Inventory Record Inaccuracy: An Empirical Analysis

Nicole DeHoratius1 and Ananth Raman2

August 2004

Abstract

This study explores the systematic variation in inventory record inaccuracy (IRI) observed both

within and across stores. Traditional inventory models, with a few exceptions, do not account for the

existence of IRI and those that do treat record inaccuracy as random. Examining nearly 370,000

inventory records from 37 stores of one retailer, we found 65% to be inaccurate. That is, the recorded

inventory quantity of an item fails to match the quantity found in the store. We identify factors associated

with this inaccuracy that are stock keeping unit- (SKU) and store-specific. SKU-specific factors such as

item cost, selling quantity, and method of distribution account for the observed variation in IRI within

stores. Store-specific factors such as the density and variety of inventory observed at each store account

for the variation in IRI across stores.

1
University of Chicago - GSB, 5807 South Woodlawn Ave, Chicago IL, 60637, 773-702-2388 (ph), 773-834-3976
(fx), ndehorat@ChicagoGSB.edu
2
Harvard Business School, Boston, MA 02163, 617-495-6937 (ph), 617-496-5265 (fx), araman@hbs.edu

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1. Introduction

Although computerized tracking of inventory at the stock keeping unit (SKU) level is commonly

assumed to be accurate, we found discrepancies in 65% of the nearly 370,000 inventory records3 we

gathered from multiple stores of a leading retail chain. This retail chain, hereafter termed Gamma is a

large, public retailer with annual sales of roughly ten billion dollars. It has highly modern operations,

including electronic point-of-sale scanning and automated replenishment systems, in each of its nearly

1,000 stores and all of its warehouses. Yet, for sixty-five out of every one hundred records examined, the

recorded (“system”) inventory quantity failed to match the quantity found in the store at the time of a

physical audit. Figure 1 depicts a histogram of the difference between the system and actual inventory

quantity for each of the records we observed.

We found inventory record inaccuracy (IRI) at Gamma to be both pervasive, present across

multiple products contained in multiple stores, and substantial in magnitude. The absolute difference

between the inventory quantity recorded in Gamma’s automated tracking system and the actual inventory

quantity averaged nearly five units. Moreover, fifteen percent of Gamma’s inventory records, nearly

55,000 of them, had an absolute error of eight units or greater, more than half the average target quantity

of inventory maintained on the shelf for that SKU in a given store4. In aggregate, the value of the

inventory reflected by these inaccurate records amounted to 28% of the total value of the expected on-

hand inventory.

Maintaining accurate inventory records, records that reflect physical reality, is both crucial to the

performance of retail organizations and central to the vision of supply chain integration. U.S. retailers

spend one percent of annual sales, or roughly thirty billion dollars per year, on automated inventory

management tools to track sales, forecast demand, plan product assortment, determine the quantity of

3
Each record represents one SKU-store combination: a specific SKU found in a particular store.
4
According to Gamma managers, the average target quantity of inventory per SKU maintained on store shelves is
fourteen. Understandably, each product has a different targeted on-hand quantity depending on, among other things,
the lead-time to replenish the product and the anticipated demand for that item.

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items needed to replenish store shelves, and control inventory (Steidtmann 1999). Yet, to operate

according to plan, the inventory management tools currently used in practice require recorded inventory

quantities for a given retail store to accurately reflect the inventory quantities physically present in that

store. Take, for example, automatic replenishment systems. In the presence of inaccuracy, these systems

may not know the true on-hand quantity of certain products. Consequently, such systems, designed to

trigger an order when the shelf quantity of a particular product reaches a certain level, could either order

when an order was unnecessary or fail to order to when it should. Similarly, demand forecasting systems,

designed to forecast future demand based on historical sales patterns, can not discriminate between items

that have no sales due to a lack of customer demand from those that are out of stock at the store but are

not replenished due to record inaccuracy.

Inaccurate inventory records also have a negative impact on the use of information technology

upstream in the supply chain. Inaccurate retail sales and inventory data can confound manufacturers’

efforts to manage retail inventory levels under vendor managed inventory (VMI) programs and render

ineffective many collaborative planning, forecasting, and replenishment (CPFR) programs. Such efforts,

whereby retailers and manufacturers share sales and inventory data to optimize the supply chain, are often

touted as a solution to the bullwhip effect (Lee et al. 1997). Many manufacturers even plan their own

production on the basis of retailer sales and inventory data.

Our objective in examining the problem of IRI at Gamma is first to determine the extent of the

IRI problem and second to characterize it within and across stores. We demonstrate that within store

variation in IRI, measured as the absolute difference between the recorded and actual inventory quantity,

is associated with several SKU-specific factors. For example, IRI is positively associated with the annual

units sold of a particular SKU and negatively associated with the cost of that SKU. Moreover SKUs

shipped to a Gamma store from a vendor have greater record accuracy than those shipped from Gamma’s

own distribution centers. The variation in IRI observed across stores is associated with several store-

specific factors. For instance, the inaccuracy of an inventory record is positively associated with a store’s

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inventory density, measured by the total number of units in a given selling floor area, and the variety of

products offered in that store.

Record inaccuracy has been observed in the context of manufacturing and distribution (Wight

1984, Millet 1994), investment banks and brokerage houses (Capital Markets Report 2000), government

agencies (Laudon 1986), and phone and utility companies (Redman 1992, Knight, 1992). However, to

our knowledge, this is the first study to examine record inaccuracy empirically across multiple sites of the

same firm. By examining the problem of IRI, our study makes several important contributions. One,

there exists considerable interest in the IT community in evaluating the inaccuracy of data contained in

and used by information technology systems (Ballou and Pazer 1985 1987 1995, Morey 1982, Redman

1995, Strong et al. 1997, Wang and Strong 1996). Recognizing that accuracy has been identified as one

dimension of data quality in IT, this paper contributes to this community by revealing the magnitude of

the inaccuracy problem in IT systems and reporting unique descriptive statistics illustrating the extent of

the inaccuracy specifically in inventory records.

