How To Perform an Inventory Adjustment

When an item is nowhere to be found in the warehouse, back storage room, or on store shelves—yet your inventory list insists the product is in stock—your store is experiencing an inventory discrepancy. 

Missing products are only one type of inventory discrepancy—inventory issues can also stem from changes in a product’s value, condition, or category. These errors—whatever their cause—can negatively impact your customer experience, brand loyalty, and your bottom line. Conducting regular inventory audits, followed by inventory adjustments to align your physical stock with your recorded inventory, can help you avoid these costly mismatches. 

Learn how to identify discrepancies, understand the different types of inventory adjustments, and follow a four-step process to correct your records and maintain accurate stock levels.

What is an inventory adjustment?

Inventory adjustment refers to the process of correcting your books when the numbers in your inventory management system don’t sync up with your existing inventory. For instance, if your system shows 500 units but a physical count reveals only 470, you would record an inventory adjustment to reconcile the difference. 

The inventory adjustment process is a normal part of supply chain management, and it’s used to account for damaged goods, theft, clerical errors, or excess inventory in a company’s warehouses and distribution centers.

Conducting regular inventory audits and following them up with inventory adjustments helps your sales and fulfillment departments get work done faster and with fewer errors. It also helps your accounting team produce accurate financial statements for tax reporting and for keeping stakeholders informed. And if you’re the one responsible for all of those tasks, it makes your life easier, too.

Types of inventory adjustments 

Inventory adjustments can take multiple forms. Here are eight types commonly used in retail business accounting.

• Quantity increase adjustment. A quantity increase adjustment, also known as a receipt adjustment, is used when there’s more physical inventory on hand than is recorded in the computerized system. This can happen when goods are received but not recorded, or when clerical errors inflate the system count.

• Quantity decrease adjustment. You’ll need to make a quantity decrease adjustment if a physical count shows fewer inventory items than the system accounts for. Also called a shrinkage adjustment, this accounts for damaged inventory, theft, spoilage, misplacement, or misrecorded sales.

• Cost adjustment. A cost adjustment is an update to inventory value when the recorded cost of inventory items is in error. This usually happens because of supplier price changes, data entry mistakes, or outdated costing methods. Cost adjustments ensure that inventory records reflect their true replacement cost, which helps keep financial statements accurate.

• Write-off adjustment. An inventory write-off adjustment removes items that are no longer sellable because of damage, expiration, obsolescence, or because they’ve gone missing. 

• Write-down adjustment. A write-down reduces the value of inventory that market conditions suggest you’ll have to sell at a reduced price. It’s appropriate when items are slow moving, outdated, or have dropped in resale value, and helps maintain accurate inventory valuations. Applying data analytics to past inventory transactions and income statements can help businesses predict which inventory items may need a lower price tag.

• Reclassification adjustment. A reclassification adjustment changes the category, status, or type of inventory when its intended use changes. This can happen when raw materials become finished goods, when items are bundled or broken into new SKUs, or when sellable products are reassigned for internal use—such as floor displays or in-store testers. 

• Unit of measure (UOM) adjustment. A UOM adjustment corrects discrepancies caused by misusing units of measurement, such as counting by the case instead of by the piece. You’d use this when inventory quantities need to be standardized or corrected to restore order to your inventory balance.

• Location adjustment. This type of adjustment corrects where inventory is stored in your system when the physical movement of an item wasn’t recorded properly. It doesn’t change your total inventory—just its assigned location. You might also make a location adjustment when items move into temporary statuses like “quality check” or “quarantine,” which removes them from the sellable pool without changing total stock.

Causes of inventory discrepancies

Inventory discrepancies can stem from quantity issues, valuation issues, or classification issues. The list below focuses on the most common cause: mismatches in quantity—when the physical stock you have on hand doesn’t match what’s recorded in your system.

• Human error. Mistakes in scanning, counting, or recording receipts lead to inaccurate stock levels.

