Padding the Numbers

Retail store managers occasionally manipulate inventory systems to increase their year-end bonuses and preserve their jobs. Here's how to find this fraud and deter it. 

Alex is excited. This manager of a chain discount store thinks he'll be receiving a substantial year-end bonus - if he meets the company's projected numbers for his store.

But as the months progress, his store falls short of projected sales goals, and the loss prevention manager warns him of an alarming rise in shoplifting and suspected employee thefts.

However, at the end of the year the store apparently meets its goals and Alex receives his fat bonus.1 The loss prevention manager is mystified. He wonders how certain store departments have drastically reduced huge losses.

Inventory Shrink Padding

Shoplifters, dishonest employees, and paperwork errors are the traditional reasons for losses in the retail environment. But there's a much more subtle element, that if left unchecked, eventually will undermine a store's inventory systems and inhibit the measure of inventory flow and stock shortage. This hidden element of loss - inventory shrink padding - is defined as subtly disguised fraudulent inventory system entries, hidden within legitimate numbers, which are intended to camouflage real inventory shortages. Shrink is the difference between book and actual inventory values.

Loss prevention managers and fraud examiners who detect this method of fraudulent inventory system manipulation will enter a maze of inventory control and point-of-sale system reports (showing current or past sales transactions), cunningly laden with false inventory gains, which mask true inventory losses. This type of fraud can cause a store's on-hand inventory integrity to collapse like a house of cards.

After this act of fraud is discovered, the company's accounting department must reconcile and book several high shortage inventory cycles before the process is cleansed and the store's true inventory numbers are evident. A fraudster - often the store's manager or assistant manager - cleverly will manipulate the inventory numbers over many months to make the transactions appear normal and to limit his exposure.

He often pads the numbers to greedily grab for huge bonuses and to preserve his job. Though he may gain in the short run, the false impression of current on-hand inventory levels is nothing more than a temporary smoke screen.

Alex, the store manager, found this out the hard way. His store's loss prevention manager, Marcus, told the operations manager that he was concerned about the store's low inventory shrink percent. The store's operations manager, Stephanie, concurred and said the store's inventory shrink number was bogus. She said she believed the store manager had falsely entered product back into the inventory.

Marcus did some research and tracked fraudulent inventory system entries directly to Alex. After being interviewed, Alex admitted only to a few of the falsified entries. His company terminated him for gross misconduct. After he left, auditors found large quantities of non-existent product worth thousands of dollars that had swollen the store's inventory.

Techniques Used to Pad

Inventory shrink padding can be carried out using disparate methods within the numerous inventory system functions being used in today's retail environments, such as discount stores, home improvement stores, department stores, specialty retail stores, and others.

Following are several methods used to fraudulently shrink pad a store's inventory.

Deliberately misstating inventory totals through the post-inventory adjustment process or by consciously not researching overages during inventory reconciliation
This form of shrink padding can be difficult to detect simply because of 1) the sheer volume of discrepancies needing to be reconciled; 2) the logistics of auditing numerous stores conducting simultaneous inventories; 3) and researching discrepancies within a reasonable time frame once inventory is taken.

Using fictitious store refunds to purchase shrinkage.

To carry out this method, the fraudster manager must first generate a false return at the sales register. Let's say he uses a $100 camera to do this. By generating a false return he's now added one camera back into the store's inventory system. No physical camera is placed back into inventory because the refund generated simply adds a quantity of one unit to the book inventory system. He's now left with an overage of $100 in the sales register because no customer exists to receive the refund.

After the fraudster researches the inventory records, he remembers that two watches valued at $50 each have been missing. (Most likely an employee or customer stole them.) He selects one of the same type of watch from the jewelry department and rings up a sale, which shows two watches sold. This offsets the earlier $100 false return transaction. He returns the watch to the jewelry department. The register now balances, and the missing watches now are officially removed from the book inventory as sold to pad the known shrink loss. The manager later "removes" the camera from the inventory by performing a prior-day void at the register.

