Ultimately, the motivation to stop business abuse will likely be profit-driven, rather than ethics-driven.


~ Thomas Yake

 

 

 
 

Yake & Associates, Inc., Newsletter
Special Edition
SHRINKAGE: FACT OR FICTION
Business Abuse: A Major Factor in Retail Failures
by Thomas Yake

 

Mergers and acquisitions among some of this country's major retailers are developing into some alarming situations. A recent article in the Wall Street Journal reports that creditors of Revco D.S. may have grounds to sue former shareholders and others involved in the failed buy-out for "fraudulent conveyance." An article in Forbes Magazine describes the acquisition of Zayre Discount Stores by Ames Department Stores as "the worst acquisition in an era of bad acquisitions" and details the "apparent conflict of interest" of Ames' Chairman James Harmon.

 

As the string of failed and troubled takeovers continues to unravel, I believe we can anticipate even more imbroglios and more disclosures stemming from litigation involving business abuse.

 

To many investors, shareholders, creditors and employees who have place their trust and invested their future and financial security in the retail business, the disclosures hold lessons for the future. It will also become clear why a retail business cannot be bought and sold as if it were a piece of prime real estate.

 

The disclosures, combined with the current wave of pressure for ethical behavior in business and a growing interest in understanding organizational behavior (politics), present opportunities for change. Ultimately, the motivation to stop business abuse will likely be profit-driven, rather than ethics-driven, and that's okay. Doing the right thing and making a profit are not mutually exclusive concepts, as I will illustrate in the article that follows.

 

In this Special Edition of the Sentry Post, I want to share my personal observations about business abuse and my views about the rationale, the challenge and the opportunities for change.

 

I was 15 years old when I had my first lesson in business abuse. It was January, 1965, I was working part-time as a stock boy at a Zayre's Department Store on the outskirts of Indianapolis. Another stock boy and I were in the receiving area awaiting our next assignment.

 

The store manager came over to us and, gesturing to the overstock area where the bicycles were stored, he told us to compact all the bicycles that were left over after Christmas. He delivered the instructions matter-of-factly. He might have been telling us to unload a truck or move some merchandise out to the showroom floor.

 

When we asked why we could not give the merchandise to charity, he said that the company could not "write it off." I remember thinking it must have something to do with taxes. When I was 15, I didn't know anything about shrinkage, and the term business abuse hadn't been invented yet. But the practice of business abuse was well established. Merchandise compacting was a regular event at Zayre. Each year dozens of bikes, along with clothing, tools, cosmetics and seasonal goods were destroyed.


My observations in business abuse continued throughout my 25-year career in the retail industry. Eventually, I learned the real reason for compacting merchandise: It was all part of a complicated system to cover up buying and operational deficiencies.

 

In later years at Zayre, this system, which centered on manipulation of "the shrink figure," became more refined and better orchestrated. It evolved to include unrecorded mark-ups, padded mark-downs, so called "Advise of Error" forms and vendor charge-backs.

 

The latter was particularly well structured. "Vendor hit lists" were distributed to the store managers, and every week they were to take mark-downs and use the vendor charge-back form to "hit" selected vendors with fictitious lists of damaged or defective merchandise.

 

The merchandise which, in reality was on hand, had to be "relieved" somehow or be reported as overstock during the physical inventory process. Thus, entire merchandise categories were fed to the compactors. The compacted merchandise was either booked as shrinkage or reported to vendors on merchandise "charge-back" forms.

 

"Advise of Error" forms were used to notify the distribution facilities of bogus shipping errors - typically, shortages. If the distribution facility was in another zone, region or profit center of the company, the AOE's were filled out to indicate that certain merchandise was missing (although it actually had been received), thus shorting the distribution facility and falsely crediting the store, inflating inventory and padding shrinkage.

 

(It should be noted that in some zones or geographic regions, the practices were more aggressively applied than in others, which illustrates the sub-culture that can develop within large, decentralized organizations.)

