As explained within this whitepaper on loss prevention, shrinkage is the reduction in value of stock or inventory (source). More specifically, the level of shrink within any given business is defined as the difference between the recorded or book value and the actual or physical value of stock on hand (source). As for common causes that drive related variances between book and physical values of inventory, there are numerous factors and they typically revolve around the follow key areas:
So why is shrinkage a key area of concern, particularly for loss prevention professionals in retail? The answer becomes quite clear when recognising that stock, or inventory, is typically the largest current asset for retailers (source). A recent article published by iTest Cash highlights the importance of shrinkage within Loss Prevention. Titled ‘5 Ways to Improve Retail Loss Prevention’, 4 of the 5 top tips given within the article focus on how to combat inventory shrinkage driven specifically by external and internal theft (source).
Let’s take a quick look at how shrinkage within inventory impacts year-end financial reporting and performance. As noted above, shrinkage within inventory is the difference between the book and physical value of stock on hand. When noting the common causes of shrink, namely theft, it follows that within any specific reporting period the actual physical value of inventory will therefore tend to fall below the recorded or book value. This causes a reduction in the stated asset value for inventory, which directly impacts upon the balance sheet and reduces total net assets.
Noteworthy is that a reduction in asset value or impairment under Generally Accepted Accounting Principles (GAAP), for example reducing the book value of inventory or stock through shrinkage, requires an equivalent write-down through the profit and loss account. But how does this work?
Gross profit is the difference between revenue and cost of sales (source); the latter equates to the cost of goods sold (COGS) within retail:
Gross Profit = Revenue - COGS
Furthermore, the Cost of Goods Sold is calculated using the following expression (source):
COGS = beginning inventory (opening stock) + purchases – ending inventory (closing stock)
Shrinkage will therefore reduce the value of ‘ending inventory’, or closing stock. The effect of this write down, so as to reflect the actual level of stock on hand, produces an immediate impact upon the profit and loss account through increasing COGS, via subtracting what has proven to be a smaller figure for closing stock than that expected from book valuations. As per the above equation, increasing COGS in turn reduces the overall Gross Profit that a business makes.
Within grocery, supermarket gross margins are typically around 5%, which is somewhat of a knife edge. Therefore, any further reduction to them can rapidly tip a business operating on these slim margins into a loss making position, as related impairments wash down to the bottom line. In addition, any reduction to the bottom line, even if the business remains profitable, still delivers immediate implications for the owners/shareholders of the business along with those of the senior management team, particularly if the latter are incentivised through shares or profitability rewards.
To explore the last point a little further, company value is driven by projections that estimate the level of free cash flows that it will generate in the future. Free cash flows are calculated using the following equation (Vernimmen et al (2014)):
Gross operating income (EBITDA)
– Normalised tax on operating income
– Change in working capital
– Capital expenditure
= Free cash flow from the firm
EBITDA, or earnings before interest, tax, depreciation and amortisation provides a measure of profitability (source). Therefore, any factor that impacts upon profitability, for example shrinkage as noted through the free cash flow calculation above, has the propensity to destroy corporate value. This also illuminates the need for retail companies to demonstrate tight controls over shrinkage, otherwise a failure to do so will undermine their ability to deliver reliable levels of future free cash flows. The latter, as we have shown, remains the key determinant that underpins shareholder value. As an aside, it also raises the prominence of loss prevention and asset protection as a critical operational area within retail.
In addition to the obvious loss of profit that shrinkage produces, it can also induce a number of vicious circles, which can prove extremely difficult to break. Furthermore, these vicious circles have the propensity to combine and instil a feedback path that has the potential to fuel rapid decline, if left unchecked.
For example, stock monitoring systems may indicate that particular product lines are in stock, when in actuality as a result of theft, they are not. However, since the system is showing stock, this may prevent purchasing from replenishing respective lines. In short, we have a theft induced supply chain failure that will remain broken until some form of manual intervention is made to correct the discrepancy. We therefore not only have to consider the lost profit arising from shrinkage caused by theft, but also the potential risk of theft induced supply chain failures. As for the cost of supply chain disruptions to business, Reuters reported that these may have caused up to $4 trillion in lost revenues in 2020 (source), citing a range of factors, including Covid-19. The current Covid pandemic has provided demonstrable proof of how critical supply chains are to securing revenue, it has also illuminated how they underpin the survival of firms (source). To summarise, you cannot sell what you do not have nor cannot supply. Therefore stressed or failing supply chains deliver an instant hit to revenue through an inability to capture it.