Two, operations researchers have noted the importance of incorporating uncertainty, such as

record inaccuracy, into buffer stock calculations, ordering policies, and the timing of inventory counts

(Iglehart and Morey 1972, Ehrhardt and Taube 1987, Porteus 1990, Bergman 1988). This paper identifies

the factors associated with IRI, and consequently the factors associated with additional uncertainty not

present in traditional models. These factors include not only previously recognized variables such as item

sales and item cost but also product variety and inventory density, variables never before, to our

knowledge, associated with IRI.

The remainder of the paper is organized as follows. Section 2 details our empirical analysis,

including a description of our research site (2.1), the development of our hypotheses (2.2), and an

explanation of data and variables of interest (2.3). Section 3 presents our methodology followed by our

empirical results in section 4. Section 5 discusses several managerial implications while section 6

concludes by defining the limitations of our study and suggesting directions for future research.

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2 Empirical Analysis

2.1 Research site

Gamma, a large public retailer with annual sales of roughly ten billion dollars serves as the

research site for our analysis of IRI. Gamma employs over 50,000 individuals and is currently the largest

operator of superstores in the world for its specific retail category. Gamma controls the largest market

share for this retail category by offering a broad assortment of more than 9,000 different products in

stores of approximately 24,000 square feet.

Gamma invested substantially in advanced information technology to support the operation of

Gamma stores. Each Gamma store utilizes the same technology, including electronic point-of-sale

scanning for all its sales and an automated replenishment system to replenish store inventory. Computers

maintained at Gamma’s corporate headquarters upload sales data collected by the point-of-sale scanners

nightly. Such data include the quantity of each item sold throughout the day as well as the time of the

sale. These data are used for a number of marketing and financial purposes including the analysis of

buying trends, the effectiveness of store promotions, and the calculation of store profit.

Operationally, Gamma uses these data, in combination with additional operational information, to

generate orders for the replenishment of store inventory. Gamma uses an order-up-to inventory policy

with periodic review. Using the recorded quantity of daily sales for each item, Gamma calculates the

quantity of each item remaining in every Gamma store. Once the quantity for a particular item left on the

shelf drops below a particular pre-determined level, an order for that item to be delivered to the store is

automatically generated5. For this process to work according to plan, it is critical for Gamma’s inventory

records to be accurate. Should a record be inaccurate so that the recorded quantity of an item does not

reflect the actual quantity on the shelf, a replenishment order may be generated unnecessarily, not at all,

5
This quantity is calculated automatically by the replenishment system using information such as the quantity of

inventory remaining on the shelf, the forecasted demand, the delivery lead-time and lead-time variability, as well as

a target service level for that item.

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or for the wrong amount. Consequently, Gamma may not be able to meet customer demand or stores may

carry excess inventory each of which imposes an unintended cost on the organization.

In the section that follows, we hypothesize several factors associated with of IRI at Gamma.

Generation of these hypotheses involved not only examining existing literature but also conducting

extensive fieldwork at Gamma. We visited fifteen stores, two distribution centers, and met with

personnel throughout Gamma in an effort to understand the flow of inventory and information about that

inventory through the organization – from Gamma warehouses to Gamma stores. These five hundred

plus hours of interviews and observations were invaluable in helping to shape, in general, our

understanding of the replenishment process at Gamma and, in particular, to identify opportunities for

recorded inventory levels to diverge from actual inventory level6.

2.2 Hypothesis Development

We group our hypotheses into two categories: hypotheses related to SKU-specific factors (H1

through H3), and hypotheses related store-specific factors (H4 through H7). This grouping reflects the

analytic strategy we propose in section 3 where we simultaneously model within store variation in IRI as

a function of SKU-specific factors and across store variation in IRI as a function of store-specific factors.

Annual Selling Quantity

H1: IRI is positively associated with the annual selling quantity of an item. In other words, the

more (fewer) units per year an item sells, the greater (lower) its IRI.

Support for this hypothesis can be found in the accounting and inventory management literature

as well as in practitioner accounts of warehouse inventory management. Johnson et al. (1981) argued that

inventory accounting populations were more inaccurate than other accounting populations due to the vast

number of inventory transactions that occur. Rout (1976), Stahl (1988), and Backes (1980), in their work

on warehouse inventory and inventory cycle counting, argued that inventory records with greater numbers

6
See DeHoratius (2002) for additional details of this fieldwork including a detailed process flow diagram and
accompanying description.

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of transactions were more likely to be inaccurate. And both Emma (1966) and Sheppard and Brown

(1993) found errors in inventory records to be correlated with item demand.

Observation of Gamma stores and distribution centers also motivates this hypothesis. In

particularly, we uncovered two categories of processes failures, mis-scanning and mis-picking, that can

result in discrepancies between recorded and actual inventory quantities. Mis-scanning occurs if a

checkout person scans one item twice, rather than each item separately, when a customer is buying two

similar (but not identical) items with the same price (e.g., an 8oz. Can of Coke and Diet Coke). This

innocuous action by the checkout person ensures that the customer pays the correct amount and may even

save the customer time as the checkout person avoids handling the additional item. However, it generates

a discrepancy in the inventory record. When the inventory of two items should have been depleted once,

the inventory of only one item will be depleted twice thereby causing a mismatch between the recorded

and actual inventory quantity for these two items. Mis-picking impacts inventory records similarly. A

warehouse employee can mistakenly ship the wrong quantity of a particular item to a store or even send

the wrong item altogether. In an apparel warehouse, for example, it is quite easy for an employee to

mistakenly pick a “medium” instead of a “large” garment. Stores typically do not scan merchandise on

receipt allowing for such errors to remain invisible. Since items that sell more, rather than fewer, units in

a given year proceed more often through stores and warehouse scanning and picking processes, we expect

annual selling quantity to be a factor associated with IRI.

Item Cost

H2: IRI is negatively associated with the cost of that item. In other words, the inventory records

of expensive (inexpensive) items are more (less) accurate than those of expensive items.