 

Distortion of the inventory accounting system was not a cause, but an effect of ego-driven, politically motivated behavior. Such convoluted cover-ups are easy in a large company with a multi-layered management structure, where accountability can be easily covered up and/or shifted.

 

At Zayre Corporation, business abuse was not only an accepted practice, it was an integral part of the company's operating procedures and blatantly included in employee training. Store managers were methodically taught these practices throughout the chain. Their eligibility for promotion, or in some cases, for continued employment, was contingent upon their compliance with these practices.


To a great extent, the store managers' job performance was evaluated according to their ability to manipulate the shrink figure. Some were so successful that stores actually showed large overages in merchandise - a "positive shrink" - at year end!

 

At Zayre, and other retail companies, the term shrinkage became a convenient euphemism for "out of control." Retailers have routinely used "the shrink figure" to measure "losses" for decades. Considering the widespread manipulation of shrinkage and the lack of industry standards for compiling the shrink figure, the notion of using that figure to measure anything (except the extent of business abuse) becomes ludicrous.

 

It's no wonder that when Ames purchased Zayre Corporation they got both more and less than they bargained for. They acquired a retail operation with seriously depleted financial resources, along with a corporate culture that not only condoned but promoted business abuse.

 

Retraining employees after a major acquisition should be a high priority among the new owners/managers and investors. Employees must not only be taught how to report and record merchandise transactions accurately, but why. In a corporate culture where business abuse is entrenched, resocialization and behavior/attitude modification will require clearly communicated objectives and standards.

 

In some large, decentralized, publicly held retail operations, politics has been allowed to take precedent over profit and accountability has been lost, along with any sense of responsibility to comply with the mandate of the shareholders: to make a profit and to provide a return on their investment. The corporate culture of these companies provides the ideal climate in which business abuse thrives. (It also creates a theft-prone environment in which employees find it easy to justify stealing from the company.)


Most employees do not set out to harm the company. I contend that most employees are basically honest and eager to do what is right for their employer. It is incumbent upon the employer to define what "right" is, and thus, to ensure that the work place, the corporate culture, is conducive to ethical behavior, rather than to theft or to other integrity violations. There must be clear signals that politics is not more important than profits, that distorting financial reports, and other breaches of integrity, are unethical, unacceptable and bad for business.

 

In retailing (or in any other business for that matter), managing employee honesty and integrity is as critical to the success of the business as is managing every other facet of the operation - accounting, purchasing, sales or personnel. Often, when there is a breakdown in honesty, there is also likely to be an increase in other forms of business abuse, such as sexual harassment, discrimination and drug abuse.


As with other aspects of employee behavior, there must be clear standards for ethical behavior, conveyed at every opportunity - during the interview and hiring process, in training sessions and during performance reviews. Not just because it's the right thing to do, but because it's good business, for everyone concerned.

Without such standards and training, business abuse can continue indefinitely. For example, a company doing $1 or $2 billion in sales can easily conceal losses created by operational and/or buying errors. Unexplained shrinkage can go on for years, especially in companies where there have been intentional distortions.

 

Inventory distortions are like a game of hide-the-nut-under-the-shell; eventually, you run out of "shells" under which to conceal the bogus losses. As the game evolves, the issues become more convoluted and the actual losses more staggering. For example, if a store doing $10 million in sales annually has a real shrinkage of five percent, and that figure is manipulated down to two percent, the difference of 3 percent represents more than $300,000. Multiply that by, say, 100 stores in a chain, factor in the destruction of hundreds of thousands of dollars worth of perfectly good merchandise, and the magnitude of the problem becomes catastrophic.

 

Historically, inventory shrinkage has received remarkably little attention from outside accounting firms. The outside auditor is entrusted with determining the accuracy and integrity of the company's financial statement, but the primary role of the auditor is to "express an opinion" as to whether the financial statements are fairly presented in accordance with generally accepted accounting principles.