Overstating inventory counts from lists

Pre-count lists, attached to boxes placed on pallets in the warehouse, contain written quantities and the Universal Price Code (UPC) labels for hand-scanning product bar codes. The contracted inventory service workers will scan the UPC and then key those quantities into handheld remote terminals taken from those previously written quantities from each sheet without physically counting the product. A dishonest manager later can overstate quantities with little risk of discovery when the reconcile counts take place.

Someone other than management should hand count all on-hand products and verify them with the lists and UPC labels.

Counting inventory product that has been replaced by warranty billing

Warranty billing is the process by which a retailer has agreed to repair or replace its customers' damaged or defective products if purchased with a warranty service plan. If the manufacturer doesn't require that the store send back defective products returned by customers, dishonest managers might hide the products that have no value and later count them as good products thereby creating false inventory. This form of fraud may be quite difficult to detect unless the systems reports documenting warranty replacements can be verified during the inventory cycle. A post-inventory reconcile process also can help to detect this form of fraud.

Locating the Source

Shrink padding fraud masks true inventory losses, which creates false gains by posting non-existent product back into a store's current inventory. Legitimate systems adjustments made to the store's book inventory typically are a result of store transfers, vendor product returns, product being transferred among warehouses, defective or damaged product, and empty boxes probably due to theft. However, we can discover fraudulent inventory system entries by studying slight variations in inventory system adjustments that contradict typical patterns of normal inventory flow. Some retailers have incorporated "exception-based" reporting programs, which isolate and track suspect inventory variations, greatly reducing the time spent researching large volumes of irrelevant inventory data. However, often there's no substitute for rolling up the sleeves and pursuing the paper trail. Here are some key indicators pointing to possible shrink padding activity:

• Key inventory paperwork documenting adjustments are suddenly missing.
• Current inventory shrink percent shows a significant decrease over the previous year.2
• Vendor return merchandise claims increase or vendor return shipping documents are missing. (Vendors permit returns contingent to strict requirements such as products that are outdated, defective, or discontinued by the store.)
• There's an unexplained increase of store transfers prior to taking inventory. (These transfers could be bogus; no actual product would leave the building.)
• Unexplained product overages remain after inventory reconcile.
• Sales and refund reports, which track all cash register transactions, show suspect patterns of repeat unmatched high-dollar store credit activity issued on transactions without original sale receipts. (Even though point-of-sale programs capture all transactions, they don't necessarily have the ability to separate and identify suspect transaction activity as effectively as exception-based reporting programs.)
• Warranty billing documentation is missing or a significant increase in replacement activity occurs shortly before the store conducts inventory.
• The manager spends too much time discussing his store's numbers as they relate to his annual review and bonus potential.

Cases of Excess Padding

In one case we examined, the store manager selected a product with a retail price of $50 each and a store cost of $15 each. During a day's business, he would go to the register, scan in the product's UPC, and then ring in 10 units as being refunded on one transaction - worth $500 total - as returns thereby causing those units to be added or gained to the store's book inventory. These fraudulently refunded items later would show as gains back to his current book inventory. He would use these refunded dollars to offset his fraudulent sales transactions - totaling approximately $350 on average - designed to cover his store's known theft losses such as empty packages found after conducting random product counts.

He routinely committed this shrink-padding fraud several times per week using a wide range of product. He would perform system adjustments during the same inventory cycles and remove those same originally refunded items at the full retail price of $50 each with a store cost of $15 each. He removed these units through system adjustments to keep his activity from flagging huge inventory overages on paper. These system adjustments caused a net bottom line loss of only $150 of inventory cost, with a net gain of $350 in book inventory added back to pad his current inventory shortages.