Researchers in both accounting and operations management have identified a connection between

record inaccuracy and the cost of an item. Cushing (1974), for example, maintained that personnel are

more likely to scrutinize transactions representing large dollar amounts than minor dollar value

transactions. Sheppard and Brown (1993) demonstrated that inventory records for expensive electronic

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parts are more likely to be accurate than inexpensive parts. They proposed that differential monitoring by

stockroom staff accounted for this observed relationship between part value and record accuracy.

Similarly, we observed that Gamma store managers and employees, in an effort to prevent theft,

paid greater attention to expensive items when checking shipments into their stores and monitoring

inventory levels throughout the year. For store managers who were paid a percentage of store operating

profits, the theft of a single expensive item could substantially impact store profitability, and store

manager compensation, whereas the theft of a single or even multiple inexpensive items might have little

effect on either. Not surprisingly, store managers themselves paid greater attention to the delivery and

movement of high value items. Moreover, company policy regarding the handling of distribution center

shipments to the stores explicitly directed the attention of store employees to high value items. This

policy stated that only inventory above a certain dollar amount should have its quantity verified upon

delivery. Since no items shipped from Gamma-owned distribution centers were scanned into the stored

upon receipt, low value items went onto store shelves without anyone checking whether the quantity

actually delivered matched the recorded delivery amount, an amount that had already been added to the

store’s inventory once it had left the distribution center.

Shipping Source

H3: Records for items received by the store directly from the vendor have greater accuracy than

those received from Gamma-owned distribution centers (DCs).

Research by Baker et al. (2002) regarding transaction costs and vertical integration lends support

to this hypothesis. They argue that an upstream party will refuse to take any costly action when the

downstream party is not paying a bonus for quality performance. Applying their framework to our

context, the DC, unlike the vendor, does not have an outside option to sell its goods to someone else and

therefore expends only minimum effort to ensure quality (e.g., accurate shipments). Moreover, the store

cannot penalize the DC for low quality by, for example, sourcing items from competing DCs. The

inability of the store to source from other distribution centers in the face of poor quality, or the lack of an

alternative source, results in misaligned incentives. On the other hand, vendors are motivated to expend

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more than the minimal amount of effort on ensuring quality performance, accurate shipments in this case,

by the threat of outside options for the retail store.

Observations made during fieldwork conducted at Gamma identified differences in the handling

of DC-shipped and vendor-shipped items that also supports this hypothesis. Gamma stores receive most

of their merchandise from company-owned distribution centers but do receive some SKUs directly from

vendors or distributors. Gamma permits these vendors and distributors to bypass its distribution facilities

in order to offer frequent, small quantity shipments to stores using third-party delivery companies (e.g.,

UPS or FedEx). Unlike shipments received by stores from the DC, described above, items received by

stores from vendors are scanned into store inventory by store employees upon arrival.

Inventory shipments from Gamma DCs to stores, on the other hand, appear in store inventory

records once en route to the store. Then, Gamma store employees do not scan individual items upon

arrival but rather verify the shipment quantity only for items exceeding a particular dollar amount, as

previously noted. Should a discrepancy be discovered for items above that threshold amount, the DC

does not automatically credit the store for that inventory or expedite a shipment to compensate the store

for the missing item7. Instead, the DC managers initiate an investigation into the missing item and,

depending on their findings, may or may not credit the store’s inventory. These investigations entail

examining the output of the electronics scanner at the DC on the shipment day in question. If the DC is

able to verify that the item was scanned out of the DC, the store record stands. Had the item been stolen

from the loading area or en route, packed onto the wrong truck, or unloaded at the wrong store, there

would be no way for the store to update its inventory records to reflect the actual shipping quantity.

7
We hypothesize that store managers will draw attention to a discrepancy more often when the DC fails to deliver a
particular item and not when the DC delivers too much of that item. A store manager benefits when she is able to
sell an item for which she never incurred the cost of carrying that item. It was not unusual, according to Gamma
management, for some store managers to repeatedly deny receiving entire pallets of goods destined for other stores.
These pallets can be mistakenly unloaded at one store given that each truck contains multiple store deliveries on any
given day. It often took the intervention of corporate management, threatening a store visit or a store count, for a
store manager to step forward and admit that the pallet had made its way to his or her store.

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Inventory Density

H4: High (low) levels of inventory density are associated with high (low) levels of IRI.

This hypothesis is analogous to those found in studies, both empirical and theoretical, of the

relationship between manufacturing performance and inventory levels, particularly in the context of Just-

in-Time (JIT) manufacturing. Schonberger (1982), in his work on JIT manufacturing, noted that process

problems are more difficult to identify in the presence of excess inventory. Likewise, crowding in retail

stores makes it difficult for store employees to periodically monitor store inventory for anomalies such as

stock-outs. Retailers often use stock-outs to detect discrepancies between recorded and actually

inventories. Because stock-outs are, at times8, easily visible, store employees can readily check the

recorded inventory level for these items, spot any mistakes, and request an update of the recorded

inventory level. Gamma stores, like those of many other retail chains, are becoming increasingly

crowded as merchandisers stock more inventory in a fixed amount of square footage (Ketzenberg et al.

2000). The greater the inventory density, the less likely “holes” in the shelf will appear, making the

identification of stocked-out items more difficult.

Furthermore, Bertrand and Van Ooijen (2002), justifying the inverse relationship between

inventory and productivity in the Japanese automobile industry found by Lieberman and Demeester

(1999), suggest that high levels of inventory are associated with a high workload level that, in turn,

generates workplace pressure, a variable that has been associated with greater levels of human error (e.g.,

lower levels of process quality). It is quite plausible that the source of error generation in the retail

context is quite similar to that found in manufacturing with high levels of inventory density acting as a

proxy for workplace pressure.

Product Variety

H5: Higher (lower) levels of IRI are associated with higher (lower) levels of product variety.

8
Stock-outs are only easily visible in the shelf area is kept free of merchandise. It is not uncommon for customers
to leave items on an open shelf or even to shift items from one shelf location to another. In these instances,
identifying stock-outs through a visible inspection system is more difficult and time consuming.

