Managerial Incentives, Options, and Cost-Structure Choices

Abstract

This study explores a relationship between changes in managerial risk-taking incentives and adjustments of firms’ cost structures, particularly the operating leverage (fixed-to-variable cost ratio). We find that managers reduce operating leverage by substituting fixed costs with variable costs, mainly in the SG&A and R&D cost components, in response to reductions in option-based compensation after the issuance of SFAS 123R. Managers facing a decrease in risk-taking incentives adjust operating leverage downward because high operating leverage intensifies the downside potential of earnings. Overall, we present compelling evidence that managers adjust the cost structure of their firms in response to a reduction in risk-taking incentives.