The role of financial slack on the relationship between demand uncertainty and operational efficiency

Abstract

Global business practice shows that firms tend to maintain more financial slack during the time with volatile demand. But whether holding excess financial resources translates to better operational efficiency in an uncertain environment is an open question. Intuitively, financial slack is considered to alleviate the impact of demand uncertainty by providing a buffer, which can be committed to adjusting operations in dealing with demand uncertainty. However, agency theory suggests that financial slack may lead to agency problems, which amplifies the negative relationship between demand uncertainty and operational efficiency. These two views seem contradictory. Based on a sample of 1176 U.S. companies from 2000 to 2021, we investigate whether financial slack alleviates or exacerbates the impact of demand uncertainty on firms' operational efficiency. We define operational efficiency as the conversion efficiency of a firm's input to output in an improved production function, which we use stochastic frontier analysis (SFA) methodology to estimate. Our analysis find that demand uncertainty hurts firms' operational efficiency, and this negative effect is further pronounced for companies with greater financial slack. This result confirms the risk-exacerbating role of financial slack. Additional tests revealed that managers with greater financial slack show poorer cost management performance instead of more investment when facing severer demand uncertainty. Our study contributes to the literature by providing a better understanding of financial slack's role in operational management.