Management Expectations and Asymmetric Cost Behavior

Abstract

The documentation of asymmetric cost behavior in response to changes in demand has attracted much scholarly attention over the past decade. Most studies propose that this cost asymmetry is due to the influence of management expectations on their deliberate resource allocation decisions. This study examines empirically the effect of management expectations on cost asymmetry, and, principally, the tension between these expectation-based decisions and constrains imposed on these decisions by two economic drivers of the cost asymmetry — the availability of initial slack resources and adjustment costs. Using the tone in the forward-looking statements (FLS) of a sample of 10-K reports as a measure of management expectations, we document a positive and significant relation between the favorableness of management FLS tone and the degree of cost stickiness. Furthermore, we demonstrate that managers’ expectation-driven decisions can reverse the previously documented anti-sticky cost behavior imposed by high slack resources. Notably, we find the impact of management expectations on the degree of cost asymmetry is strongest when both the initial amount of slack resources and the magnitude of the adjustment costs are high. Conversely, when both the magnitude of the adjustment costs and the initial amount of slack resource are low, management expectations have no impact on the degree of cost asymmetry. Our combined evidence supports the theoretical explanation in the literature that management expectations influence their resource allocation decisions, and indicates that other economic determinants may need to be considered when assessing the impact of these decisions on a firm’s cost structure.