Behind The Losses For Inventory Shrinkage

Ernesto Hontoria

Versión en castellano: Detrás de las pérdidas de inventario

Since I started working in the retail industry 10 years ago, shrink has been a constant challenge to defeat, and also the most elusive thing to deal with. It is something very real that hits the bottom line of retail companies, but it is  also something ethereal, hard to catch and then impossible to fix.

It is not a particular phenomenon for the two retails companies I have worked for in the past decade. As I started looking at shrink statistics on the web, I found that it is a pretty common issue in the industry. In United States, for example, retail industry shrinkage was estimated at 45 billion dollars in 2015, which represented 1.38% of their sales[i]. Similar ratios have been published for Canada, Colombia and Chile in Internet.

Retail shrinkage, or just shrink, is the portion of the inventory that gets lost, damaged or stolen. In a white paper prepared for ECR Europe (Efficient Consumer Response), Paul Chapman and Simon Templar[ii] wrote a more elaborated definition of  shrink: “Intended sales income that was not and cannot be realized” … because goods have been lost, stolen, damaged or simply have lost their quality and cannot be sold at its intended price (needs to be sold at discount).

In this last definition, the value of a product is a combination of several factors including quality level, and timing (being in the right place at the right moment). A product on the shelf, in good conditions could be sold at its intended price, but when the product fails to meet customer expectations because its quality has been compromised in the process, or it is not in the right place, at the right moment (misplaced, lost or delayed), the retailer miss the opportunity to sell the product, or need to mark down the price to sell it, incurring a loss. For example, Christmas’ products are sold at discount the day after Christmas.

The most extreme case is when the product cannot be sold at all, because it is lost or completely damaged, or just because missed completely the timing. For Chapman and Templar markdowns due to quality issues are also part of the shrink, but in my experience, markdowns are not considered shrink. Needless to say, this is a matter of the internal policies of each company.

Depending how the company manages its inventory, shrink could be classified into two categories: Known or Tracked Shrink, and Unknown Shrink. The first one is the loss that has been identified and processed through the inventory system, and therefore has already hit the inventory levels in the company’s database and books. The Unknown Shrink, on the other hand, is the one discovered during inventory counts, following the reconciliation between the physical count and the inventory levels in the system.

 In general known shrink is generated by products that need to be disposed of because they are damaged, spoiled, out of code, expired, etc. It is known because retailers can scan the products before disposing them, affecting immediately the inventory levels in the system. Other sources of known shrink could be tasting or sampling tables, donations and, in some cases, markdowns.

Unknown shrink is associated with internal and external theft, intercompany fraud and process failures, such as pricing mistakes, accounting errors, failing to scan the products at the point of sale, etc. If the retailer is using an automated store replenishment system to restock the store inventory (systems that automatically order new items when the stocks get to a certain threshold), the unknown shrink can cause the store to run out of stock, before the inventory reordering threshold is reached. Thus, the unknown shrink could penalize such retailers twice: it is not just the merchandise lost, but the loss potential of sales for not having the product in stock. Shrink reduction could bring potential sales improvement opportunities to retailers [iii].

In the United States, theft has been the biggest cause of shrinkage in the retail industry as a whole, both from employees and customers alike. As per one research done by Global Retail Theft Barometer, and posted by Ray Hartjen, Director, Content Marketing & Public Relations in the blog of Retail Next, in 2013-2014 the biggest source of Shrink in the US retail industry was dishonest employees followed by shoplifters[iv]. Vendor fraud and paper errors were the other 2 sources of shrink as shown in the following chart.

In Canada a survey conducted by the Retail Council of Canada (RCC) and PWC also found that theft was the main cause of inventory shrinkage in the retail industry, but shoplifters outpaced dishonest employees. Curiously paperwork errors almost double US industry. The following table shows theirs findings[v]:

Cause of Shrink	2012	2008
Internal theft	33.4%	19.0%
External theft	43.0%	65.0%
Paperwork errors	19.9%	16.0%
Vendor fraud	3.7%

Different sources have pointed that total shrink in US has been between 1.38% and 1.5% in the last 4 years, which is slightly higher than the average shrink rates found by RCC and PWC in the Canadian market[vi].

