reduces inventory and increases cost of goods, either directly or through a shrinkage account that rolls into COGS.
How often should retailers count inventory?
At least once a year with a full count, plus cycle counts during the year for high-value or high-theft items.
What if the count is higher than the records?
Investigate before adjusting. It’s often a receiving or data entry error, such as stock received but never entered.
What’s the difference between perpetual and periodic inventory?
A perpetual system updates stock with every transaction, so shrinkage shows up as the gap at the next count. A periodic system calculates cost of goods at period end, so shrinkage is included in COGS rather than shown separately.
How do I value damaged or obsolete stock?
Inventory on FIFO or average cost is generally carried at the lower of cost and net realizable value. If you can’t sell an item for what it cost, write its value down. Confirm the amount with your CPA.
Can I do the count during business hours?
It’s possible with cycle counting, one section at a time. For a full year-end count, counting after close avoids sales changing the numbers mid-count.
Who should do the count?
Pair staff who don’t normally manage that section, with a manager or your bookkeeper reviewing variances. Fresh eyes catch more.
