Operational Level 3 - Understanding Shrinkage

"Trust in God but tie your camel."

Inventory shrinkage (or shrink) is the loss in inventory value (or, sometimes measured as potential lost sales) due to theft, breakage, and errors.  It can be expressed in dollars "our store had $15,000 in shrink this year", or as a percentage of sales "our store's shrink is 1.5% (of sales)".  The opposite of inventory shrinkage is called inventory swell, where inventory value increases due to breakage, theft, and errors—errors being the only logical explanation for inventory swell. 

Shrink is a popular topic in the retail industry and can be measured in different ways (some indices use shrink at retail value and some use cost value) so be careful you're comparing apples-to-apples when discussing shrink with peers and professionals.  Mango's Level 3 - Shrink metric is consistently reported and is used by thousands of retailers so it is a solid peer benchmark and its threshold of -0.5% of sales is tight.  Stores passing Operational Level 3 - Shrink have outstanding inventory processes, accurate staff and are not seeing significant inventory losses.

1. Inventory Shrinkage Basics

Inventory shrinkage is part of (and usually the significant component) of a store's overall theft loss. Other types of loss not involving inventory include cash theft, bookkeeping embezzlement, vendor billing theft and invoicing errors.  Our focus here is on inventory loss, but it is important to remember that your shrink metric is part of a wider loss prevention strategy in your store. Total store inventory value (a SKU's quantity-on-hand multiplied by its cost for every SKU in the store) is constantly changing.  Store inventory value is reduced when items are sold at the front counter (system quantity-on-hand is reduced when sold) and increased when purchased.  Sales and purchases are the two main ways inventory value changes in your store. Inventory value can also change outside the sales and purchasing process, this is done when we adjust a SKU's quantity-on-hand via PIP (Physical Inventory Posting) or in Inventory Maintenance.  We call the result of these adjustments shrink.  Usually, shrink is a reduction in inventory value to account for theft and breakage, but many times an adjustment can increase inventory value and when this happens it's called inventory swell.   When a SKU's quantity-on-hand is adjusted (via PIP/IMU) the change in quantity on hand is called a variance, and the dollar result (variance times the SKU's cost) is called shrink if negative (theft) and swell if positive.      Shrink and Gross Profit  Unlike inventory change involving a sale or purchase, shrink accounting does not affect cash. For example, when you sell an item for $11 that costs $5, inventory is reduced by $5 and cash increases $11 (the $6 difference between cash increase and inventory reduction is called gross profit).  When the item is replenished then inventory increases $5 and cash is reduced by $5 (inventory increase and cash reduction balance so there is no gross profit).  However, if the item is stolen and its quantity-on-hand adjusted then inventory value is reduced by $5 (-$5 shrink), but notice there is no balancing cash event; this imbalance ($5 inventory reduction, zero cash change) comes through your income statement as a gross profit loss of $5. If you don't quite follow the gross profit accounting example above then it's alright, just remember: shrink affects your store's inventory asset and gross profit, dollar for dollar.  If you can't find that 18v Cordless Drill and zero out its quantity-on-hand then your inventory value and gross profit are reduced by the cost of the drill.  If you miscount a few extra Weber grills and swell inventory then inventory and gross profit are increased (along with an increase in tax liability). If we want to measure shrink accurately then we must also be accurate with our sales and purchasing processes: add to quantity-on-hand when an item comes in the back door and subtract from quantity-on-hand when it goes out the front door. This is a very simple concept but it is not easy to implement in a busy store with 30,000 SKUs and 300,000 purchasing and sales transactions each year!