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 This hypothesis is consistent with those found in operations management regarding the impact of

increased variety on performance measures such as labor productivity, rework, design costs, inventory

holding costs, overhead costs, and/or plant performance (Skinner 1974, Kekre 1987, Hayes and

Wheelright 1984, Baumol and Ide 1962, Lancaster 1979 1990, MacDuffie et al. 1996, Lindsley et al.

1991, Berry and Cooper 1999, Fisher et al. 1999, Foster and Gupta 1990, Anderson 1995, and Fisher and

Ittner 1999, Moorthy 1984). Essentially, increasing product variety is akin to increasing the

organizational “complexity cost”. In manufacturing such costs include reduced manufacturing efficiency,

frequent changeovers, and the activities need to track and support each variant (Thonemann and Brandeau

2000, Yunes et al. 2004).

We argue increased product variety in retailing leads to additional complexity with stores and

distribution centers carrying multiple items, possibly very similar to each other. Among the problems

occasioned by increased product variety is difficulty in differentiating, during the checkout process in

stores as well as the picking process in warehouses, SKUs that are nearly identical. As a result,

salespeople may scan one item multiple times without recognizing that the customer is purchasing

multiple products that differ from each other. And, warehouse employees may incorrectly pick and ship

one item in lieu of another. This is especially true if like SKUs are located in close proximity, as is the

case at Gamma. Srinivasan et al (1994) demonstrated that shipment discrepancy rates increase in the face

of increasing variety in manufacturing. In retailing, product variety increases the likelihood of DC mis-

shipments to stores, and increases the likelihood of mis-scanning at the store, both of which causes store

inventory records in differ from the actual inventory at the store.

Audit Frequency

H6: IRI increases with the number of days since the last physical audit.

Backes (1980) and Flores and Whybark (1987), in their work on manufacturer inventories, argued

that error accumulates in inventory records until such time as the records are updated by a physical

inventory audit. Neeley (1983) maintains that, aside from eliminating the source of the error, increasing

the frequency of inventory audits is the primary means of minimizing IRI in manufacturers’ warehouses.

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Morey and Dittman (1986) develop a framework for determining the optimal timing of audits needed to

attain a predetermined level of accuracy while Ernst et al. (1993) developed an approach for monitoring

IRI through tailored inventory audits. Iglehart and Morey (1972) recommended modifications to existing

inventory policies and physical inventory counts to compensate for IRI. They recognized that errors in

inventory records impede order fulfillment by warehouses and that existing stocking policies assume

inventory quantities are known with certainty.

Gamma conducts physical audits of inventory at every store, yet the time that elapses between

inventory audits differs among stores. Gamma audits some stores, for example, annually and others

semiannually. Immediately after an audit, recorded inventory levels are updated to reflect actual

inventory levels. These records then subsequently deteriorate through errors in tracking transactions (e.g.,

inventory mis-shipments, mis-scanning). Thus, we expect items in stores whose last audit was conducted

more recently to have lower levels of inaccuracy.

2.3 Data Collection and Variable Definition

In an effort to understand the extent of the IRI problem at Gamma, and to test the hypotheses

generated above, we gathered data from numerous Gamma stores. We randomly selected twelve stores

served by each of two DCs operated by Gamma and thirteen stores served by a third Gamma operated

DC, for a total sample of thirty-seven stores from among more than 1,000 Gamma stores in the US9. In

addition, we restricted our choice to stores that had been opened for at least two years to ensure that each

store was viable and eliminate any operational complexities that might exist in the ramp-up of a new

store.

The information collected about each inventory record includes the results of the 1999 physical

inventory audits conducted in these thirty-seven Gamma stores. Audit teams, using hand-held scanning

devices to register the quantity of each item in the store, count the inventory during a period when the

store is closed to customers. Store managers and, at times, management from the corporate office are

9
No store receives inventory from more than one Gamma-owned distribution center.

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present to ensure timely and accurate counts. Management accounts suitably for the inventory en route to

a particular store by including it in the store count. The information system updates store inventory when

the item leaves the retail-owned distribution center. These audits provide detailed information about each

SKU in the select thirty-seven Gamma stores amounting to a total of 369,567 observations in 1999.

These physical inventory audit reports consist of a list of SKUs in a particular store followed by two

corresponding unit quantities, one representing the “system count” (i.e., the number of inventory units for

each SKU recorded to be on-hand at a particular store), the other the “actual count” (i.e., the number of

inventory units for each SKU actually present in the store at the time of the audit). From these audit

reports we created two variables, RECORDED QUANTITYij (RQij) and ACTUAL QUANTITYij (AQij),

representing the system count and the actual count for item i in store j, respectively.

Outcome Variable

We derived our dependent variable used in the analysis below from these two variables RQij and

AQij. We define a variable ERRORij that measures the absolute difference between the recorded

inventory quantity (RQij) and the actual inventory quantity (AQij). ERRORij captures the magnitude of

record inaccuracy for each inventory item contained in every Gamma store sampled. Because there are

numerous ways to define IRI, it is important to discuss the rationale behind our choice10.

Schrady (1970) provides a comprehensive review of plausible IRI measures and highlights their

advantages and disadvantages. Researchers needing to operationalize the concept of error have done so in

a variety of ways. Some studies have used two categories, accurate and inaccurate (Raman et al. 2001),

while others have set error thresholds (e.g., a record is considered inaccurate if the discrepancy is 1% or

more of the record balance otherwise it is considered accurate; a record is considered inaccurate if the

discrepancy amounts to a monetary value of $1 or more, (Rinehart 1960, Sheppard and Brown 1993)).

Still others have defined record inaccuracy in percentage terms by dividing the absolute size of the record

error by the on-hand quantity (Emma 1966), by dividing the absolute size of the record error by the

10
Note that ERROR is not the same as “shrink”, defined as the difference between recorded and actual inventory
levels measured in dollars.

