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Redefining Inventory Shrinkage—Four New Buckets of Loss

What does inventory shrinkage mean to you?

For most companies, the answer to this question would be obvious: a significant problem, and usually something that is getting worse, not better, despite unprecedented developments in technological solutions and growing loss prevention budgets.

Some retail companies across the globe are gleaming examples of how to manage inventory shrinkage, consistently attaining extremely low levels of loss. The rest, however—and surveys from the United States and Europe support this view—continue to lose billions of dollars or euros a year through the rather euphemistically termed problem of “shrinkage.”

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When ECR Europe established its Shrinkage Working Group in 1999, its first task was to agree what it meant by the term shrinkage—what did it include and what did it exclude? What seemed like a deceptively simple task proved problematic and rather controversial. Definitions varied enormously among the European retailers and manufacturers present at the meeting.

Does it include known and unknown loss? Should cash be considered part of inventory shrinkage, or does it only relate to products? What about losses suffered in the supply chain? Should it be valued at retail or cost prices?

Eventually, the group agreed upon a compromise and concluded that shrinkage involved losses suffered by organizations as a consequence of the following criteria:

  • Process Failures: Losses due to operating procedures within an organization.
  • Internal Theft: The unauthorized taking of goods or cash by staff employed by the company.
  • External Theft: The unauthorized taking of goods or cash by customers or other non-company employees.
  • Inter-company Fraud: Losses due to suppliers or their agents deliberately delivering fewer goods than retailers are charged for, or retailers deliberately returning fewer goods to manufacturers or suppliers than agreed or specified.

It was also agreed that inventory shrinkage included known and unknown losses and that costs should be quoted at retail prices.

While this was in no way a perfect definition, it enabled the working group to move forward in terms of carrying out research and developing new thinking on how to tackle the problem. Indeed, some of the case studies using the ECR Europe shrinkage road map have proven it to be a resilient and valuable tool in reducing shrinkage.

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Part of the success of this work undoubtedly came from the applicability and simplicity of the original shrinkage definition, often referred to as the four buckets of shrinkage. However, it can be argued that it oversimplifies a complex and multifaceted problem. Indeed, it requires the user to delve much deeper into each “bucket” before any real notion of what constitutes the causes of these types of shrinkage becomes apparent.

It also tends to overemphasize the problem of malicious shrinkage—those types of inventory shrinkage purposefully carried out by individuals or organizations intent upon profiting from loopholes in flawed processes and procedures. While most survey work suggests that malicious forms of shrinkage do indeed account for a significant proportion of stock loss, the current definition, by not detailing the myriad of underlying causes, suggests that it constitutes the majority of the problem.

Redefining Shrinkage—Four New Buckets of LossIn 2006, the ECR Europe Shrinkage Working Group proposed an open debate on what the term shrinkage should include and exclude. At that time, the group put forward their vision of what it might be.

The ECR Europe Definition and Typology of Shrinkage

The starting point is a clear definition of shrinkage. The ECR Europe white paper, “Measuring Retail Shrinkage: Towards a Shrinkage KPI,” arguably offers one of the most concise and workable understandings available. This report suggests that shrinkage is “intended sales income that was not and cannot be realized.” In other words, a company did not receive the income from the goods it has purchased that it originally expected.

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Known versus Unknown Loss

An important point is whether both known and unknown losses should be included in the typology. Some argue that if losses are known, then they are not part of the inventory shrinkage equation. For example, food that goes beyond its sell-by date is written off and duly recorded.

Likewise, stock that has been reduced to clear typically involves calculating and recording the reduction in profit.

For both of these examples, some companies would argue that because a record has been made, they should no longer be considered a part of the shrinkage pie; namely “We know where it has gone, why, and what it has cost us.” For others, simply because a company can record the loss does not mean that it has solved the problem.

What if members of staff are purposefully discounting stock early for their family and friends? What if staff members hide stock to ensure it goes beyond its sell-by date, thereby making it available to themselves at lower or no cost? Might excessive waste in a store be symptomatic of a management team that has lost grip or indicate a supply chain that is malfunctioning?

ECR Europe’s view is that both known and unknown losses should be included in the typology because both can be reduced and both can be intimately related. Offering store managers an option to prioritize unknown shrinkage less than known loss is potentially a costly strategy to adopt. So the starting point for the revised ECR shrinkage typology is to include both known and unknown loss as part of shrinkage.