The double whammy that shrinkage may throw at cash flow, through simultaneously reducing revenue and increasing COGS, can also manufacture a third, which those operating on thin margins are particularly exposed to. If the related drop in profit precipitates a loss making scenario, cash flows may become negative and, depending upon the level of reserves on hand, impinge the ability of the firm to purchase stock (source). The latter can quite quickly lead to a complete supply chain failure and deliver an irrecoverable situation.
As noted within this article, current loss prevention strategies focus on using a mix of CCTV and human capital. For example, to deter potential thieves by acknowledging them when they enter into stores and by recording their actions once inside. Research has also shown that internal theft from employees can account for around 34.5% of fraud incidents (source). Therefore, regular stock checks and tracking inventory on hand against that on book also provides an active deterrent, as it clearly communicates to workers that related lines are continually being tracked and monitored for discrepancies.
There are also software solutions available that can link up to and interrogate EPOS systems, then analyse the results. This is done through identifying unusual activity on lines, for example a number of sales followed by none may indicate an underlying theft issue wherein the system is showing stock but there is none available on hand to buy in a specific store. Related data can then be used to trigger manual interventions, so as to further investigate the root cause and correct inventory levels pending respective outcomes. However, to a large extent this is trying to correct the situation by shutting the door once the horse has bolted. Ideally, businesses need technology systems that provide alerts before these events take place.
Humans cannot be everywhere, firstly they are too costly and secondly, as research has shown, they have a poor perception of risk. As noted with this ‘article’, humans have pretty much a unique ability to ‘see’ and then communicate what they have ‘observed’ to others. However, they also have somewhat flawed and unreliable decision making characteristics that are not necessarily desirable, particularly when relying upon them for raising alerts. However, most retail establishments have an incredible amount of ceiling-mounted electronic eyes through the investment that they have made in CCTV. Yet, and ironically so when in the age of big data, they do very little with the huge amount of data that these systems capture on a daily basis.
By using software to correctly interrogate and interpret the data captured by CCTV, we may use the electronic eyes that these systems provide to replace the current reliance on human reporting. Data outputs from CCTV may also be used to guide the actions of humans, so that they can deliver appropriate interventions when needed. Noteworthy is that computers are good at things that humans are not, in particular repetitive tasks, parallel processing, data manipulation and following strict rules. However, humans excel in areas that technology struggles, for example critical thinking and strategy formulation. Correct integration of IT and human capital may therefore use the strengths of IT to counter the weaknesses of humans, and vice versa. Now consider for a moment the level of operational efficiency that this type of system has the potential to deliver.
Recent developments in software, compute and AI now provide numerous opportunities within retail to derive new inimitable sources of sustainable competitive advantage. Consider the field of computer vision, which uses artificial intelligence to turn the data captured by CCTV into meaningful information. This potentially holds the key to delivering wholesale improvements within operational efficiency through giving humans what they need to make efficient and correct decisions (source).
Let’s view the potential of managing customer experience and shrinkage through the lens of computer vision. AI models now have the capability to spot, identify and report suspicious behaviour, through analysing loiter times along with the movements of specific individuals. Consider someone hanging around in a shopping aisle, are they looking for an item they cannot find or are they waiting for the coast to be clear before they attempt to steal a number of items?
By analysing this data, which CCTV already captures, and generating notifications IT may be blended with human capital to deliver a system that combines the strengths of both. By responding to notifications, staff can approach individuals identified as displaying unusual behaviour. If it proves to be a potential customer who simply cannot find what they are looking for, staff can guide them to where they need to be and in doing so facilitate sales, which as an aside also improves overall customer experience. However, if the individual was a potential shoplifter, when approached, experience suggests that they will attempt to make a rapid exit from the store. An outcome that reduces shrinkage through removing or limiting the opportunities for theft to occur.
If you are looking to release this level of latent value from your existing CCTV network and to do so whilst eliminating the need for infrastructure upheaval, why not get in touch? To learn more or discuss how we may help you improve loss prevention and drive operational efficiency within your organisation Contact us now.