The Surprising Plague Killing Retailer Profits

Editor's note: A previous version of this article incorrectly attributed Checkpoint Systems' RF security tag to another company. The Fool regrets the error.

Retailers face lots of challenges, such as already-low profit margins pressured by competitors, consumers cutting back during economic downturns, and even shoplifting. There's a big challenge that few recognize, though: employee theft. In some cases, these losses exceed total profits earned.

In the 2009 textbook Financial Accounting, Jerry Weygandt offers this startling information: "The average employee caught stealing costs his or her company $1,341, while the average loss from a shoplifting incident is only $207." Overall, the average inventory loss in supermarkets because of theft is 2.28%. If that doesn't sound like much, check out the following grocers' net profit margins:

Data: Yahoo! Finance.

Clearly, the grocery business is a tough one, with companies really struggling lately. If you're thinking that Whole Foods Market (Nasdaq: WFMI), with its fancier fare and heftier prices, would have a heftier margin, you're right: 2.73%. That sure beats the companies above, but it's still low compared with other large, successful companies. And given that the average employee theft rate tops 2%, even Whole Foods is losing a huge chunk of its profits to the scourge.

At a Cincinnati Kroger store, for example, a policeman working security charged the grocer nearly $3,000 for hours he never worked. In New Jersey, an A&P employee bilked the company out of $1,620 by taking cash for phony merchandise returns.

Supermarkets are not the only victims, though. Employees can steal through fraud and embezzlement from all kinds of businesses. The Association of Certified Fraud Examiners has estimated that American businesses lose 7% of their revenue to employee fraud. That amounts to hundreds of billions of dollars.

Interestingly, not all employee theft is intentional. When a software package called StopLift that analyzes check-out activity was used at one store, it found that most losses were because of cashier error. After reassigning or retraining the employees in question, losses dropped by 86%.

Signs of hope
In a recent report, the National Retail Federation (NRF) found that employee theft outweighed shoplifting, representing 43% of losses versus 35%. Losses for the overall industry totaled a whopping $33.5 billion. Clearly, this is a big problem.

There's reason to be hopeful, though: The NRF data showed retail merchandise losses overall averaging 1.44%, down from 1.51% in 2008 and 1.61% in 2006.

If such companies could cut these loss rates in half, they could increase their profitability enormously, and in some cases would start posting profits instead of losses. The fact that they're making headway is good news for investors.

Theft-fighters
Interested investors might want to take a look at companies involved in reducing merchandise losses because it's clearly a critical activity for retailers. Checkpoint Systems (NYSE: CKP), for example, offers tools such as radio frequency (RF) security tags, which are used at companies such as Walgreen (NYSE: WAG) and Rite Aid (NYSE: RAD).

As a Walgreen vice president noted, "To gain a competitive advantage, we have to stay on top of all the tools that are available to us, whether we are looking at our businesses from the point of view of loss prevention, distribution, merchandising or marketing." Rite Aid has roughly cut its front-end merchandise losses in half with Check Point technology.

Shrinkage is an often-overlooked aspect of retailing, but it's a critical one, and especially so in these tough economic times when many people are feeling especially desperate. Strong and promising companies will work on reducing their theft and other merchandise losses, in order to boost profitability.