Inventory Variance

Increased ProfitsWith the Holiday season soon behind us, now is a good time to review the past twelve months and evaluate both quantitatively and qualitatively the areas of your business that have worked well, in addition to those areas that could stand improvement.

Most retailers take a physical inventory in conjunction with their fiscal year end.  Certainly this is a recommended practice from an accounting perspective.  From an operations standpoint, the benefits of a clean and thorough physical inventory are numerous. If for example, a physical count is taken once a year and the inventory levels in the computer are adjusted and “cleaned up” to reflect the recent count, logically speaking, there will be no time in the year when the inventory reports will ever be more accurate and up to date. One of the more significant reports to generate after the inventory is reconciled is the inventory variance report. Most POS systems have one. This report reveals the differences between the book and physical inventory.  Book inventory is what the computer says you have on a given date and physical inventory being what you just counted and actually have in the store.

In my dealings with independent merchants over the better part of the past three decades, I have found that most stores assume a very casual approach to inventory adjustment.  This runs the gambit from the nonchalant retailer who merely accepts the difference and moves on (what I refer to as the “oh well, it is what it is” approach), to the operation that looks into every missing sku in an effort to tighten up the operation and prevent further discrepancies.

Analyzing Inventory Variance

Book and physical inventory should be monitored at the store and classification level.  Several things can cause a disparity between these numbers. Markdowns that were not properly recorded are a potential problem area to check into, assuming the store is operating under the retail method and markdowns are kept track of. Transfers between stores are where a multitude of problems tend to occur as well.  It is not uncommon to find one store showing shrinkage and another store coming up with an overage by the same amount.  The solution here is an obvious one: tighten up the transfer process. Discrepancies can also arise from goods being received into the wrong classifications when the merchandise arrives.  If purchase orders are filled out properly with correct department/class information, this too can be held to a minimum going forward.  Missing tickets and human error at the point of checkout is another cause of inventory variance.  I am continually reviewing classification information from independent shoe merchants and almost always see a class described as “unknown” or “missing.”  I have seen extreme examples where sales in these classes can be some of the highest volume classes in the store.  Needless to say, there shouldn’t even be a classification in the store to track unknown or missing merchandise. In order to keep the merchandising information credible all sales must be put into a classification when sold.

Another area for shrinkage is theft, both internal and external.  Having said that, I can almost assure you that I will get emails from merchants who will claim they have never heard of this happening in their stores.  Remember, just because you aren’t aware of something doesn’t mean that it hasn’t or can’t happen.  There isn’t a retailer on the planet that hasn’t had some experience with theft with the possible exception of the new store that has been just open for one day and frankly, I wouldn’t bet on that scenario.

A respectable shrinkage goal would be anything less than two percent. Inventory shrinkage is a component of cost of goods sold along with purchases, freight in, alterations, trade discounts earned and the difference between beginning and ending inventory.  So, if a store’s year-end shrinkage is high, the COGS will be higher and the gross margin will be reduced accordingly.  Recently, I have suggested that several of my own clients begin using inventory shrinkage as one of the components of manager bonus programs in an effort to illuminate the importance of closely monitoring this area of potential loss. In severe cases, inventory shrinkage can alter open-to-buy numbers thereby creating a potential shortage of inventory, which could lead to missed sales.

As you embark on the year-end introspective ritual of looking for areas of improvement, don’t overlook inventory variance. It just might be the difference between being profitable and being very profitable.

Ritchie Sayner is Vice President of Business Development for RMSA Retail Solutions. Ritchie Sayner is Vice President of Business Development for RMSA Retail Solutions. Contact Mr. Sayner at or 816-505-7912.Sayner at or 816-505-7912.