While fraud may be your first thought when a business files an inventory loss claim, it isn’t always the culprit behind missing items.

Complex production processes, varied accounting methods and the sheer volume of items make it difficult to measure inventory accurately. As a result, many companies experience inventory shrinkage, or a discrepancy between recorded inventory and actual inventory.

One common reason behind inventory shortages is miscalculating the amount of inventory used. For example, an ice cream shop might think it can dip 100 cones in a can of chocolate, but it actually got 95 cones out of the last can and 85 from the one before that. Unless the shop keeps historical data on its chocolate usage, its inventory count likely won’t be accurate.

Data entry and human errors, including coding items incorrectly, paying a vendor invoice twice or overshipments to customers account for many other shortages. A thorough review of a company’s books and its physical inventory will often uncover the problem.

While inventory discrepancies often are the result of honest mistakes, fraudulent schemes also abound. One common scheme involves “ghost inventory,” where an employee pays for fictitious orders that are never delivered. Other schemes involve falsifying physical inventory quantities, including consigned inventory in total values, and failing to write down obsolete inventory. 

Inventory control

Before investigating a claim, ask the company to explain its recording methods so you can note anything unusual. Some companies use a periodic system where they record inventory changes at the end of an accounting period, while others use a perpetual system, recording changes continuously. Watch for any abnormal inventory shrinkage or a pattern of shrinkage in one department or location.

Other red flags to look for include slowing inventory turnover, inventory increasing faster than sales, and shipping costs decreasing compared with inventory volume. Changes to gross profit margins, or the gross profit divided by sales are another reason for suspicion–an unusually high figure could indicate overstated inventory, while a low margin may indicate inventory theft. Unusual bookkeeping entries, such as round figures or credits in the purchases section, can also signal that something is amiss.

When working with companies to resolve their loss claims, encourage them to improve their reporting. Inventory management software, which tracks average turnover, top-selling items and other critical information, can help businesses get a handle on their books.

Reducing inventory is another way to minimize claims as well as cut inventory-related costs. Many companies realize savings by adopting Just-In-Time inventory management practices, where they order materials as needed instead of hanging onto them for months. Tighter controls are another important deterrent against inventory losses. Companies should ensure that the person recording a transaction isn’t same person who processes it and limit asset access to necessary employees.

Whether a company’s loss claim is the result of a pilfering employee or just sloppy data entry, understanding how the organization’s inventory works and ensuring it is recorded accurately can help avoid similar issues in the future.