Retail versus Cost

Whether the costs of inventory shrinkage should be expressed at retail or cost price is another key part of the debate. Those in favor of the former argue that expressing losses at retail prices ensures that the problem of shrinkage is taken more seriously within the company and reflects the true cost of doing business. Some companies with this view have even renamed their loss prevention departments “profit protection.”

For example, simply considering items at cost can exclude all the additional or consequential costs of doing business associated with a particular product, such as transportation, marketing, and the salaries of the loss prevention team. Others argue that the retail price is much too crude a figure and does not take into account the profit margin on a product and can over-inflate the true cost of the problem.

Given these arguments, the view of ECR Europe is that shrinkage should, for the most part, be calculated at retail prices, but it also recognizes that there may be times, particularly when discussing the problem internally, that it should also be thought of at cost price. In addition, the issue of profit margin should not be lost, and there may be times when this needs to be part of the shrinkage equation.

A New Typology of Shrinkage

Proposed here is a new typology for thinking about inventory shrinkage within retail businesses. Its starting point is recognizing that shrinkage is part of a broader concept called total loss, which is made up of two elements: shrinkage and cash loss.

While focusing at this time on these two elements, there may be other elements to consider. For instance, there is a growing debate about the issue of the cost of safety within retailing, while others point to the problems of counterfeiting and the black and gray markets.

Focusing first on the typology as it relates to shrinkage, four new headings under which a series of causes can be grouped have been developed:

  • Physical loss
  • Value variance
  • Process variance
  • Unknown loss

Key to these four areas of inventory shrinkage is that they are all capable of potentially being recorded by the business; the last one by a simple process of deduction, meaning if the other three are known, the remaining losses must be unknown. Outlined below are the constituent parts of each component, together with some examples to elaborate what they include.Redefining Shrinkage—Four New Buckets of Loss

Physical Loss

This category of inventory shrinkage refers to the actual loss of goods within the business via the following factors.

Damage—Goods that have been damaged during the process of delivery, storage, and merchandising, which means they cannot be sold for any value. Examples would include a pallet of sugar that is left outside in bad weather, cartons of washing powder crushed by a forklift truck, pears or bananas that have been badly bruised, or bottles of wine that have been smashed.

Wastage/Spoilage—Products that have reached their expiration date or gone beyond agreed temperature parameters and are no longer safe to sell to consumers or staff. Examples would include fresh meat and vegetables, fish, ready-made meals, frozen foods, dairy produce, bread, and flowers.

Internal Theft—Known incidents of theft by staff that have been recorded by the company. Examples would include items recovered from members of staff that cannot be resold, empty bottles of spirits found in the staff toilets or locker areas, torn packaging without contents found in backroom areas, or detected incidents of non-scanning of items or the use of refunds or voiding of items at the register for friends or family members.

External Theft—Known incidents of theft by members of the public, including contract staff, that have been recorded by the company. Examples would include items recovered from shop thieves that cannot be resold, empty bottles of product found in customer toilets, or torn packaging without contents found on the shop floor or changing areas.

Value Variance

This category of inventory shrinkage covers those causes of loss that refer to changes in the value of the product that mean that the original envisioned return is not realized.

Reductions—The original price of a product is reduced in order that the product is more likely to be sold, such as goods about to reach their sell-by date, have been partially damaged, or have been discontinued. Examples would include ready-made meals close to their expiration date, end-of-line clothing, and partially damaged boxes of washing powder.

Pricing—Losses caused by errors in the way in which goods are priced and sold in the business. Examples would include goods coded incorrectly on the store inventory system, staff incorrectly pricing product in the back room areas or on the shelf, a mismatch between agreed and actual selling price, or a member of staff entering the wrong price at the register.

Missed Claims—A failure to claim for refunds or rebates on items returned to a supplier. An example would include newspapers and magazines not sent back within an agreed time to the distributor.

Process Variance

This category contains four items that relate to processes that impact upon the movement of goods and information through the business and the way in which they are monitored and accounted for.

In Auditing—Errors, such as stock being incorrectly counted, in the audit process during annual stock checks and periodic cycle counts. An example would be the incorrect counting of packs of batteries that are located at multiple locations within a store or distribution center.

At the Checkout—Errors occurring at the point of sale that lead to a discrepancy in the store book stock. Examples would include a checkout operator entering the wrong code for a product; entering a single code for multiple varieties of a product, such as canned pet food; not scanning free products as part of a promotion, such as buy-one, get-one-free offers; a register operator forgetting to scan goods, such as items at the bottom of a cart or those removed from keepers/safer cases; or a cashier using a “dump” code to sell items that are not easily scanned or identified.

