Do Financial Resources Determine Cost Behavior?

Abstract

According to previous research, firms prefer to temporarily maintain unutilized resources when business activity decreases, thereby reducing future ‘congestion costs’ that occur when revenue growth resumes. We argue that such optimizing behavior – referred to in the literature as sticky costs – is conditional on financial resources that support the increase in risk that results from maintaining additional costs. Using data from US manufacturing firms between 1984 and 2018, we find overwhelming support for the hypothesis. Across a range of tests, the most financially constrained firms have the least sticky costs. Firms that lack financial resources such as debt capacity and cash holdings essentially do not exhibit sticky cost behavior. Large firms with significant financial slack, in contrast, display cost stickiness that exceed the baselines results by a factor of three. While the latter finding is suggestive of poor cost discipline, our findings show that these firms are in fact associated with superior cost efficiency. Our results are consistent with the view that excessive adjustment to cost structure is an important component of financial distress.

Keywords: Cost Stickiness, Financial Constraints, Cost Efficiency, Financial Slack

JEL Classification: G30, G32