Our investigation originally exposed this pattern of fraudulent system entries by comparing refund documents, which tracked duplicate item refunds against inventory valuation reports. These reports showed his inventory system adjustments in which he added or subtracted various products from the store's book inventory. It became apparent that those same units being gained, due to his fraudulent refund activity, were the same items being removed a short time later through his numerous inventory system adjustments. During an interview, the store manager admitted his fraudulent shrink padding activity over several years totaling approximately $72,000 in false inventory gains. He said that he committed the fraud to improve the store's stock shortage numbers, which would increase his annual performance review scores.

In another case we investigated, the store manager created fraudulent vendor return merchandise invoices listing numerous high-dollar products he already knew were missing from his store's inventory due to theft. He would process these vendor return invoices himself and later hide the original paperwork, which would create ghost shipments on paper without shipping the correct quantities requested per the vendor return merchandise invoice.

The store shipped product to the vendor; however, the manager overstated various quantities - much of which was from product already missing from his inventory - when generating the return merchandise invoice. By doing this he removed the product from the book inventory by listing it on the shipping invoice. Eventually, those lost dollars did affect his bottom-line numbers; however, it left his shrink percent untouched from the missing product. So he shipped product back to the vendor but many shipments were less than the total quantities stated on the paperwork.

On average, one to three months would elapse before his store received a vendor return merchandise claim for the missing product listed on the shipments. Once a store received a vendor claim, it had 30 days to contest or accept. The store manager intercepted all vendor claims and hid those related to his fraudulent activity in a training manual on his bookshelf before the warehouse manager ever had a chance to research them. His store would take the entire loss for the return merchandise claim but he knew the loss would be re-classified into an entirely different category on the store's profit and loss statement - the cost of goods account - which would leave his store's shrink percent virtually untouched.

The store manager later was terminated for poor job performance unrelated to the fraud. When the next inventory was booked, this store's inventory shrink percent skyrocketed and raised suspicions. The new store manager questioned the figures in the cost of goods account. We discovered that shrink padding fraud had occurred in misstated vendor shipments for approximately $30,000.

Final Outcome

Companies rarely prosecute managers who are caught manipulating their stores' inventory numbers. Although companies' investigations may show solid patterns of fraudulent system entries, most are reluctant to reveal this form of internal fraud to those outside the industry. This disinclination stems from the proprietary nature of most information in the key investigative documents such as the amount of product markup, profit margin percents, and department shrink percents, and annual bonus payouts awarded managers.

Also, businesses want to resolve these cases internally because they often can't prove that the fraudster was successful in gaining monetarily. In some cases, the companies discover the shrink-padding manipulation long before they book the final year-end numbers. Even after the internal interview clearly has documented the crooked manager's intent, the fraudulent entries haven't yet led to a bonus check. Even if the company could prove the manager had manipulated the entries with this intent in mind, it would be hard to convince a judge or jury - unfamiliar with complicated retail inventory functions - without proof of monetary gain. No big bonus check, no conviction.

Normally, the fraudulent manager is interviewed and then terminated for falsifying company documents or for some other related infraction in the company's corrective action guidelines.

The goal in investigating fraudulent shrink-padding cases is to secure a complete account of the methods and specific entries made during the entire course of the criminal activity. This information is invaluable to reestablish some semblance of order to the store's compromised inventory system and improve internal controls.

Jim Firsich, an Associate Member of the Association, is a regional director of loss prevention in specialty retail and a professional security consultant in Denver, Colo. 

1 Details in this case history have been changed.
2 Here's an example of how the shrink percent is determined: Corporate accounting claims the store's inventory level should be at $2.5 million but the actual inventory counted is $1,917,000. The store's sales were a total of $21.3 million so the store's inventory shrink percent would be 2.7 percent - $2.5 million minus $1,917,000 divided by $21.3 million equals 2.7 percent. After the store's final inventory count is taken, final figures are compared against other accounts totals e.g. total store sales, inventory adjustment dollars, receiving variances dollars, etc. These account totals are calculated with the store's final physical inventory dollar totals. The final physical inventory dollar amount is compared against the book inventory dollar amount and a store shrink percent is recorded.