Recently I attended a meeting with a CFO of a Men’s Apparel Retailer who is very supportive of proactive loss prevention programs. He has been in the retail industry over 30 years at senior level and has a demonstrated record of success in both good and bad economic times. During the meeting we had an interesting debate on whether or not a reduction in shrink improved EBITDA at retail (CGS + Margin) or at cost (CGS)*.
This issue of retail versus cost contribution to the bottom line goes to the core of a loss prevention programs ROI. Hopefully, most loss prevention professionals would argue from the retail method perspective. The challenge for us is most CFO’s (finance professionals in general) are clearly thinking from the cost method contribution. To better understand this debate the CFO stated the following to me, which helped crystallize the core issue;
“You have helped me improve my earnings at cost by reducing my inventory losses, but show me the margin pickup on that inventory. You would need to help me improve my sales to improve my bottom line at retail.” In essence he believes that shrink reduction only equates to reduced inventory losses and that inventory is owned by the retailer at cost (the landed cost of the manufactured goods).
For the record he (and every other CFO) is absolutely correct. Based on GAAP accounting rules the inventory sits on his books at cost and when it is stolen (or lost) it is relieved from his inventory at cost, otherwise called shrink. Further, when you apply a proactive, effective loss prevention program less of that inventory is stolen and the resulting shrink improvement equals an EBITDA improvement directly related to the cost of the inventory. However, here is where things start to get a little dicey. First my friend the CFO runs a “retail” company not a “cost” company and sells his inventory at a markup (retail). His success and profitability is directly related to the margin pickup based on those sales. Also contributing to the confusion is an absence of GAAP rules relating to how shrink is calculated or reported (an interesting debate for another time).
Now for the loss prevention perspective on this subject to really confuse things. Let’s think about the stolen inventory scenario and add in the concept of “inventory turns”. First a good loss prevention professional has implemented a program that has reduced the amount of inventory losses. In its simplest terms the inventory wasn’t stolen and is now sitting safely in the store waiting to be purchased (the CFO contribution). At some point (and I don’t know when) the inventory will be sold at retail (not cost), resulting in not only obtaining cash for the cost of the inventory but also the margin (markup) or the retail contribution.
As it relates to inventory turns it is best to think about it in terms of an example. Let’s say you happen to have an inventory turn rate of 2.5 (you sell through your store inventory 2.5 times per year) then it is reasonable to suggest that the inventory you protected in the store during the first 6 months of the year will indeed be sold that fiscal year thus contributing to your EBITDA at retail (COGS + Margin).
Did you capture all the margin dollars on the inventory in your stores based on your shrink reduction? Clearly the answer is NO but in the scenario above I did capture all the cost (calculated based on year end physical inventory) and at least half the margin. Further, if the retailer had a higher inventory turn rate more margin would be captured.
A loss prevention professional would also make the point that the product that is typically stolen (whether through internal or external theft) is the higher value, more desirable product which also makes it more saleable. Therefore, it stands to reason when shrink is reduced the store now retains more of this type of product for sale, resulting in improved sales. So, although I can’t say to my CFO friend with absolute accuracy that I helped improve earnings on a dollar for dollar basis at retail in a particular fiscal year, I can absolutely say that the improved shrink results did contribute to the bottom line; “all” of the cost and a “good portion” of the margin. AND if this shrink improvement continues or is maintained, the retailer will eventually capture “all” the margin on the protected inventory over multiple fiscal years.
In response to the original statement made by the CFO; YES, a good loss prevention program reduces inventory losses, improves earning at retail (cost & margin) and IMPROVES SALES!
Do you think shrink reduction can lead to actually improved sales? I am interested in your comments.
Written by Steven May, CEO of LP Innovations
Want to test this outcome? Analyze your shrink results year over year and compare that to comp sales by store for three separate categories. Group stores together where shrink increased, decreased and stayed the same. Compare each group’s comp sales performance to the overall comp store results. Please share with me your results.
* EBITDA is the accounting term Earnings Before Interest, Taxes, Depreciation and Amortization. CGS is the accounting term for Cost of Goods Sold.