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recorded quantity (Ernst 1993), or as the percentage of total records with actual discrepancies (Millet

1994)11.

No measure, as Schrady (1970) notes, is without its weakness. Our chosen measure of error,

absolute error, is similar to that found in research on medical errors where an error is defined as a failure

of a planned action to be completed as intended (Kohn et al. 2000). Some medical errors have adverse

effects while others do not but all are counted with equal weight because errors utilize valuable resources

in an unintended way. In retailing, the intent is to have the recorded quantity reflect the actual quantity

on-hand. When this is not the case, resources are used to detect, compensate for, and correct the error.

Furthermore, given that prior research on the bullwhip effect (Sterman 1989, Lee et al. 1997) has shown

even small errors in retail demand signals can lead to large fluctuations in the supply chain, we believe it

is appropriate to focus on even small differences between recorded and actual inventory levels. We

recognize, however, that our measure of error does not take into account the fact that positive and

negative discrepancies may impact Gamma differently as that is beyond the scope of this initial study.

We were unable to measure error as a percentage of either on-hand or recorded quantities since

the on-hand quantity and/or the recorded quantity was, at times, zero making calculating this ratio, for

numerous items, infeasible. Moreover, we believe that defining error in relative terms may mask the

actual problem since automated replenishment systems often allow for very little safety stock and it is not

necessarily the case that being off by one unit when there are already one hundred units on hand matters

less than being off by one unit when there are only five units on hand. Being able to definitively claim

that high error relative to on-hand quantities is worse than low error relative to on-hand quantities actually

depends on a number of other factors such as the margins derived by the product, customer demand for

the product, substitution, etc. Perhaps, in our context, one measure of relative error could be absolute

difference between record and actual inventory quantities divided by the target on-hand quantity. This

11
Those defining error in percentage terms often do not have access to item level data but rather must rely on
aggregate measures of record inaccuracy.

- 14 -
would provide some insight into the magnitude of the error relative to the “planned ideal”. However,

target on-hand quantities vary throughout the year and were not readily available.

Independent Variables

We also obtained for each SKU in the 1999 audits, data such as the price Gamma paid for the

item in that store (ITEM COSTij), unit sales per store during the year preceding the audit (QUANTITY

SOLDij), and an indicator variable denoting whether the item had been shipped to the store from one of

Gamma’s DCs or direct from the vendor (VENDORi).

We also obtained variables describing Gamma stores. Specifically, we measured each store’s

inventory density, product variety, and the number of days between the current and previous audit.

Inventory density, DENSITYj, is the total number of units in store j divided by that store’s selling area

(units per square foot) whereas product variety, VARIETYj, measures the total number of SKUs in store j

(in thousands). The number of days between audits for store j, DAYSj, is a measure of audit frequency.

Select descriptive statistics for each of these variables can be found in Table 1.

3.0 Analytical Strategy

To test each hypothesis, we fit a series of hierarchical linear models to our data12. Hierarchical

models allow us to take into account the multi-level structure of our data (i.e., SKUs are contained within

stores) (Raudenbush & Bryke 2002). Although IRI is measured at the item level, our hypotheses are

measured at both the item and the store level of analysis. Hierarchical models enable us to consider these

multiple units of analysis (SKU- and store-specific) within the same model simultaneously by taking into

12
One could argue that a nonlinear hierarchical model, such as Poisson, might be a better fit for our data given that
the outcome variable includes only integers and is highly skewed. However, our data violates the one assumption
(that the variance and the mean of the outcome variable are equal) necessary for utilizing such a model. We chose,
instead, a linear model with a log transformation of our outcome variable and select independent variables.
Although this choice generates fitted outcomes that are non-integers when the observed outcome take only integer
values, we recognize that these fitted outcomes are estimates generated under a given set of assumptions, as are the
outcomes of any model.

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account the lack of independence between measurements at different levels (Seltzer 1994). More

specifically, observations of SKUs that are contained within the same store cannot be assumed to be

independent. An additional advantage of hierarchical models is that it allows for unbalanced data

(Jayasinghe et al. 2003), a characteristic of our data set which does not have the same number of observed

records for each store due to minor merchandising differences across stores.

The equations below summarize the final models used to test our hypotheses. We predict

ERRORij as a function of SKU-specific factors (QUANTITY SOLDij, ITEM COSTij, VENDORi) in a

“level one” model. This model characterizes the variation in IRI within stores based on SKU

characteristics. Level one coefficients are empirical Bayes estimates with maximum-likelihood estimates

for the variance component (Raudenbush et al. 2001).

LN(ERRORij) = β0j+β1j*VENDORi+β2j*LN(ITEM_COSTij)+β3j*LN(QUANTITY SOLDij)+

β4j*(PC ONEi) + β5j*(PC TWOi) + β6j*(PC THREEi) + β7j*(PC FOURi)+rij

rij ~ N(0, σ2) for i = 1…..369,567, items and j=1-37 stores.

Our “level two” model incorporates our store-specific hypotheses of IRI (VARIETYj, DENSITYj,

and DAYSj). In this model, the intercept and the slope from the level 1 analysis serve as the dependent

variables. Here we examine the variation in IRI across stores. Level two coefficients are generalized

least squares estimates with maximum-likelihood estimates for the covariance component (Raudenbush et

al. 2001).

β0j = γ00 + γ01DAYSj + γ02VARIETYj + γ03VOLUMEj + γ04DENSITYj+γ05DC ONEj +γ06DC TWOj + U0j

β1j=γ10 β2j = γ20 + U2j β3j = γ30 + U3j β4j = γ40 +U4j

β5j = γ50+U5j β6j = γ60+U6j β7j =γ70+U7j

U0j ~ N(0, τoo) where τoo is the conditional variance after controlling for product variety, density, regional

effects, and store sales, or Var(Boj | VARIETYj, VOLUMEj, DENSITYj, DAYSj, DC ONEj, DC TWOj).

