Beyond the Usual Inventory Shrinkage Definition: Total Retail Loss

There is no agreed-upon inventory shrinkage definition, but the total retail loss typology may help.

retail loss, inventory shrinkage definition

There is little consensus on what constitutes “loss” within the retail world nor how it should be measured. The terms “shrinkage” and “shortage” have been loosely applied to encapsulate some of the areas that generate loss, but they are not terms enjoying a clear and agreed-upon definition across the sector. Equally, measuring losses at retail prices is probably the most common method adopted to capture the scale of the problem, but again, it is not without its critics.

While the term “shrinkage” has been used for probably the last hundred years of retailing, there continues to be wide variance on what is included and excluded when this term is used, with some retailers using an inventory shrinkage definition that describes only those losses captured through identified discrepancies in inventory counts, while others add in additional types of loss recognized through other forms of recording practices.

The inclusion or exclusion of losses associated with the retailing of items such as food adds further ambiguity. Should products that have been recorded as going out of date be included in an inventory shrinkage definition? What about those items that have been reduced in price to encourage a sale due to oversupply or a change in consumer demand, or products that have been damaged in the supply chain?

Even more variability exists when the losses associated with what are sometimes called “process failures” are considered. Should those losses that are generated by mistakes within the business be included in the overall shrinkage figure, such as product set-up errors, non-scanning at the till by members of staff, the reduction in sales caused by products being out of stock, or shelves not being replenished accurately?

In addition, there is increasingly a tranche of losses that can be associated with discrete and purposeful decisions made by retail organizations as part of pledges and guarantees to consumers, such as price matching, compensation for poor service, and guarantees of product availability. Should these be included in a definition of retail loss? Finally, the growing breadth and complexity of the retail landscape is putting stress on the applicability of  traditional inventory shrinkage definitions. How might losses associated with online and so-called omni-channel retailing be measured and understood?

Researching Total Retail Loss

It is within this context that both RILA and the ECR Community Shrinkage and On-shelf Availability Group decided to support a research project not only to explore how retailers currently view the problem of loss, but also to work toward developing a new definition and typology that might better capture how losses are impacting their businesses. The research utilized a number of different methodologies—an extensive literature review; a questionnaire to a group of large European retailers; 100 face-to-face interviews with senior directors in ten of the largest retailers in the United States, representing 27 percent of the total retail market; and a series of workshops and focus groups with loss prevention representatives from a range of European retailers and manufacturers.

Limitations of the “Inventory Shrinkage Definition”

Consensus is actually very hard to find on what the term “shrinkage” means and what should be included and excluded when it is being calculated. Some regard an inventory shrinkage definition as a catchall for a wide range of losses suffered by retailers, including both crime-related events, such as staff and customer theft, and errors incurred as part of the process of retailing, such as incorrect pricing, changes in price, damaged products, and food items going out of date, while others only seem to use it to refer to variance in the value of expected and actual inventory. The review of the existing literature on how shrinkage is defined and understood can be summarized as follows:

  • There is no agreed-upon inventory shrinkage definition.
  • Most published estimates of shrinkage are based primarily on measures of unknown loss where the root cause is unidentifiable.
  • The focus of most definitions of shrinkage typically relate only to the loss of merchandise.
  • In most surveys the measurement of shrinkage is requested at store level—the retail supply chain rarely features.
  • There is relatively little consensus on how shrinkage should be measured although most surveys collect information at retail prices.
  • Expressing shrinkage as a percentage of total sales is the most commonly used method to illustrate the scale of the problem.
  • The categorization of shrinkage is confusing and often relies on catchall phrases that lack firm definitions or seem incapable of capturing the various types of risks associated with an increasingly complex retail environment.
  • The terms “retail crime” and “shrinkage” are sometimes used interchangeably with the former including the costs of responding to losses, while the latter may or may not be based on known and unknown losses.

Developing Total Retail Loss

Among the difficulties of benchmarking any retail business using the indicator of shrinkage are the problems associated with understanding what categories of retail loss are included or excluded, particularly under the rather catchall terms of administrative error/process failures. Some companies taking part in this research adopted very strict criteria—shrinkage is only the value of their unknown losses based on the difference between expected and actual stock number/values, with anything else being regarded as known and therefore not included in the calculation. Other companies were much more inclusive, incorporating a number of other types of loss ranging from damages, wastage, spoilage, and price markdowns to the costs of burglaries, robberies, and even predicted losses from organized retail crime (ORC).

