David Clark

Like a love that they've taken for granted, building material dealers can be pretty cavalier about their inventory. No wonder so much of it disappears. The question is: Why don't they care?

Shrinkage–the unpleasant shortfall between the value of the inventory you thought was in stock versus what's actually there–is a topic that experts believe too many dealers ignore, or deny, or dismiss with overly generous benchmarks. That's in part because fighting shrinkage requires that a dealer confront a rogue's gallery of characters: the thieving employee, the shoplifting customer, the error-prone record-keeper, and the reckless forklift driver. Shrinkage mainly is about a company's internal failures, and that's never a happy topic to confront.

But confront it you must. We're too far away from a housing recovery for you to count on increased sales to paper over your troubles, and with banks expected to stick to their miserly ways, every dollar you can save through shrinkage control is extra money to increase your cash flow and improve your profit statement.

"Shrink management is a culture," declares Bill Hayward, CEO of Hayward Lumber in Monterey, Calif., and a former ProSales Dealer of the Year. "It takes years to get it in line and a short period of time for it to get out of line. We take it very seriously because fixing the problem has a long tail, which equals years of unnecessary loss."

What's the Standard?

Experts and leading dealers differ on how much shrinkage is too much, but all the numbers for pro-oriented firms tend to be lower than what a more retail business can expect. According to the University of Florida's latest National Retail Security Survey (NRSS)–generally regarded as the country's most definitive research on the subject–reports from 138 retail corporations turned up an average loss from shrinkage in 2010 equaling 1.49% of sales. But there's huge variation by type of business; grocery chains reported an average 3.12% shrink rate in 2010, while electronics/computer/appliance stores posted just a 0.36% loss rate.

NRSS polled only four companies in what it called the Home Center/Hardware/Lumber/Garden category, and none were named. But given the report's focus on huge retailers (the average sales for all survey participants was $18.2 billion), one could assume these were big-box operations. For this group, average shrinkage was 1.09%.

The overall NRSS rate of 1.49% is the second-lowest since the survey began two decades ago. The survey's authors speculate this might be because companies with higher rates have gone out of business and thus don't take part in the polling any more. However, LBM leaders that ProSales interviewed credit the recession for what they say has been a decline in building supply shrinkage. After all, they say, the less inventory you have, the easier it is to count and the harder it is to lose.

Where your current shrinkage rate stands depends first on whether you even track it. Paul Bumblauskas, an LBM consultant who is also an accountant, recalls asking roughly 30 companies at roundtables whether they tallied their shrinkage numbers. He was surprised when only about 15 said they did. Bumblauskas suspects that dealers who never bother to measure shrinkage could be losing as much as 2% of their annual sales to the problem.

Among those who do, a ProSales sounding of experts suggests the benchmark drops to roughly 0.5% of sales. And for those who do it well, alarms go off when the rate tops just 0.25%. At a facility with $5 million in sales, dropping from a 2% shrinkage rate to 0.25% is worth $88,500.

Spotting Troublemakers

Much as you might hate to believe it, close to half of all the shrinkage you're seeing at your building supply company is caused by your workers, according to NRSS results and anecdotal evidence from LBM experts. In Champaign, Ill., a newspaper recounted recently how, while revising financial statements for her late father's concrete supply company, a daughter found evidence that led to charges that the supply company's bookkeeper had been draining $100,000 a year from the firm for nearly a decade. Bumblauskas recalls a dealer who put security cameras in his store and then watched his credit manager steal a garden hose. "The manager said he thought he was entitled given what he was being paid," Bumblauskas says.

"Lumberyard executives have high values, and they assume their employees do too," the consultant adds. "There are definitely dealers with good, moral people working for them. So maybe their shrink is 1.5% instead of 2%." In other words, even good companies can have bad shrinkage rates.

Next come burglars. NRSS survey participants identified outsiders as the cause of roughly 31% of all shrinkage. Dealers in Texas have been particularly plagued by this in recent years. The Lumbermen's Association of Texas and Louisiana says that, since spring 2009, it has tracked 88 incidents in which millions of dollars' worth of goods were stolen, shingles being the No.1 item taken.