Note that we specified the intercept and the slopes of ITEM COSTij, QUANTITY SOLDij, PC

ONEi through PC FOURi as random. VENDORi was not specified as random because our initial

- 16 -
exploratory analysis (see results for Null Model below) showed that VENDORi does not have a

significant variance component. Furthermore, both level one and level two models include several

controls that are described below along with other model details. Table 2 presents the results of the

hierarchical models fit to our sample.

Variable Transformations

We transformed ERRORij, ITEM COSTij, and QUANTITY SOLDij into their natural log to

account for the extreme range of values and the skewed distributions found in our data (Goldstein 2002).

Moreover, because our measure of IRI and quantity sold can be zero, and the natural log of zero is

undefined, we added one unit to each observed unit of error and quantity sold (e.g., if the observed

quantity sold was 11, we used 12 for our regression analysis)13.

Note that LN(ITEM COSTij) and LN(QUANTITY SOLDij) are centered at the store mean so that

the intercept term B0j can be interpreted as the mean error in store j for an item of average cost and annual

selling quantity shipped from the distribution center (VENDORi=0) in Gamma’s most profitable product

category, PC FIVE (PC ONEi =PC TWOi=PC THREEi=PC FOURi=0). DAYSj, VARIETYj, VOLUMEj

and DENSITYj are all grand-mean centered. Finding statistically significant parameter estimates for the

level 1 predictors (B1j, B2j, and B3j) indicates existence of a SKU-level effect within stores. Finding

statistically significant parameter estimates for the level 2 predictors (γ01, γ02, and γ04) indicates existence

of a store-level effect across stores.

Controls

We include product category dummies PC ONE through PC FOUR in order to control for any

unmeasured effect on record inaccuracy that is common to all items in a particular product category.

Product categories classify each SKU into similar groups based on the type of product. Thus, it is

plausible that if all SKUs in one product category were small in size then the SKUs in this product

13
We also ran models, adding numbers less than one (0.5 and 0.33) to determine whether our choice of
transformation had any impact on our results. It did not. Each of the predictors remained statistically significant at
the same level, and we observed only a slight difference in the estimates of our coefficients and standard errors.

- 17 -
category are more likely to have inaccurate records if size and record inaccuracy are associated.

Including these dummies allows us to control for each of the five product categories as a surrogate for any

such unmeasured characteristics.

VOLUMEj, which measure the total annual units sold per store, is one of several controls

incorporated into this store-level model. We believed it important to control for any variation across

stores in transaction volume while testing our store level hypotheses. DC ONE and DC TWO represent

additional store level controls. We include these two dummies to control for any unmeasured effect on

record inaccuracy that is common to all items contained in stores from a particular geographic region.

For example, one could hypothesize that regional differences in crime, regional Gamma management, or

employee (both store and DC) quality all impact store error. Crime, in the form of theft, influences store

error in that it generates a discrepancy between recorded and actually inventory quantities for the stolen

item. Similarly, regional management may enforce select inventory management practices that influence

store error for all the stores in a particular region. For example, regional management could monitor store

activities such as checking of stocked-out items differently thereby causing regional differences in store

error. Finally, the quality of employee may differ regionally such that employees in some regions may be

more or less likely to adhere to store inventory management polices (e.g., checking inventory upon receipt

for missing high value items). Consequently, we include regional dummies to account for these factors.

Regional dummies also control for performance differences across Gamma distribution centers

since each of the three Gamma DCs is located in a separate geographic area and serves all of the stores in

that area (e.g., one DC serves all the stores in New England, another the stores in the Mid-West, and the

third all the stores on the West Coast). Inventory practitioners often attribute problems with IRI to errors

in DC processes. Rout (1976) identifies, as sources of DC process errors, inventory stored in the wrong

location, use of weigh counting, and mis-identified inventory. Von Hoffman (2000) observes that

mistakes in the definition of shipping quantities can also generate errors (e.g. shipping one case rather

than on unit of a particular SKU). Stores that receive shipments from DCs that have developed the

capability to avoid such errors are likely to have fewer items for which recorded and actual inventory

- 18 -
quantities do not match. Because separate management teams operate each of the three Gamma DCs

independently, we expect that such capabilities would differ. This is especially true since, rather than

imposing consistent corporate-wide DC policies, Gamma allows these DC management teams to develop

their own unique policies and practices necessary for effectively running DC processes.

The following example also illustrates how DC processes play a significant role in ensuring the

accuracy of store records. Corporate management at Gamma, in planning for the opening of a new store,

filled the store with inventory and scheduled its opening day. However, instead of opening the store,

Gamma management sent an audit team to count store inventory without informing either store or

warehouse employees. This new store audit revealed that 29% of store records were inaccurate before a

single customer had entered the store. This means a discrepancy exists between the recorded and actual

inventory quantity for roughly 3,000 SKUs in a typical store even before the occurrence of any customer-

related transactions.

4 Results

A histogram of our measure of IRI, ERRORij, across all stores reveals that sixty-five percent of

the inventory records in our sample are inaccurate (Figure 2). ERRORij ranged from zero to 6,988 units

and averaged 4.98 units. Twenty-two percent of the records observed were in error by one unit and

twenty percent were in error by six or more units. The average ERROR within a store also varied (Figure

3). This store error ranged from a minimum of 2.4 to a maximum of 7.9 units.

Null Model

Our hypotheses predict that both SKU- and store-level characteristics are significantly correlated

to IRI. For this to be true, significant between-store variance in IRI should exist. Estimates for a null

model with no SKU- or store-level predictors specified, found in Table 2, allow us to reject the null

hypothesis that the variance in the store mean ERROR is zero (X2=12466.43, p<0.001). Therefore, we

can not assume that all stores have the same mean level of ERROR in our explanatory model. Instead,

variation exists among stores in IRI.

- 19 -
 This model also identifies the intraclass correlation, or the proportion of variance in ERROR

between stores (3.37%), estimates the within store residual variance (1.56), and serves as a base-line

model for our subsequent analyses. Note that an estimator of the reliability of the sample mean derived

from this model, 0.997, indicates that the sample store means tend to be quite reliable indicators of the

true store means.