	Shrink Rates
Sales Range	Low	High	Average
0 - $500M	0.04%	2.19%	0.95%
$500M - $1B	1.29%	1.29%	1.29%
$1B - $5B	0.06%	2.00%	1.20%
>$5B	0.58%	1.34%	0.94%

In Colombia, according to data presented by FENALCO, an organization that groups Colombian retailers, inventory losses fluctuated between 1.12% and 1.46% of sales in the period between 2004 and 2015, as shown in the graph below[vii]:

Retail Shrink in Colombia.
Source: FENALCO - Revista mermas 2016

Since all these numbers are based on surveys, they could be affected by the composition of respondents in both countries. Different types of retailers could have different shrink rates, depending on the merchandise they sell. Jewelry stores will have different shrink rates than gift shops. Also the weight of individual retailers in the total survey could bias the sample.

In Chile, the Chamber of Commerce of Santiago (CSC) and the Grupo ALTO posted the results of their 'Third Radiography of Inventory Losses'[viii] segmenting the industry in its different types of retailers, as observed in the following graph:

Shrink per Type of Retailer in Chile.
Source:  ALTO y CCS -Tercera radiografía de mermas (2016)

As was the case in the 3 previous countries, the study found that theft constitutes one of the main causes of inventory losses in Chile, accounting for almost 80% of the unknown shrink.

Probably this is a good point to introduce in this analysis a sub-sector of the retail industry of my particular interest: supermarkets.

A survey presented by FMS solutions[ix] found that total shrink for the grocery industry in US was 2.8% of their sales in 2016, while in Canada the same ratio was slightly lower at 2.7%. Both rates are almost twice the retail industry reference. The higher shrink of grocers compared to average retailers is most likely related to the perishable nature of some of their products.

A research by FMI and The Retail Control Group into the causes of retail supermarket shrink indicates that 64% of the shrink is operational while 36% is caused by theft[x]. Supermarkets, grocery and convenience stores are not just dealing with theft, as other retailers do, but need to manage the shelf life of their merchandise. Inventory management becomes a critical point for controlling operational shrink. The chart below details the findings of the above mentioned research.

The lifespan of perishable products seems to be an important factor explaining the higher shrink rates in the grocery industry, as can be inferred from the following table (also from the same source), but with shrink broke down into different departments. I have modified FMS’ table copying down only the two columns that I consider most relevant[xi]: weight of each department in total store shrink (Shrink contribution) and shrink as a rate to sales.

DEPARTMENT	Shrink Contribution	Shrink Rate
Meat	18%	4.10%
Produce	16%	4.80%
Deli	14%	7.80%
Bakery	6%	8.00%
Seafood	5%	6.20%
Dairy	4%	1.50%
Floral	2%	5.10%
PERISHABLES	65%	4.62%
Grocery	14%	1.10%
GM	8%	2.70%
RX	5%	2.20%
HBA	3%	2.50%
Frozen	2%	0.80%
Beer/Wine/Liquor	2%	1.00%
Video	1%	4.10%
NON-PERISHABLES	35%	1.48%
TOTAL	100%	2.70%

As could be seems in the table, fresh departments with perishable goods have a higher shrink rate than departments with non perishable products. Indeed when added total non perishable departments the shrink rate is aligned with the retail industry at 1.5%, suggesting that the higher shrink rates in the grocery industry (when compared to retail) is due to the nature of its merchandise.

But we need to understand that the shelf life is not determinant per se of poor shrink rates. According to John Anthony, Sales Executive & Bar Consultant - BarMaxx[xii], shrink rates in bars could be between 5% to more than 45% of sales, and their merchandise is not precisely affected by durability of their products. If you thought that the shrink rate of a supermarket was too high, you will be surprised to know that when a bar is shrinking its inventory in the range of 5% to 10% of their sales, owners feel very proud of their shrink performance. As per John Anthony table (copied below) a shrink below 15% is considered good for bars, which are used to have shrink rates between 16 and 24%.

