Newswise — In this study, published in the Journal of Accounting and Economics, Kama and Lehavy focus on understanding how managerial perception of future demand uncertainty and the price they can charge for products impact their choices of the type of resources they plan to use in the business.
Building off their previous work on how performance optimism and pessimism affect managerial resource allocation decisions, Kama and Lehavy use innovative linguistic analysis tools to extract managerial perceptions of the uncertainty surrounding future price and demand as reflected in their forward-looking statements.
Kama and Lehavy find a remarkably strong link between managers’ views on future uncertainty and their resource allocation decisions, particularly whether they choose to invest in committed versus flexible resources. The study found that when managers face higher uncertainty about the level of future demand, they shift their cost structure towards committed resources such as infrastructure, equipment, and permanent staff.
Conversely, when facing greater uncertainty around what price they could set on selling future products, they change their cost structure to depend more on flexible resources such as temporary workers, vendor services, or supplier contracts.
Kama and Lehavy share a few key insights on their study in the following Q&A.
Based on your study, why do managers shift their cost structures when facing uncertainty around demand or price?
Our research reveals a crucial insight: When managers sense greater uncertainty about whether the expected selling price will cover expenses, they tend to opt for a cost structure with a higher ratio of variable to fixed costs, which we call a more elastic cost structure. This choice provides the flexibility needed to adapt to changing economic conditions, and this flexibility becomes increasingly valuable as uncertainty grows.
On the other hand, when they expect uncertainty surrounding the demand for their products to be higher, managers tend to reduce cost elasticity by committing more resources to capacity. This strategy aims to avoid extra expenses that arise when there is not enough capacity to efficiently handle future surges in demand, thus mitigating what is known as congestion costs.
How do company-specific factors such as financial stability or industry competition affect managerial decisions?
Interestingly, various company characteristics can influence managers’ responses to uncertainty about future demand. For instance, our research indicates that managers in firms with longer production cycles are more concerned about demand uncertainty. This heightened concern is probably because they cannot quickly and efficiently scale production to meet sudden increases in demand. We also show that managers’ view of demand uncertainty affects cost flexibility only in firms with low financial risk. These financially robust firms are not as worried about the negative impacts of low demand for their products compared to firms with high financial risk that are more sensitive to the losses triggered by lower sales volumes.
One last factor is related to industry concentration. In highly concentrated industries, where competition is minimal, firms enjoy significant control over pricing, costs, and production volumes. As a result, these companies are less worried about how uncertainty around price and demand fluctuations might impact their cost structures. Our research shows that managers’ concerns about price and demand uncertainty significantly influence cost flexibility in industries with relatively high competition rather than in those dominated by a few key players.
Are there any examples of industries currently facing uncertainty around demand or price? How might your research clarify some of their cost structure decisions?
The auto industry exemplifies a sector grappling with significant uncertainty about future demand and product pricing, particularly regarding electric vehicles. Faced with unpredictable demand and potential congestion costs, several auto manufacturers have opted for less flexible cost structures, investing heavily in committed resources like battery manufacturing technologies and reallocating existing assets.
This approach aligns with our findings on how managerial perceptions of demand uncertainty influence cost flexibility. Unfortunately, the anticipated high demand for EVs has not yet materialized, resulting in losses and forcing these companies to reverse some of their earlier decisions.
What are the practical implications of your findings, and how might they be used by the various stakeholders?
Understanding the link between managerial expectations and resource allocation decisions has crucial practical implications, as these choices directly impact a company's reported earnings. Our research findings offer significant insights for various stakeholders. Board members can more effectively evaluate managerial performance and understand the reasoning behind resource allocation. Investors can enhance their analyses of earnings forecasts by factoring in the influence of managerial expectations on these decisions.
Additionally, resource providers, including employees and facility lessors, can see how managers' outlooks on future success and uncertainty may lead to workforce and space adjustments in response to changing sales levels. Finally, policymakers can better understand the implications of their uncertainty-shaping decisions on resource allocation, including impacts on the job market.
RSS