SKU-Level Factors

Table 2 also presents the results of a random-coefficient regression model with only SKU-level

predictors. Hypotheses 1, 2, and 3 predict that SKU characteristics are associated with IRI. We estimated

a level 1 model including these variables with no predictors specified for the level two model.

Collectively, these variables explained 18% of the within store variance in IRI14. Since each fixed effect

coefficient is stasticially significant (p<0.001), each of these variables will be retained when we

incorporate our store level predictors. Note that the direction of the effect for item cost (-) and quantity

sold (+) support our hypothesized relationships. Moreover, the statistical significance of each of the

random effect estimates of variance for the SKU-level predictors item cost and quantity sold (p<0.0001)

indicate that there is sufficient variability among stores in these variables to treat them as random. The

insignificance of the random effect coefficient for vendor (p>0.500), on the other hand, suggests that we

retain only its fixed effect in subsequent models.

Inclusion of Store-Level Factors

The addition of our store-level predictors allows us to examine the simultaneous influence of

store and SKU characteristics on ERROR. Table 2 presents the results our investigation of the

relationship between ERROR and QUANTITY SOLD, ITEM COST, VENDOR, DENSITY, VARIETY,

and DAYS while controlling for regional effects and product categories. This model reveals that SKU-

level variables such as an item’s cost and its selling quantity are associated with ERROR as is an item’s

14
This is determined by calculating the reduction in the residual within store variance in ERROR that remains
unexplained after taking into account the cost of an item, it annual selling quantity, its shipment source, and
controlling for its product category ((1.281-1.56)/1.56).

- 20 -
shipping source, after controlling for the impact of product categories and regional differences15.

Examination of the fixed effects estimates show that QUANTITY SOLD, ITEM COST, and VENDOR

are statistically significant (p<0.001, p<0.001, p<0.001, respectively). We therefore reject the null

hypotheses that ITEM COST, QUANTITY SOLD, and VENDOR are not related to IRI within stores. As

hypothesized, IRI increases with quantity sold (H1: confirmed) and decreases with item cost (H2:

confirmed). Note that in a typical store, the record inaccuracy of an item shipped from the vendor is 15%

less than an item with the same characteristics (item cost, quantity sold, and product category) shipped

from the retailer’s own distribution center (H3: confirmed).

The inclusion of these store-level variables resulted in being able to explain 58% of the variance

in average IRI across stores. The main effect of store-level variables DENSITY and VARIETY were

both statistically significant (p=0.035 and p=0.081, respectively) after controlling for SKU-level

predictors. In a typical store, controlling for all other hypothesized variables, we observe greater

inaccuracy in stores with greater levels of inventory density (H4: confirmed). Similarly, IRI and product

variety is positively correlated (H5: confirmed). However, the fixed effect for DAYS was not

statistically significant (p=0.222) (H6: rejected). Two possible explanations exist for this finding. One,

audits do not have the impact expected on IRI perhaps due to fallibility in the inspection process (Ballou

and Pazer 1982). Two, Gamma managers may actually conduct intermediary audits of select items (e.g.,

add merchandise) in preparation for certain seasonal events or in expectation of visits from district

managers or executives from headquarters conducting store visits. Thus, the number of days between

physical audits may not be a true reflection of the actual audit frequency and inventory updating.

5. Discussion

15
Examining the variance inflation factors as part of our collinearity diagnostics, we failed to detect the presence of
multicollinearity among our predictors. Thus, we do not expect our estimates to be biased due to excessive
collinearity in our model.

- 21 -
 Despite the extensive use of IT that has made it easier, and less expensive, for retailers to collect

and store data about the flow of goods through their organization than ever before, the tracking of

inventory remains prone to error. Our empirical investigation revealed the magnitude of this error across

multiple stores of the same retail chain. We found that the variation in IRI found within stores is

associated with the cost of an item, its annual selling quantity, and the distribution method used to ship

that product to the stores. And, store-specific characteristics such as product variety and inventory

density are related to the variation in IRI we observed across stores.

This paper underscores the importance of measuring IRI in the retail context. Figure 4 shows the

percentage Gamma SKUS in each product category that was out of stock at the store but not out of stock

in the record. This percentage ranged from approximately 10-13% depending on the product category.

These are, in essence, invisible out of stocks - SKUs that, without manual intervention, will remain

unavailable for customer purchase because the system is unaware of the actual on-hand quantity. Lost

sales are often the consequence of stock outs in inventory systems depending on a customer’s willingness

to substitute, the proximity of competing stores, etc. (Anupindi et al. 1998, Nahmias 1994, Wecker 1978,

Emmelhainz, L. W. et al. 1991, Emmelhainz, M. A. et al. 1991, Nahmias and Smith 1994).

IRI is in many ways similar to the product quality problem that absorbed managers and

researchers in manufacturing many years ago. Like product quality issues then, managers today are often

unaware of the presence, magnitude, and characteristics of IRI. Echoing the solution to product quality

problems, Morey (1985) notes three mechanisms for improving service levels in the face of IRI: increase

the frequency of inventory counts, maintain additional safety stock, or identify and eliminate the source of

the errors. Our findings speak to each of these mechanisms.

First, we demonstrate empirically that the frequency of inventory counts may not impact record

inaccuracy as expected. It may be that, like product quality, prevention, rather than inspection, has the

most impact on IRI. For a discussion on the benefits and drawbacks of inspection on product quality see

Garvin (1988).

- 22 -
 Second, additional buffer stock may not be equally necessary across all items in all stores. By

incorporating the factors associated with IRI, researchers can extend the work of Iglehart and Morey

(1972) who modify a single item inventory model with periodic review to compensate for shortages

caused by inaccurate inventory records through additional buffer stock. Similarly, researchers can

include additional specifications into the single period newsvendor model Porteus (1991) considers in the

face of uncertainty in the initial stock level. These are just two examples of the potential research

extensions possible through the integration of our empirical findings and existing theoretical models16.