Shrink Rate	…it is considered…
5% - 10%	- Excellent
11% - 15%	- Good
16% - 24%	- Average
25% -34%	- Poor
35% - 44 %	- Very Poor
45%+	- Extremely Poor

Following Anthony’s article, there are five major contributors to shrinkage in a bar: spillage, overpouring, under-rings, complimentary drinks, and theft. When added all together, the cost is over $5 billion per year in losses to the US hospitality industry.

If we take a closer look on the causes, for example, spillage is referred to broken bottles from accidental drops, or spills while preparing drinks; overpourring is produced when bartenders are consistently pouring more sprits than they should in the drinks they are preparing; under-rings occurred when a drink is not sold at full price, for example if a bartender serves a premium liquor but enter it as a standard one in the POS (point of sales) system; as well as complimentary drinks; we can infer that shrink in a bar is mainly attributed to employees, instead of the life span of its products[xiii].

As happens in bars, shrinkage in supermarkets and grocery stores could be affected by employees’ spillages, overpourring, under-rings, etc., in its own ways.  An interesting table presented by FMS Solutions (that I am reproducing below) allows us to compare top performers vs. the average store in their sample[xiv]:

	Pack	Top performers
Total store	3.00%	1.50%
Dry grocery	1.60%	0.90%
Dairy	2.80%	1.70%
Produce	5.60%	4.20%
Meat	5.90%	3.90%
Deli/Prepared foods	8.60%	4.90%

The performance gap between top performers and regular grocers could be caused by several factors, including the size and layout of the stores, their inventory systems, but I am of the belief that as with the bar industry, an important part of the gap is related with their employees. It is not necessarily due to dishonesty, but things like better training, better processes and more engaged employees, could make a difference in the amount of products that never reach the final consumer or get wrongly registered in the POS. It is not just the perishable nature of the merchandise, shrink rates seems to be deeply related to human factors.

This brings us to the point of what companies can do towards reducing its shrink. As I have anticipated there is no such thing as a silver bullet for controlling shrink levels, but a combination of strategies for dealing with it.

In the executive summary of the web page ‘Where’smy shrink?’ claims that companies with lower than average shrink rates have implemented cross-functional training for loss prevention, audit and store operations personnel to coordinate operational best practices around supermarkets. Operational controls and processes are the foundation for any profit optimization effort[xiv].

They also stated that the implementation of best practices begins with the recognition that supermarkets are kind of an ecosystem of connected conditions. In such environment, companies need to address shrink loss in a holistic manner with collaborative and shared accountability[xvi]. Loss prevention is a corporate mater that cannot be left alone in the hands of individual store managers, but rather needs coordination to create awareness regarding loss prevention in all levels of the organization. It is about changing the playing field to discourage shoplifting and dishonest employees’ behaviors, to implement proactive controls and to follow those controls with discipline on a daily base. It is about a well-trained, shrink-aware store team, led by a management team that understands the right balance between a sales-driven, and a control-oriented store environment. It is about engaging the employees... and efficiently using the available technology…

In an article titled ‘Howto Fight Shrinkage in a Grocery Store’, Felicia Greene mentions 4 recommendations for reducing shrinkage[xvii]:

1.    Reduce overripe produce through a proactive inventory management. Basically means that produce managers could minimize losses from overripe produce, if they mark down prices when products past their optimal sell date but are still marketable, or if they send those still usable products to the store's deli, or bakery for cooking them. With these kinds of actions the store could recover some of its costs rather than throwing the usable products away.

2.    Implementing Shoplifting Deterrents. Store managers could discourage shoplifters scheduling shelf-stocking routines in aisles and hours with higher documented theft rates.

3.    Cashier Training. Improving POS skills in cashiers will reduce inventory errors trough a reduction of hand-key merchandise codes. Poorly trained cashier who cannot differentiate between cheaper and higher-priced produce (like organic and regular bananas), or who cannot find the right product in the POS system screen are prone to keying manual codes that could wrongly affect inventory levels and store's profits.

4.    Self-checkout Monitoring. Self-checkout POS are a potential source of shrink for honest and dishonest customers. A customer using self-checkout machine will -most likely- make same kind of mistakes than an untrained or poorly trained cashiers, when selecting non bar-coded products in the POS screen. There is also a potential for dishonest customers to enter an item code for cheap produce, instead of entering the correct code for their higher-priced item. Store managers can flag these problems by selecting a technology-savvy employee at the self-checkout podium.