2. Mango's Level 3 - Shrink and other industry shrinkage metrics

In our industry, we run into three different ways to account for and benchmark inventory shrinkage.       A. Mango's Operational Level 3 - Shrink Metric Mango's Operational Level 3 - Shrink metric can be considered a subset of your store's overall inventory shrinkage.  Here, we are purposefully excluding many types of expected, noisy and controlled shrinkage so that we're left with a clean representation of inventory theft in your store. This way, shrink can be consistently measured and compared to peer stores.  Mango's Level 3 - Shrink metric uses the SKU's replacement cost (to represent the cash loss to replenish), and is shown as a percentage of sales. The time period measured is twelve trailing months (TTM). Mango's shrink figures represent inventory value loss and will show as negative numbers. For example, shrink of $6,000 will show as -$6,000 representing a loss of $6,000 in inventory value at replacement cost.  Keeping errors from polluting your shrink metric will be your most important task, without tight processes and variance review, you will likely measure errors instead of theft! Operational Level 3 - Shrink =  (Total Shrink - Excluded Shrink) / Sales for the trailing twelve months. Excluded shrinkage is important to monitor, but is measured separately so that a big closeout event or season-end live goods write-offs do not affect your Level 3 metric. The goal is to keep your Level 3 - Shrink metric under -0.5% of sales or better than -$6,000 (at replacement cost) annually for the typical store.  This allows for reasonable theft (a couple of items a day), cashiering, and purchasing errors. Stores experiencing more than -0.5% need to determine if their excessive shrink is a result of professional theft or is a result of loose inventory procedures. Your Operational Level 3 - Shrink metric is a unique and powerful tool and should be used to help protect your store from professional theft.       B. Financial Shrinkage  *for owners and accountants* Many stores account for shrinkage on their financial statements as a line-item as a part of the cost of goods sold (COGS) equation. Typically, a store will budget 2% (of sales) as a shrink expense, so a store with $1 million in sales will budget $20,000 (inventory reduction at cost); because shrink is part of cost-of-goods-sold, this lowers a store's budgeted gross profit margin by 2 percentage points.  Many stores do not account for shrinkage directly and simply lower their gross profit percentage projections by 2 points. For example, a store itemizing shrink at 2% would show a gross profit of 47% and then subtract 2 shrinkage points for a net gross profit margin of 45%, whereas a store not itemizing shrink would simply show 45% for a budgeted gross profit margin. Both methods will work but itemizing shrink allows you to budget and monitor financial inventory shrinkage.  Financial shrinkage is the total (including excluded shrink) net dollar effect of quantity-on-hand variances. You can see financial shrink figures in your monthly RPH report (Eagle system) and in Mango's Charts.pdf, Inventory Change Makeup page. Warning: financial shrinkage in your Eagle RPH report includes Defectives (typically Shrink Type X), for which your store is substantially reimbursed. It also may contain significant errors: if you change a bucket of chain showing 250 on hand at $75.00 to 1 on hand at $75.00 is -$18,750 shrink for example, or make adjustments from negative quantity-on-hand, or delete SKUs with quantity-on-hand values, etc. For this reason, Mango's financial shrink figures should show a better picture of a store's true overall shrinkage.      Mango Financial Shrink vs. Eagle RPH Shrink Issue Mango Financial Shrink RPH Notes Errors Removes Includes Large inventory adjustments are included in RPH. Negative QOH induced swell Removes Includes Swell from a negative value is included in RPH, which under-reports shrinkage, sometimes dramatically. Deleted SKUs or Keep Stock Changes Includes Removes Deleted SKUs are also deleted from RPH, even the SKU was deleted with inventory value. Defective Items Removes Includes Unless explicitly excluded, your RPH total includes defective shrink. If a store uses its Eagle RPH total as an income statement line item then please take the above table into account to ensure a true picture of inventory loss is represented.       C. Inventory Shrinkage - NRSS Each year, the National Retail Federation along with the University of Florida publish what is considered the loss prevention industry benchmark called the National Retail Security Survey (NRSS). In this report, inventory shrinkage is reported as a percentage of inventory loss (at retail value) divided by sales. Although the sample size for the survey is relatively small (around 100 stores) with only a handful of stores in our segment (4 hardlines stores in 2015), it is widely used to trend retail criminal behavior and retailer's attempts at combating theft. It's important to note this survey uses shrink at retail value divided by sales instead of shrink at cost divided by sales in an effort to represent potential lost sales. Therefore, the NRSS metric will be about double the cost-based metrics in your Eagle RPH and Mango's shrinkages metrics. Using retail instead of cost to measure shrink is widely used in the loss prevention industry so remember to double your store's shrink percentage when comparing to this benchmark. The table below helps explain the different types of shrinkage you might come across. Shrinkage type Metric Measures Good for  When to use it Mango Level 3 - Shrink Adjusted shrink at replacement cost divided by sales Peer and store benchmarking, shrink control Store operations, retailer group, talking with other Mango stores Financial Shrinkage - Eagle RPH Shrink at replacement cost (typically) Financial tool Accountant Financial Shrinkage - Mango Shrink at replacement cost Financial tool Accountant Inventory Shrinkage - NRSS Shrink at retail value  divided by sales Industry benchmark Loss prevention professional, other non-mango stores

3. Errors and Shrink - keeping errors out of your shrink metric

Maintaining a clean shrink metric will be one of your biggest challenges. Many stores not accustomed to monitoring shrink tend to use Inventory Maintenance or PIP to correct purchasing and point of sale mistakes, keep in mind, it only takes a few of these corrections to render your shrink metric meaningless: Changing a bucket of chain costing $75.00 from 250 on hand to 1 on hand creates $18,675.00 in shrink; three times more than the typical store's annual Level 3 - Shrink budget. Adding to quantity-on-hand through inventory maintenance rather than creating a purchase order will create inventory swell and obscure true shrink in your store. Using PIP/Inventory Maintenance instead of a Credit PO to reduce inventory when returning merchandise to vendors inflates shrink and over-reports purchases. Correcting point-of-sale or purchasing errors in PIP will obscure your shrink metric for large errors and attribute sales and returns to the incorrect SKUs which impacts order point calculation, returns validation and sales analysis.  Clearly, we must have a routine process to monitor and fix large shrink to ensure variances are due to theft and breakage rather than large corrections to other processes. In Mango, this process is called Variance Research and is performed monthly as your store's inventory coordinator processes its Shrink Report.

4. Prerequisites - start with good processes and inventory accuracy

If your store has been following along with Mango's Operational Level steps then the processes and settings below should be old hat for your store. If your store has not completed its Operational Level 1 - IRA Checklist or has not passed Operational Level 2 - Dollar Accuracy yet, then please make sure you've taken the training for these levels.  Prerequisite checklist: Shrink viewer, Replacement Cost Variance column (Operational Level 0 - Completion PIP Overview Video). Inventory Coordinator position filled. Delete Control (follow Mango's Delete Procedures, Eagle Settings Row 1). Force all variances through PIP (Eagle Settings Row 2). Operational Level 1 - IRA passed or checklist completed. Operational Level 2 - Dollar Accuracy passed or checklist completed. Weekly - Shoots Outs Monthly - Process Mango's Count Sheets

Print the Level 3 Checklist here!
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