Third, the findings related to inventory density and product variety have important implications

for identifying and eliminating the source of IRI. Gamma has been increasing both the inventory and

number of SKUs in their stores over time in an attempt to satisfy more, and more diverse, customers.

Moreover, vendors are constantly pressuring the chain to carry more merchandise and to increase variety

in order to achieve higher customer service levels. Our analysis, however, suggests that increasing

variety and inventory might instead compromise service levels by increasing IRI. The additional sales

that stocking more inventory in a particular store generates needs offset the cost of carrying this additional

inventory, including any costs associated with the increase in IRI.

This does not imply that the additional complexity associated with variety and density can not be

managed appropriately. Managers must identify the root cause of inventory record inaccuracy problems

and determine the impact additional variety and density has on these activities. Perhaps designing

structured replenishment processes and procedures, clear visual identification of items and their location

in storage, in transit, and within store; and developing exception reporting to identify errors and

appropriate problem solving techniques to correct and prevent error reoccurrence may allow for the co-

existence of complexity and accuracy in the same way product quality and variety co-exist in Toyota

Production Systems (Spear and Bowen 1999, Hopp and Spearman 2004).

16
Recent interest in Radio Frequency Identification Technology and its supposed ability to impact inventory record
inaccuracy has also led to a re-examination of traditional models.

- 23 -
6. Limitations of this Study and Future Research

We recognize the existence of several limitations to our study. First, we were unable to control

for all factors that might impact variation in IRI across stores. It is plausible that employee tenure and

training, store manager practices, as well as other unmeasurable factors may influence store level IRI.

Developing measures to determine the impact of such factors on the within-store variation in IRI may be

of considerable interest to operations and organizational behavior researchers alike.

Second, we study the retail stores of one firm and therefore face concerns over the external

validity of our study. Studying one firm allows us to control for factors that may influence IRI and vary

across firms such as information technology, firm ownership, and incentive design. However, in order to

generalize from the results of our study, we recommend future replication and extension of this study. \

For the sake of brevity, we elected not to explore the differences in IRI across product categories.

We hope to design future studies that would enable us to delve more deeply into product category

characteristics that might be related to IRI. Similarly, we did not explore any financial implications of

IRI. Additional research linking IRI to store or retailer performance or further investigation into the

financial trade-off between increased variety or density and increased inaccuracy is warranted.

- 24 -
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Table 1: Variable Definition and Sample Summary Statistics

Standard Deviation
Variable Name Mean Minimum Maximum
SKU-Level (Level 1), n=369,567
ERROR (units) 4.98 28.54 0.00 6,988
ITEM COST ($) 20.43 66.85 0.01 3,474
QUANTITY SOLD (units) 71.47 318.60 0.00 40,229
Store-Level (Level 2), n=37
DENSITY (units/ft2) 8.28 1.62 5.43 11.36
VARIETY (# of SKUs/1000) 8.90 0.72 6.01 10.14
DAYS (days) 342.27 111.23 105.00 523.00

Table 2: Hierarchical Linear Modeling Results for Inventory Record Inaccuracya

Variable Null Model SKU-Level Predictors Store-Level Predictors

Level 1
Intercept 0.643*** (0.055***36) 0.760*** (0.064***36) 0.685*** (0.027***30)
VENDOR -0.174*** (0.004 36) -0.161***
ITEM COST -0.144*** (0.000***36) -0.144*** (0.000***36)
QUANTITY SOLD 0.175*** (0.001***36) 0.175*** (0.001***36)
PC ONE -0.291*** (0.020***36) -0.298*** (0.020***36)
PC TWO -0.196*** (0.016***36) -0.196*** (0.016***36)
PC THREE -0.386*** (0.020***36) -0.386*** (0.020***36)
PC FOUR -0.050*** (0.005***36) -0.050*** (0.005***36)
Level 2
DC ONE -0.014
DC TWO 0.244***
VOLUME 0.003***
DAYS 0.000
VARIETY 0.038~

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 DENSITY 0.026*
Within-Store Residual 1.563 1.281 1.281
Variance
a Entries are estimations of the fixed effects with robust standard errors. In parentheses are estimations of

the random variance components, their significance, and degrees of freedom. ~p<0.10, *p<0.05,

**p<0.01, ***p<0.001

Figure 1: Histogram of the Difference Between Recorded and

Actual Inventory Level
40.000
Percentage of Records

35.000
30.000
25.000
20.000
15.000
10.000
5.000
0.000
1000+

1000+
601-800
201-400
51-100
-10
-8
-6
1
-2
0
2
4
6
8
10
51-100
201-400
601-800
Difference Between Recorded and Actual Inventory Level (Units)

Figure 2: Histogram of the Absolute Difference Between Recorded & Actual

Inventory Levels (n=369,567)
35
Percentage of Inventory

30

25 22
Records (%)

20

15
10 9
10
6
4 3 3
5 2 2 1 1 2 01
5

1
0.0
04

02

01
00

0.
02
2

1
0.

0.
0.

0.

0.
0.

0.

0
0

10

11-50

51-100

101-150

151-200

201-250

251-300

301-350

351-400

401-450

451-500

501+

Absolute Difference Between

Recorded and Actual Inventory Level (Units)

- 32 -
 Figure 3: Average Inventory Record Inaccuracy Within Stores

8.00 Maximum 7.87

7.00
6.00
5.00
Units

Minimum
4.00
2.44
3.00
2.00
1.00
0.00
Store

Figure 4: Examining Items Out of Stock

2
.9

14 20,000
7

12
.0
3

18,3 18,000
.6

12

25
Product Category Stocked

11

.0
Percent of Items in Given

Number of Items Stocked

12
Out at Time of Physical

Out at Time of Physical

11
2
.0

16,000
10

10 14,000
8 12,000
Audit

10,5 Audit
0 9 10,000
6 8,74
3 8,000
4 5,57 6,000
0
4,000
2
1,19 2,000
0 6 -
1 2 3 4 5
Stocked out items as % of product category total
Product Category
Number of Stocked Out Items (AQ = 0)

- 33 -