Some initiatives that responders of the independent grocers financial survey have taken for controlling their inventory shrinkage can be summarized in the following way[xviii]:

·       Some grocers are recording shrink information at department level, making department managers responsible for setting goals and implementing shrink reduction programs. Then they measure shrink performance against the established goals. There was also mention of tracking and analyzing shrink at article level.

·       Benchmarking shrink rates against others allows grocers to discover areas for improvement. Better yet if they can compare to the best-in-class companies and set aggressive targets for shrink.

·       Implementing incentive-based shrink curbing program, or putting a price on waste reduction.

·       Some responders have implemented policies in where employees must write all items that are pulled for retail floor (I suppose for disposal) and look if they are able to re-utilize some of the “unpretty” items within deli.

·       Others have invested in software to improve their forecast sales, and to adjust production sheets in deli departments accordingly.

·       Some respondents have said that their internal loss prevention department conducts audits and training.

·       There are also grocers that have established shrink committees composed of corporate and store-level employees, involving employees of all levels.

·       There is also a more vigilante approach of some companies that do product data monitoring starting at receiving point, all the way to the retail floor. Some have floor walkers and also installed cameras, for ongoing checks per aisle.

Conclusions

Shrink can be classified as known and unknown. Known shrink is the shrink that could be tracked in the inventory system, and therefore it will reduce correctly the inventory levels in the store database, allowing automated store replenishment system to work correctly.

Main sources for known shrink are products that have lost their quality and cannot be sold, or products that have been given away as donations or sampling. Assuming as true the findings of FMI and The Retail Control Group, known shrink will be around 46% of grocers’ shrink (ordering inefficiencies 14%, production planning errors 11%, product handling errors 9%, rotation errors 8%, damaged goods 4%) leaving 54% of shrink untraceable in systems.

Unknown shrink it is more pernicious as it could cause the store running out of stock, before the inventory reordering threshold is reached (if using automated replenishment systems) and causing the loss of potential sales for the stores. Unknown shrink it is normally associated with theft (internal and external), intercompany fraud and process failures, such as pricing mistakes, accounting errors, failing to scan the products at the point of sale, etc.

Employees at store level are the key factor to understand, control and reduce shrink. As happens in bars employees will mark a great difference in shrink rates through their behaviors. Retail floor employees are responsible for spillage, overpouring, under-rings, complimentary drinks, and could be also for theft.  Systems, processes and policies also play an important role, but not as critical as people do.

Plans for reducing inventory shrinkage level seems to work better when they took an holistic approach of the problem, involving employees at all levels of the organization, including loss prevention, store and department managers, retail floor employees, accountants, and IT.

References:

John Anthony. You’ve Got Shrinkage: Healthy vs. Unhealthy Shrinkage Behind Your Bar. http://barmaxx.blogspot.ca/2013/05/youve-got-shirnkage-what-every-bar.html

Paul Chapman and Simon Templar. Measuring Retail Shrinkage: Towards A Shrinkage KPI. ECR Europe 2004. https://ecr-shrink-group.com/files/Measuring-Shrinkage-White-Paper.pdf

Denise Sullivan. Common Shrinkage Percentage in Food Service. http://smallbusiness.chron.com/common-shrinkage-percentage-food-service-65032.html

Bob Graybill, President & CEO FMS Solutions. 2015 Independent Grocers Financial Survey. https://cfig.ca/wp-content/uploads/2015/06/IGFS_2015_CFIG-PRES.pdf

Bob Graybill, President & CEO FMS Solutions. 2016 Canadian Independent Grocers Financial Survey. https://cfig.ca/wp-content/uploads/2016/02/FMS-stage-Monday.pdf

Felicia Greene. How to Fight Shrinkage in a Grocery Store. http://smallbusiness.chron.com/fight-shrinkage-grocery-store-67002.html