 

The tests used to form that opinion are not designed to detect fraud or other irregularities in the financial statements unless they result in a "material misstatement." An item is "material" if the resulting change is significant to the company's financial position or operating results, taken as a whole. An inventory shortage of $5 million in a company with $100 million in earnings or an increase in inventory shrinkage from 1.0% to 1.5% would probably not be considered "material", as long as the ending inventory is properly stated.

 

The auditor always reviews inventory procedures and analyzes significant trends. But unless the shrinkage results indicate a material misstatement in the financial statements, no further investigation will be done because inventory shrinkage is not the auditor's main concern.


Fortunately, new standards adopted by the American Institute of Certified Public Accountants (AICPA) change the auditor's responsibility for detecting and reporting errors and irregularities. The new standards require that audits be designed to provide "reasonable assurance" that irregularities and/or errors will be detected.

 

How do we break the patterns of shrink figure manipulation and business abuse? We may soon tire of moralistic discussions about ethical behavior, in government, in retailing, in the business community at large. However, if we go back to our premise that doing the right thing and increasing profits are not mutually exclusive, several opportunities become clear.

 

Heading the list is the acquisitions or takeover process. Acquisitions will continue to be a viable avenue for growth. For, whenever there is a company in trouble or operated poorly, there will be a buyer. Investors seeking to purchase a retail company, however, must go beyond "seeing if the numbers work" in assessing the viability and determining a reasonable purchase price for their prospective acquisition.

 

The problems associated with recent retail failures run deeper than a high rate of interest and failure to negotiate a reasonable price. In many cases the buyer simply overpaid for property, assuming profits could be increased by "slashing the fat." (Slashing the fat in order to service the debt can remove some vital organs erroneously or leave cancerous organs intact because they were not diagnosed.)

 

The critical omission in the due diligence process, however, has been an assessment of the corporate culture. The success or failure of an organization is, to a great extent, determined by the human factor. Buying a large company without knowledge of its corporate culture is like buying a large plot of land without considering land surveys.

 

Clearly, politics is part of every organization. It is the failure to acknowledge and understand the politics and/or the psychology that can lead to trouble, particularly in a takeover situation. Corporate culture is something that not only can be identified, but should be measured (inventoried, if you will) and factored into the takeover cost. In recent acquisitions that have been troubled by unexplained losses, the problems are not financial, but sociological and anthropological.

 

Business abuse of all types - fraud, theft and distortions - thrives on the inefficiencies, and confusion that typically accompany any major change, particularly an acquisition. When new executives are brought in to manage the investment, months can be spent in simply trying to get a "lay of the land."


Buy-outs and acquisitions also tend to create "compression problems", including loss of job security, which, in turn, breeds inordinate ambition among some survivors and decreased company loyalty in others. The accompanying dog-eat-dog attitude and deteriorating corporate identity create an environment ripe for integrity violations.

 

Shrinkage is not a mysterious phenomenon as some would have us believe. Shrinkage is caused by poor management, internal or external theft or it results from a corporate culture that tolerates (or encourages) unethical behavior (business abuse).

 

As litigations alleging negligence in the acquisition process increase and unfold, shareholder and creditor rights, fraudulent conveyance and fiduciary responsibility are likely to be among the critical issues. In cases of fraudulent conveyance, Chapter 11 bankruptcy may no longer be a refuge for companies where business abuse has dominated the corporate culture.

 

As the extent, severity and consequences of business abuse come to light, I believe we can also expect to see increasing awareness about the need for accountability, standards for conduct and standardized means of evaluating corporate cultures.

 

It won't happen overnight. The resocialization process may take months or even years in some cases. Increasingly, companies are turning to outside specialists for assistance in reducing their exposure in business abuse and corporate culture issues. The skills of a professional consultant in these areas will be as critical to operating a successful business as is the counsel of accountants and attorneys.

 

Quotes from this newspaper are permitted; please credit Yake & Associates, Inc., Newsletter/author. Reprints of articles require prior permission from and $25 fee to The Sentry Post.

 

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