Some of the respondents, however, were increasingly concerned about the continuing applicability of the term “shrinkage” in a modern retail context. One respondent said, “Listen, I think the word has become obsolete because loss prevention has evolved into asset protection, and now it’s asset profit and protection, and God knows where it’s going to be three years from now. The names have changed, the roles have changed, the roles have gotten significantly wider, but we still hang on to this word that we’ve been using that describes something that we did a hundred years ago.”

Part of this definitional variance seemed to be based on how respondents interpreted the difference between what could be regarded as a loss compared with a cost, the latter being viewed as everyday planned and necessary expenditure in order for the business to achieve its goal of making a profit. However, a considerable number of respondents made a key distinction between the value of the outcome and how this differentiated costs from losses: “Costs—they bring value to the business, they are incurred because there is a perceived positive purpose in having them, they are part of the revenue generation process, and without them profits would be negatively impacted. Losses are things, which if they didn’t happen there would be no negative impact upon profitability; they do not offer any real value to the business and simply act as a drain on profitability.”

It was also instructive to hear how some respondents adopted a process of normalizing what some considered to be losses into costs: “We plan a lot of those costs [possible types of losses], so when we’re looking at it from a planning perspective, we have that built in. Anything that we can account for and process and know what it is, we take more so as a cost rather than a loss, when we’re defining it.”

Another respondent talked about how the planning and budgeting process enabled many losses to be redefined as costs: “If it goes above budget, then it becomes a loss; otherwise, it’s a cost.” Interestingly, one respondent reflected on the dangers of this approach of “hard baking” losses into costs: “People always viewed [workers’ compensation] as a cost of doing business, but I think we’ve been incredibly innovative, and we’ve shown that, no, you can really change the way we do things. … When you view it as a cost to doing business, that’s when you lose innovation and when you lose really looking at how do you prevent [it]. We’ve done some incredibly strategic things around here in that area. In particular, I can just remember the conversations when we were doing it—it was like, a lot of people thought don’t mess with that. That’s just going to be what it’s going to be; it’s just going to gradually increase every year.”

This is a good example of how labeling something as a cost can begin to drive particular behaviors. And this can be particularly the case when a budget or target is set for a given cost/loss. It is also worth noting that many respondents adopted a much more accepting tone when types of expenditure were described as the cost of doing business—a reassuringly benign phrase, which seemed to absolve them of taking responsibility for the consequences: “We try and convert as much of [these losses] to costs. It’s then not on my agenda anymore—I deal with shrink.”

Defining Total Retail Loss

From the interviews with senior US retail executives and feedback from the roundtables held in Europe, the following definitions of costs and losses were developed:

  • Costs—expenditure on activities and investments that are considered to make some form of recognizable contribution to generating current or future retail income.
  • Losses—events and outcomes that negatively impact retail profitability and make no positive, identifiable, and intrinsic contribution to generating income.

Using these definitions, various types of events and activities can begin to be categorized accordingly. For example, incidents of customer theft can clearly be seen to be a loss—the event and outcome play no intrinsic role in generating retail profits. It makes no identifiable contribution whatsoever, and were it not to happen, the business would only benefit. Alternatively, incidents of customer compensation, such as providing a disgruntled shopper with a discounted price, can be seen to be a cost. In this case, the business is incurring the cost because it believes that by compensating the aggrieved consumer they are more likely to shop with them again in the future. The policy of compensating is regarded as an investment in future profit generation and is therefore categorized as a cost and not a loss. (That’s not to say it shouldn’t be recorded and monitored for review.)

Another example of a potential loss is workers’ compensation, where a retailer will cover the legal, medical, and other costs associated with an accident at work, such as a member of staff being hurt falling off a ladder. There is no intrinsic value to the business of a member of staff incurring an injury while at work. If it had not happened, the business could only benefit through not having to pay out for the consequences of the event. It is therefore a loss, and while a number of respondents to this research argued that it is a predictable and recognizable problem that can and is budgeted for, it still remains an event that ideally the retailer would prefer not to happen as it impacts negatively on overall profitability.

In contrast, expenditure on, for instance, loss prevention activities and approaches, such as employing security guards or installing tagging systems, can be seen as a cost. The retail organization has committed to this expenditure because it feels there will be some form of payback from the investment—hopefully lower or acceptable levels of loss that in turn will boost profits.

What these examples focus on is not whether an activity or event can be controlled or not, or where the incurred cost was planned or unplanned, but on its fundamental role in generating current or future retail income. When a clearly identifiable link can be made between an activity and the generation of retail income, then it should be regarded as a cost, whereas all those activities and events where no link can be found should be viewed as losses.

Check out the full article, “Beyond Shrinkage: Introducing Total Retail Loss,” to learn more about categorizing total retail loss and how the typology may help LP make good business choices. The original article was published in 2016; this excerpt was updated July 26, 2017.

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