Ray Hartjen, Director, Content Marketing & Public Relations. Retail Next. 3 Steps to Reducing Retail Shrinkage. http://retailnext.net/en/blog/3-steps-to-reducing-retail-shrinkage/

Matthew Hudson. Top Sources of Retail Shrinkage. https://www.thebalance.com/top-sources-of-retail-shrinkage-2890265

Neil Kokemuller.  What Is Retail Shrinkage?. http://smallbusiness.chron.com/retail-shrinkage-55148.html

Neil Kokemuller. What Is Supermarket Shrink? http://yourbusiness.azcentral.com/supermarket-shrink-24950.html

ALTO y CCS. Tercera radiografía de mermas: Pérdidas por Mermas en el retail en Chile  ascienden a US$521 millones. https://www.ccs.cl/prensa/2016/10/Comunicado%20Tercer%20Seminario%20de%20Mermas%20en%20el%20Retail%202017.pdf

FENALCO. Décimo quinto censo nacional de mermas y prevención de pérdidas - Mercado detallistas. www.fenalco.com.co/sites/.../MERMAS%202015_%20Final.pdf

National Retail Federation, NRF. RETAIL INVENTORY SHRINKAGE INCREASED TO $45.2 BILLION IN 2015. https://nrf.com/media/press-releases/retail-inventory-shrinkage-increased-452-billion-2015

RestaurantOwner.Com. Profit Tip of the Week. 75 Percent of All Inventory Shrinkage Happens as a Result of Theft. http://www.restaurantowner.com/public/Profit-Tip-75-Percent-of-All-Inventory-Shrinkage-Happens-as-a-Result-of-Theft.cfm

Restaurant Theft and the hard truth about losses in the food industry. http://cdn2.hubspot.net/hub/31499/file-271254222-pdf/Restaurant_Theft.pdf

Retail Council of Canada (RCC) and PWC. Securing the bottom line Canadian Retail Security Survey. https://www.pwc.com/ca/en/retail-consumer/publications/pwc-security-survey-2012-10-29-en.pdf

Where's my shrink? http://wheresmyshrink.com

---

[i] National Retail Security Survey (https://nrf.com/resources/retail-library/national-retail-security-survey-2016),

[ii] … ECR Europe and Cranfield University, School of Management

[iii] Measuring Retail Shrinkage: Towards A Shrinkage KPI (page 6)

[iv] Ray Hartjen. 3 Steps to Reducing Retail Shrinkage. http://retailnext.net/en/blog/3-steps-to-reducing-retail-shrinkage/

[v] Securing the bottom line Canadian Retail Security Survey. Page. 8

[vi] Securing the bottom line Canadian Retail Security Survey. Page 6
[vii] Revista Mermas 2016. Page 8
[viii] ALTO y CCS. Tercera radiografía de mermas.

[ix] FMS Solutions. 2016 Canadian Independent Grocers Financial Survey. Page 19. This survey was done mostly through independent grocers. 45.5% of them operate only one store, 40% has 10 or less stores, and just 5.2% has more than 31 establishments.

[x] Where’s my shrink? (http://wheresmyshrink.com/executivesummary.html)

[xi] Data taken from: http://wheresmyshrink.com/executivesummary.html Where’s my shrink? Section: Shrink by Department.

[xii] John Anthony. You’ve Got Shrinkage: Healthy vs. Unhealthy Shrinkage Behind Your Bar. (http://barmaxx.blogspot.ca/2013/05/youve-got-shirnkage-what-every-bar.html)

[xiii] I was trying to find some statistics on restaurants, which also manage perishable goods, but so far I have not succeeded, please, let me know if you have a source I can use for completing this analysis.

[xiv] FMS Solutions. 2016 Canadian Independent Grocers Financial Survey. Page 21.

[xv] Where’s My Shrink. Executive Summary. Integration and Collaboration ( http://wheresmyshrink.com/executivesummary.html)

[xvi] Where’s My Shrink. Best Practices (http://wheresmyshrink.com/bestpractices.html)

[xvii] Felicia Greene. How to Fight Shrinkage in a Grocery Store.

[xviii] Bob Graybill, 2015 and 2016 Canadian Independent Grocers Financial Survey. Quotes from retailers on tracking shrink.