In what might be thought of as “the growth of shrink,” American retailers are pointing to shoplifting, organized retail crime and employee theft as significant drags on their profitability. The big-box discounter Target, for one, said its profits could take a $500 million hit from shrink this year alone. Notably, in a recent CNBC appearance, the National Retail Federation’s CEO struck a Churchillian tone, calling for a war against shrink “on the docks, on the ships, and on the railcars.”

Urban areas, where consumers routinely witness individuals and groups steal inventory in broad daylight, are especially feeling the pressure of shrink. At a CVS in downtown Boston a few weeks ago, I watched a man kneel in the aisle, sweep the contents of a lower shelf into a suitcase, and stroll out to the street. On social media, meanwhile, videos of jewelry store smash-and-grabs and other brazen thefts are commonplace. In one recent clip, a man at a Walgreens whips out a blowtorch, melts open several plastic lockboxes and empties them into a bag. He seems nonchalant about the bystanders recording him on their phones.

Gone are the days when “assume 3% shrink” was a viable approach to this risk factor. Appraisers need to redouble their efforts to ferret out disparities between the inventory subledger and the physical count of goods. In addition to shoplifting and employee theft, the list of potential causes includes innocent cashier mistakes, misplaced merchandise, accidental product damage and vendor fraud. The latter can be particularly damaging. Just last month, an Amazon warehouse manager was sentenced for stealing more than $9.4 million from the company, in concert with seven other people. The U.S. Justice Department pointed to a “brazen fraud scheme involving fake vendors and fictitious invoices.”

Below are some potential questions to explore in the effort to uncover shrink.

How is the retailer fighting back?
The country’s largest retailers tend to have more anti-shrink weapons at their disposal. Their corporate loss-prevention experts might use pattern analysis to identify systemic problems at specific stores and DCs. In response, the chain could hire more security guards or roll out AI-driven surveillance cameras. Larger retail borrowers are also more likely to employ sophisticated systems for inventory tracking and management, which can help stop shrink.

On the other hand, smaller and midsize retailers tend to lack these resources. They might also suffer from a lack of inventory transparency. For example, many smaller operators run physical counts on an annual basis only. As a result, they are often unable to compare the number of in-possession sweaters, say, with the totals on the books. This can lead to large book-to-physical (aka shrink) adjustments at yearend. Appraisers need to look carefully at how these types of companies track and manage their inventory. They should ask themselves the following questions:

• Given the employment shortage, has the smaller or midsized retailer fallen woefully behind on its regularly scheduled counts of physical goods within individual stores and distribution centers?
• How frequently does the company conduct chainwide physical counts of inventory?
• How accurate are the retailer’s assessments of shrink likely to be given its overall operational efficiency (or lack thereof) and approach to inventory data and systems?

What are the costs of the borrower’s anti-shrink efforts?
The appraisal team should seek to quantify, not only the damage from shrink, but also any existing or potential costs associated with the battle against it. Possible unintended costs could include:

• Millions of dollars in spending on new personnel, monitoring and surveillance equipment—expenditures that, ultimately, must be passed onto consumers, potentially undermining competitiveness on price;
• significant harm to sales, traffic and loyalty as a result of having employed too many lockboxes and locked counters, which can drive frustrated customers right into the arms of Amazon; and
• the potential need to hire even more security and personnel during store-closing sales in the event of a liquidation.

On this last point, both shoplifting and employee theft can increase during liquidations. Chalk it up to human nature. As stores begin to sell “to the bare walls,” there are those who inevitably will interpret the visual signs of dissolution as a license to steal. Employees, believing that they are both working harder and about to receive their final paychecks, also might be more likely to rationalize theft (“They’re not really paying me what I’m owed, so I’ll go ahead and take this.”).

It is important to note that without a commensurate investment in security, shrink is likely to get worse under GOB conditions. As a result, the NOLV needs to account for this potential cost.

How hard is the inventory to steal?
Vulnerability of inventory to shrink is another factor. Shoplifting and employee theft are much more likely if the retailer’s stores are packed with small, easy-to-carry, relatively high-value items. By contrast, would-be thieves have a much heavier lift—no pun intended—if the SKU in question is a sofa or king-sized mattress.

This is not to suggest that large items are always impervious to shrink. At one recent going-out-of-business sale, consultants reported that two mattresses were stolen out of a store on the same day. It is possible that shrink will become a bigger problem across additional retail categories as lax penalties and abundant social media coverage combine to “normalize” brazen theft.

What are the broader supply chain trends?
Not only are thieves continuing to steal from stores, they also are targeting warehouses and distribution centers, along with the trucks and trains that transport goods. In addition to shuttering a Portland, Oregon, store due to shoplifting, Nike reportedly experienced a rash of thefts in Memphis, Tennessee, including $60,000 worth of shoes from five train cars, 10 to 20 cases of expensive shoes from a warehouse, and $800,000 in merchandise from 20 trucks at a DC.

Appraisal firms need to understand what’s happening with shrink throughout the borrower’s supply chain, starting when the goods have been received from the manufacturer. Initial questions could include:

• Does the retailer own and tightly control its own distribution centers, or does it rely on shared spaces with multiple users, high turnover and generally lax oversight?
• Are the retailer’s DCs running at full staff, or could overworked crews be helping themselves to the goods in “compensation” for their situation?
• What can the retailer’s inventory data reveal about shrink trends at the DC and beyond?

On this last question, the data revolution is now giving appraisal firms new weapons in the fight against shrink. With the right personnel and analytics in place, they can slice-and-dice inventory data down to the SKU level, creating more opportunities to compare received goods against actual sales.

When “red flag” disparities emerge, a proactive investigation can stem the losses. Imagine, for example, that unexplained margin-erosion has begun to occur. Questioning by the appraisal firm might reveal that shrink is contributing to those diminishing profits.

Did a third party calculate the shrink reserve?
The inventory counts produced by third-party firms should not be blindly accepted, as auditors typically analyze small samples and simply look at the paperwork to verify sufficiency of the shrink reserve—a situation that can mask a higher level of shrink.
 
Especially when working with healthy retailers, stay mindful of the possibility that company pressure can result in a too-optimistic shrink reserve. In actual testing, we have found shrink of 6 to 8 percent (both for locations that were undergoing liquidation and those that were in normal operation), even though the retailer’s shrink reserve was in the 2 to 3 percent range.

Leveraging both data and field exams
Rolling out newer, more data-driven approaches can reveal fundamental flaws in the retailer’s existing approach to inventory. It is not uncommon for mishandling of goods—such as double-counting the same shipment, either due to accidental rescanning or incorrect, manual data entry in a spreadsheet—to be behind shrink. Implementing the right technology at these levels can help pinpoint run-of-the-mill data errors more quickly and further bridge this gap.

However, these data strategies must be coupled with regular physical checks of inventory. Field examinations continue to provide lenders with a powerful tool to both monitor collateral value and catch shrink before it becomes unmanageable.

Even when supply chains were more stable and, seemingly at least, societal norms more intact, shrink was a slippery problem. With the “growth of shrink” looming larger, it’s time to ramp up the detective work and help borrowers and lenders regain control.