Product Movement—Errors generated by the movement of goods within the business. Key areas of vulnerability would include mistakes made in the receiving of goods, the transfer of goods, and returns or refunds. Examples would include shortages in deliveries to a store directly from a manufacturer or a distribution center, transfers to others stores incorrectly recorded, products for use within the store not recorded properly, or goods returned to the store by the consumer that are not entered back onto the system or cannot be returned to the supplier.

Data Errors—Errors in the recording of stock on company systems. Examples would include retail buyers or suppliers incorrectly inputting item set up details that lead to stores receiving fewer items than identified on the system; items that are incorrectly associated with the book stock database, Redefining Shrinkage—Four New Buckets of Losssuch as promotional items not linked with items in the main assortment; and products registered on the store inventory that have not been delivered.

Unknown Loss

By their nature, the causes of unknown loss are not apparent to an organization, but they can be characterized as either loss of physical product or the loss of value that the organization might have received for the sale of the goods.

There is little value in trying to guess what may be the causes of unknown loss. The important aspect of this type of inventory shrinkage is to develop ways in which the amount of unknown losses can be minimized and/or converted into known losses.

Cash Loss

The second category under the heading of total loss is cash loss, which contains four areas relating to the receipt, movement, storage, and processing of cash within the business.

Internal Theft—Cash that is stolen by employees. This could take many forms including the direct theft of cash from the register or cash office, exploitation of the refund/reduced price system, abuse of a loyalty card system, and theft of retail vouchers.

External Theft—Cash that is stolen by members of the public. This can take the form of overt physical intimidation and the threat of violence at the front end or cash office, such as register snatches or armed robbery, or more subtly through the exploitation of the company’s returns policy, such as returning goods that have been previously stolen.

Error—Non-malicious mistakes made in the counting, auditing, and transfer of cash within the business.

Unknown Loss—The loss of cash that cannot be accounted for through internal and external theft or errors in auditing or transfer of cash.

Impacts of this New Typology

There is undoubtedly a simple elegance to the original definition of shrinkage that had been used by ECR Europe in the late 1990s and early 2000s; it was easy for those new to inventory shrinkage to grasp the broad contours of the problem. However, it required a secondary level of analysis to begin to arrive at the key causes of shrinkage for which solutions could begin to be developed. While the ECR Europe Shrinkage Working Group is not suggesting that this alternative model is suitable for all retail organizations, it will hopefully encourage organizations to reflect upon three things:

  • First, recognize that inventory shrinkage is more than just the external theft of stock. It is a complex and interwoven problem that transcends company and departmental boundaries and requires a more multifaceted and coordinated approach to its successful management.
  • Second, such a typology enables detailed data sets to be created that allow more accurate benchmarking across the industry. By adding a greater degree of granularity to the measurement of shrinkage, and offering a more concrete definition of what each component contains, retailers should be able to compare and contrast their data more reliably.
  • Third, the proposed typology should enable retailers to more readily identify the real causes of shrinkage within their organizations and subsequently develop solutions to respond to them. To date, much solution selection has been premised upon guesswork and presumption, self-interest, and Redefining Shrinkage—Four New Buckets of Losslongevity.

It is also felt that the greater degree of specificity in the recording of inventory shrinkage that the proposed typology requires could also be translated into increased confidence at the store level. That is, showing a genuine appreciation of the challenges store staff face could, in turn, increase compliance with requests from the loss prevention department to tackle the problem more assiduously or introduce new stock-loss programs.

It is also felt that these categories could be easily adapted to meet the varying challenges faced in different organizational settings and locations, such as stores, distribution centers, or manufacturer production plants.

Finally, by creating a much more inclusive and holistic typology of shrinkage, which prioritizes the importance of measuring the problem in detail and highlights the myriad non-malicious causes of loss, it raises important issues about what the necessary skills and competencies of those tasked to reduce and manage inventory shrinkage within the retail environment need to be.

In the past, much of the loss prevention world was dominated by a focus on external theft characterized by a reactive security-oriented approach. What this newer typology does is emphasize the varied components that make up inventory shrinkage, the majority of which have little or nothing to do with catching thieves. This requires loss prevention professionals to fully understand the retail environment and develop solutions that may be much more about effective and robust retail procedures than they are about tagging goods and arresting shoplifters.

This article was originally published in 2006 and was updated November 10, 2016. 

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