Accounting Performance, Cost Strucutre, and Firms' Capacity Investment Decisions

Abstract:     
This study examines the effects of accounting based performance-measures, cost structure, and operational factors on firms' capacity investment decisions. We combine insights from operations and accounting theory and posit that accounting performance measures such as contribution margin as well the proportion of fixed cost in the cost structure interact with operational factors such as capacity utilization and demand variability to influence firms' capacity investments. Empirical analyses using department-level data from the US hospital industry for the period 1998 to 2005 indicate that superior accounting performance, a high proportion of fixed costs in the cost structure, high levels of capacity utilization, and large variability of demand have positive effects on capacity investment decisions. In addition to these independent effects, we hypothesize and find interactions between operational and accounting factors. Accounting performance negatively interacts with capacity utilization in influencing capacity decisions. Demand variability influences the noise in accounting performance measures and hence negatively interacts with accounting performance in determining capacity decisions. In addition, the proportion of fixed costs interacts with capacity utilization to influence capacity investment decisions such that firms with a higher proportion of fixed costs in their cost structure place a higher weight on capacity utilization when making investment decisions. This empirical study fills a gap in the capacity investment literature and contributes to the understanding of operational and accounting determinants of firms' capacity investment behaviors.

Keywords: Capacity investment, accounting performance, fixed cost

JEL Classifications: M41, G31

Working Paper Series