While many thefts appear to be the work of pure outsiders, NRSS research finds that roughly one out of every five cases of internal theft also involves an outside connection.

Often, evil intent has nothing to do with shrinkage. Rather, it's a case of poor bookkeeping. The NRSS survey found administrative errors were behind roughly one out of every seven cases of shrinkage among all retailers, but for the Home Center/Hardware/Lumber/Garden companies in the poll, it was nearly one out of five. LBM experts agree this is a particular problem for dealers, and usually for two reasons: Failure to count and failure to report.

It's still common at lots of building supply companies nationwide to take inventory just once annually. That means there's only one day a year in which a dealer knows what it has (and hasn't), with the usual result being an inability to track down the reasons for the shortfalls. What's worse, an annual inventory might turn up so many problems–each requiring a separate investigation–that there's neither time nor desire enough to tackle all of them.

Some dealers might comfort themselves by discovering cases in which they actually had more inventory than expected, but that's a false gift, the experts say. First, if you have more stock on hand than you thought, it means you bought more than you needed–and thus are paying finance charges for every day those materials remain in your yard. Second, having unexpected extra inventory increases the possibility that the products will get old and, if they remain unsold, become candidates for the "dog goods" pile.

One of your best ways to fight back is to start cycle counting. That's a process in which you periodically count a small part of your inventory, such as your best-selling or most valuable SKUs. One rule of thumb is to cycle count fast-moving items at least monthly and slow-moving items twice a year. Cycle counting enables you to keep steady track on how you're doing and alerts you to problems sooner than an annual check.

The "failure to report" problem can rear its head in several other ways. Suppose a customer orders 2x4x10s and your yard crew can't find them, so it puts 2x4x12s on the truck instead. If that change doesn't get put on the books, you'll end up on inventory day with a surplus of 10-footers, a shortage of 12-footers, and a dent in your inventory's valuation.

Similarly, it's common for crew members who damage goods to throw the stuff into a bin without telling anyone it's no longer available for sale, experts say. Accidents happen, it's true, but it's better for all concerned if the consequences get recorded. You can't manage what you don't measure.

"You need to teach people that a piece of sheetrock is a dollar bill, it's money," says Larry Adams, president of the Southern Building Material Association (SBMA). The moral: Count it before you dump it.

Johan van Tilburg, owner of Knoxville, Tenn.-based Tindell's, another former ProSales Dealer of the Year, takes that maxim to heart on his company's financial statements by making separate inventory adjustments based on five different reasons:

– Over/under counting, in which his goal is to have actual inventories within 0.5% of what's booked.

– Damaged goods, so he can see how careful the yard crews are.

– Conversions, in which a product is altered (such as cutting off the damaged end of a 16-foot stud to make it a 12-footer) and thus needs to be booked differently, as well as cases where the wrong goods were shipped so the inventory needs fixing.

– Close-outs, particularly special orders that went bad and need to be tossed.

– Credits, including returns from the jobsite that the customer didn't get credit on but can be sold to someone else.

Van Tilburg also isn't satisfied just knowing how his overall inventory value compares with what's in the computer.

'All Variances Are Bad'

"If you go for a net number and offset what's over with what's short, then you can potentially get a false sense of security," he says. "All variances are bad … 100 2x4s that you are short cannot be offset by four kitchen cabinets that you are over in physical inventory, only in dollars. … You should also look at units. Measuring it this way allows you to determine exactly where your shrink/gain is–you could be 99.5% accurate company-wide in dollars but only 94% in units."

Beyond cycle counts, consultant Jon Davis recommends bringing back gate guards. Others suggest installing security cameras. Bumblauskas wrote an entire article for ProSales on curbing employee theft. (See "Practicing Internal Controls," June/July 2010.) But even Bumblauskas recognizes there's a point at which spending money on controlling shrinkage isn't worth it.