• Theft, shrinkage, or fraud. Internal or external theft reduces inventory without corresponding record changes. 

• Damaged, expired, or unsellable goods. Breakage, spoilage, or expired items inflate recorded stock and distort valuation.

• Incorrect or missed inventory transactions. Unlogged sales, returns, transfers, or adjustments create mismatches between physical and recorded stock levels.

• Supplier or receiving errors. Short shipments, over-shipments, or mislabeled items create incorrect starting quantities and downstream errors.

• Unit-of-measure inconsistencies. Counting items in cases, packs, or individual units without consistent standards can lead to massive quantity discrepancies.

• Unrecorded returns. When returned items aren’t added back into “available for sale” stock, you’ll cause discrepancies in the inventory management system.

Benefits of utilizing inventory adjustments

Auditing and adjusting your inventory improves the health of your business. Here are some specific benefits:

• Improves inventory accuracy. When you adjust inventory regularly, it helps align system data with physical stock, reducing errors that could impact ordering, forecasting, and financial and operational reporting.

• Prevents stockouts and overstocking. By correcting discrepancies promptly, businesses keep the right amount of stock on hand, ensuring products are available when customers need them while avoiding excess carrying costs, which are the expenses incurred for holding on to unsold inventory.

• Enhances financial reporting. Proper accounting requires an accurate count from inventory departments for reliable financial statements and to better calculate the cost of goods sold (COGS).

• Identifies operational issues early. Adjustment patterns can reveal recurring problems like theft, supplier errors, or process inefficiencies. By catching these early, you can take corrective action before issues escalate.

• Supports data-driven decision-making. With accurate, real-time inventory data, teams can optimize their purchases, improve demand planning, and enhance overall supply chain performance.

How to perform an inventory adjustment

1. Conduct a physical inventory count
2. Compare your actual inventory count to your recorded number
3. Determine the financial impact of the discrepancy
4. Update your records to reflect the adjustment

Here are the four steps you need to get your inventory numbers in proper alignment.

1. Conduct a physical inventory count

Inventory adjustments usually start when you notice a discrepancy or during scheduled cycle counts, whether those happen weekly, monthly, or at year-end. Even if you use a perpetual inventory system, where inventory levels are continuously updated after every purchase, physical counts are essential. If you’re able, count items at the SKU level to determine the number of units you have on hand. 

2. Compare your actual inventory count to the recorded number

Pull the recorded quantities from whatever system tracks your inventory—typically your inventory management software, but in some businesses this may be the general ledger. Then you can use this simple formula to find out if you need to increase or decrease inventory records: 

Actual Number - Recorded Inventory = Inventory Adjustment

3. Determine the financial impact of the discrepancy

Convert the quantity difference into a dollar value that reflects your costs, not the retail price you charge customers. This value will not only affect ending inventory—the value of goods a company has for sale after a specified accounting period— but also the gross and net profits for the fiscal year.

4. Update your records to reflect the adjustment

Adjust the quantities in your inventory management system so they match the physical count. For businesses that track inventory in the general ledger, this may involve a journal entry to update the inventory account and an adjustment or COGS account. Keeping both systems aligned prevents misstatements and avoids compounding errors.

Inventory adjustment example

Let’s say you own an ecommerce luggage company that uses inventory management software that shows you have 250 units of your bestselling carry-on suitcase in stock. At the end of the fiscal year, you conduct a physical inventory count and find that you have three damaged, unusable units and two missing units, which means your usable inventory is 245.

You plug these numbers into the inventory adjustment formula:

Actual Inventory - Recorded Inventory = Inventory Adjustment 

The ensuing calculation is 245 - 250 = -5. This means the business must decrease inventory by five units for that SKU.

After identifying the shortage, you update your inventory system so the recorded quantity matches the physical count. This correction ensures more accurate forecasting and better purchasing and replenishment decisions going forward.