For example, imagine that you own a store that sells pet food. You suspect that someone has broken in, so you take a physical count of your dog food bags. After some work, your workers determine that there are 450 bags of dog food in the store.
Be careful to attribute this shrinkage to the correct causes. A large shrinkage is cause for alarm and should be further investigated. However, you can’t assume that all of the difference is due to theft. Common causes of inventory shrinkage are theft, spoilage, obsolescence, damage, and display (items that have been put on display and are no longer fit for consumption). Cracking down on theft will not necessarily reduce these other factors. [3] X Research source Retail companies should have procedures and policies in place to deal with spoilage, damage, and obsolescence automatically if these cause significant shrinkage. For example, imagine that in the previous example of a pet store, you look in your books and you are supposed to have 500 bags of dog food instead of the 450 you counted. Ask your employees about how many bags have been damaged and determine if this number could be due to factors other than theft.
Book value for inventory is calculated in different ways by different businesses. In general, valuation of inventory falls into one of three categories: Last-in, first-out (LIFO). This method uses the cost of the items added to inventory most recently to value the inventory sold or lost. For example if 5 chairs were bought from a wholesaler at $50 each and then later 5 more were bought at $70 each, the business would use the $70 cost for the first five chairs sold and then the $50 cost for the next 5. First-in, first-out (FIFO). This is the opposite of LIFO and assumes that the first inventory in is sold first. Using the same chair example, the first five chairs sold would be valued at a cost of $50 each and the last 5 at $70. Average cost. This is a method that averages the cost of all of the inventory and values each item at that cost. In the chair example this would be calculated as ((5 chairs * $50 each)(5 chairs $70 each))/10 total chairs, which results in an average cost of $60 each. [5] X Research source Using the same example from earlier, imagine your dog food costs $10 per bag wholesale (on average). Because you’ve lost 50 bags, your total inventory shrinkage is valued at 50*$10, or $500.
In the pet store example, you decide that your loss of 10 percent of your inventory (50 bags out of 500) is a serious loss. This should be reported on the income statement as stolen inventory (if you determine the cause of the shrinkage was indeed theft).
Account for the stolen inventory by debiting cost of goods sold for the value of inventory, $500, and crediting inventory for the same amount. [7] X Research source
