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Inventory shrinkage is prevalent in many industries. Radio Frequency Identification (RFID) technology has been regarded as a promising solution for inventory inaccuracy. Many retailers endeavor to push their suppliers to adopt this technology. This paper considers the situation of a retailer subject to inventory inaccuracies stemming from shrinkage problems. We apply a newsvendor model to analyze how to reduce inventory shrinkage problems by deploying RFID. We study two scenarios for managing an inventory system with shrinkage problems. In the first scenario, the retailer optimizes its operations only by taking into account the inventory shrinkage problems. In the second scenario, the retailer further improves its operations by deploying RFID. We analyze inventory shrinkage problems by optimizing order quantities and expected profits in consideration with the effect of the available rate of ordering quantity, RFID read rate improvement, and the tag price, respectively. The results show that whether the retailer deploys RFID depends on the relative value of the available rate of ordering quantity and RFID read rate improvement. We also present a formulation of the threshold value of tag cost which makes the deployment of RFID cost-effective.

Inventory inaccuracy is a major operation problem in many supply chains. According to DeHoratius and Raman (2008), inventory inaccuracy occurs when the inventory record does not match the physical inventory that is actually available. An empirical study by DeHoratius et al. (2001) reports that out of close to 370,000 SKUs investigated, more than 65% of the inventory records did not match the physical inventory at the store-SKU level. Moreover, 20% of the inventory records differed from the physical stock by six or more items. Most of the investigations dealing with this issue provide the factors generating errors in inventory systems, and conclude that shrinkage is the main factor generating inventory inaccuracy (Rekik, 2010). Shrinkage includes inventory theft, spoilage, and damage. Customers can spoil or damage products by tearing a package to try on the contained cloth item, wearing down a shoe by trying it on and walking, erasing software on computers during demonstration, spilling food on clothes, or scratching a car during a test drive (Bensoussan et al., 2007). As a consequence, some products are unavailable for sale. An ECR (Efficient Consumer Response) (2003) Europe project’s research shows that the scale of shrinkage in the fast-moving consumer goods sector is 2.41% of the whole turnover value of the sector. Process errors account for 27% of the shrinkage value, 7% is due to deceptions, 28% is due to internal thefts, and 38% is due to external thefts.1 Radio frequency identification (RFID) technology has been publicized as a promising solution for inventory shrinkage. Lee and Özer (2007) indicated that RFID can help reduce inventory shrinkage in three ways. First, the ability to accurately monitor inventory can reduce theft and avoid fraud, leading to a direct reduction of inventory shrinkage. Second, depending upon the achieved read accuracy, RFID enhances the accuracy of the information currently obtained through barcode scanning, which is more vulnerable to human error. Third, by providing visibility so that inventory records more closely correspond to actual inventory, replenishment can be more accurate, leading to fewer stock-outs. From an inventory management point of view, Rekik et al. (2009) argued that RFID has two principal values. First, the visibility provided by RFID technology highlights shrinkage problems, ensuring accurate knowledge of actual inventory levels by eliminating the discrepancy between physical and information flows. Second, RFID technology “corrects” shrinkage problems by eliminating them. A study by de Kok et al. (2008) of the effects of RFID technology derived a similar result. Despite the application of RFID mainly at the case level and the pallet level, many researchers have realized its possibility for wider use at the item level as the tag cost descends, and given attention to product application, such as Gaukler et al. (2007), Zhou (2009), and Szmerekovsky and Zhang (2008). Therefore, we will investigate the effectiveness of RFID technology at the retail level.

In this paper, we study incentives of retail stores in supply chains to invest in RFID to reduce inefficiencies of inventory shrinkage. We consider an improved newsvendor model to analyze the optimal order quantities and the expected profits of the supply chain with inventory shrinkage problems. Our analysis consists of two scenarios. In the first scenario, the retailer optimizes its operations only by taking into account the inventory shrinkage problems. In the second scenario, the retailer further improves the inventory system by deploying RFID. Furthermore, in this paper, we consider that only a portion of inventory shrinkage errors can be eliminated because RFID technology is imperfect, which is closer to the actual situation in retail stores. Finally, we analyze the effect of the available rate of ordering, the improvement rate of RFID, and the tag price, respectively. We find that the incentives of the retailer to deploy RFID depend on the relative values of available rate of ordering and the improvement rate of RFID. When the value of the available rate of ordering is lower than the critical value, the retailer gains higher expected profits under the scenario of deploying RFID. The results also show that the greatest incentives to adopt the technology occur for higher values of RFID read rate improvement. The gap in expected profits with different available rates of ordering narrows as RFID read rate improvement increases, which indicates that there exists a substitution effect between available rate of ordering and RFID read rate improvement. We also propose an analytical critical tag cost which makes the deployment of RFID cost-effective, and the RFID tag cost should be small enough to be adopted by the retail store. One common result in all of our settings supports the current reactions of supply chains to RFID technology and shows that unless the tag price is cheap enough, no retail store would benefit from an investment in this technology. Concerning the discrepancy between the quantities ordered from the supplier and the available-for-sale quantity, we have only considered the inventory shrinkage problem. Our model can be extended to include other types of problems, such as misplacement. It would be interesting to study the problem of RFID adoption in multiple sales periods.