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Is it Fraud? 4 Reasons for Inventory Loss Claims

November 8, 2019

When a business files an inventory loss claim, we often jump to the conclusion fraud is the cause of the loss. But fraud it isn’t always the reason behind the missing items.

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

Determining the Cause

One common reason for inventory shortages is that companies miscalculate the amount of inventory used. For example, the owners of an ice cream shop might think they can dip 100 cones in a can of chocolate. In actuality, they only dipped 95 cones out of the last can and 85 cones from the can before that. Unless the shop keeps historical data on its chocolate usage, its inventory count likely won’t be accurate.

Many other shortages are accounted for by data entry and human errors, including coding items incorrectly, paying a vendor invoice twice, or overshipping to customers. An analysis of a company’s books and its physical inventory will often reveal the problem.

Often inventory discrepancies are the result of simple, honest mistakes. However, fraudulent schemes also abound. One scheme involves “ghost inventory,” whereby 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.

Investigating the Claim

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. 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 inventory turnover slowing, inventory increasing faster than sales, and shipping costs decreasing compared to 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 something is amiss.

Room for Improvement

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 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.


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