The Managerial Perception of Uncertainty and Cost Behavior

Abstract

Extensive theoretical research demonstrates the pivotal role uncertainty plays in shaping a firm’s cost behavior. Our study contributes to this literature by conducting a comprehensive multivariate analysis of the inherent tension between the effects of price and demand uncertainty on cost elasticity and cost asymmetry. Using the occurrence of words implying uncertainty in forward-looking statements in the Management Discussion and Analysis section of 10-K reports to measure the managerial perception of the overall, price, and demand uncertainty, we provide evidence of a positive and significant association between price uncertainty and cost elasticity and a negative and significant association between demand uncertainty and cost elasticity. The former finding is consistent with managers’ desire to shift to a more elastic cost function in the face of high price uncertainty; the latter supports the hypothesis that firms facing demand uncertainty will increase their capacity of fixed resources to avoid disproportionately large production congestion costs associated with high demand realizations. We reconcile findings in prior studies by demonstrating that the association between demand uncertainty and cost elasticity is negative for manufacturing firms but is positive for firms in the healthcare sector. We also document that managerial perception of the overall uncertainty exacerbates the degree of cost asymmetry. Our empirical evidence supports the theoretical argument that the managerial perception of uncertainty and its components influences their resource allocation decisions, and suggests that any analysis of the relation between uncertainty and a firm’s cost behavior needs to be conducted in the context of a specific type of uncertainty and industry affiliation.