Here's his formula: Take your current shrinkage rate–and if you don't know it, assume it's 1.5%. Deduct the amount of your goal: say, 0.5 percentage point. In this example, the answer is 1%. Multiply that times your sales. For instance, if you take in $5 million in revenue, 1% of that is $50,000. That's how much you could gain from improved shrinkage controls. Now divide that number by three. In our case, the answer is nearly $17,000. That's how many dollars' worth of resources you should consider investing to reach your target.

Leon Huneycutt of Locust Lumber knows a relatively modest expense can generate big results. Two years ago, he made a deal with yard workers at his facility in Locust, N.C.: Every week, each worker will get a $50 bonus if the worker gets through the week without making a mistake or damaging goods. If the worker makes an error and it can be tracked back to him, he loses the $50. If the worker makes two mistakes, he not only loses his $50 but a portion of everyone else's bonus also gets deducted.

Honeycutt says he has noticed a marked reduction in mistakes by the yard crews and drivers. And while Locust Lumber strives to make this bonus plan a fun incentive, Huneycutt notes that peer pressure helps: "If someone makes too many mistakes, everybody is going to be on his case," he says.

Should you want to duplicate this, Huneycutt's one caution is to make certain you have a strong yard manager administering it, someone who won't get accused of playing favorites. "It takes a fairly unbiased person to oversee it," Huneycutt says.

Sometimes the inventory mistakes aren't your fault at all but rather are due to vendor or distributor mistakes–or worse. Respondents to the NRSS survey attributed 4% of their losses to vendor fraud, but the four respondents in the Home Center/Hardware/Lumber/Garden category said vendor fraud accounted for 7% of their losses.

Several experts suggested you counter vendor fraud by having the receiving crews check deliveries based on what was ordered, not what's on the shipper's manifest.

The assumption that shrinkage isn't much of a problem now because business is slow and inventories are low doesn't bode well for those who look forward to busier days. "When times are good you develop bad habits," says the SBMA's Adams. "That's when special orders are done incorrectly, when merchandise is damaged because our people are like ants on an anthill, running into each other. … Sometimes when we have a pickup in business, we get so excited we start getting away from basic things that we should be thinking about all the time. And the truth is, that's when we should be spending more time."

Most experts hope dealers will use this year–a time in which housing starts and thus business is expected to show modest growth–as an opportunity to stick to better practices despite the speedup as well as get rid of trash on the balance sheet, such as those dog products that have gone unsold for five years.

How To Investigate

At Tindell's, van Tilburg always has the wrench out, looking to keep money from dribbling away. "Any shrinkage warrants investigation," he says. "Any and all adjustments/write offs have to be investigated and signed off by a manager and then a monthly review is held with the vice president of operations."

His store examines shrinkage problems by reviewing all tickets pertaining to that time period, including cycle counts for the item involved that occurred both before and after the adjustment was made. Then, if it doesn't see any clerical errors, van Tilburg starts sniffing out theft. "Who was in the yard–any new customers, any cash pickups?" he asks. "Are all tickets signed by yard employees [as per policy] or did somebody load themselves?"

Myron Andersen, president of Builders., a Dealer of the Year based in Kearney, Neb., differed from NRSS when he said most of his company's shrink is due to damaged goods, not theft. By that measure, he says Builders.' average shrink over the past five years has been 0.5%. But Andersen also has two people working fulltime just managing inventory, and he sets aside a 0.75% reserve to cover differences in inventory valuations. That's usually enough to give his balance sheet a boost at the end of Builders.' fiscal year.

Paul Hylbert, the former president of ProBuild and now chairman and CEO of Kodiak Building Partners private equity fund, sides with Andersen and against Bumblauskas on whether mistakes cause more shrinkage than theft. He shares van Tilburg's view that no shrink is acceptable. But he also believes one needs to avoid putting lipstick on this pig through accounting practices such as inventory reserves.

"It's important not to be lulled into satisfaction because at year end an accounting 'gain' is recorded," he says. "We should all be measuring real shrink, not the difference between the reserves taken to cover shrink and physical inventory value. Write-ups are nice, but they can cover up a lot of sins."

Regardless of how you run things, these experts suggest one thing is certain: Shrinkage is as eternal a struggle as sin. And when times turn good, the opportunities to stray increase.