The Effect of strategy on the asymmetric cost behavior of SG&A expenses

Posted by Apostolos Ballas - Jan 04, 2021

In a recent study, forthcoming in the European Accounting Review, Vassilis Naoum, Orestes Vlismas and I, explore the effect of strategy on the asymmetric cost behavior of SG&A expenses.

A traditional assumption in cost accounting is that the relationship between variable cost items and sales volume is linear and symmetrical for both activity increases and decreases. Current cost accounting research identifies a phenomenon in which variable costs are sticky because they respond asymmetrically to increases and decreases in sales revenues. That is, costs decrease less when sales revenues fall than they increase when activity volume rise by an equivalent amount. This cost phenomenon attributes an explicit role to managerial deliberate resource-commitment decisions. When sales revenues fall and there is uncertainty about future demand, managers purposely retain slack resources or delay resource reductions because of high retrenching adjustment costs (e.g., costs of firing employees; loss of morale) and of restoring resources (e.g., training costs; installation costs) when volume is restored. Therefore, managers cut resources to a lesser extent when activity volume decreases than they will expand resources when volume increases, generating cost stickiness or asymmetric cost behavior.

A firm’s strategy shapes its business model, affects its cost structure, and directs managerial behavior. Asymmetric cost behavior is attributed to deliberate managerial resource commitment decisions. A plausible assumption is that a firm’s strategic orientation affects the underlying economic rationale of the resource allocation managerial decisions associated with cost asymmetry. Further, firms with fundamentally different strategic orientations might exhibit different manifestations of asymmetric cost behavior (i.e., cost stickiness versus cost anti stickiness). For this reason, our study emphasizes on Miles and Show’s strategic typology and focuses on the two distinct generic strategies that comprise the endpoints of the strategy continuum: “defenders” and “prospectors”.

Firms characterized as “prospectors” attempt to be innovative market leaders and to implement a build strategic mission that focuses on maximizing long term economic benefits. The effective implementation of a prospecting strategy requires the deployment  of organizational activities that (i) consume resources which are associated with the level of the SG&A expenses, (ii) their strategic significance for the future operating performance elevates the levels of the associated future and current period’s adjustment costs and (iii) are anchored with managerial expectations for increased uncertainty for the future level of future sales beyond the sales volatility attributed to demand uncertainty. As this, firms classified as prospectors tend to exhibit SG&A cost stickiness. On the other hand, firms characterized as “defenders” have strategic orientation which aims on maximizing current period’s earnings at the expense of future economic benefits. Managers of these firms focus on achieving incremental growth primarily through market penetration, efficient cost management and effective usage of single core technology. For this reason, the implementation of strategic orientation of a firm classified as “defender” is likely to reduce the levels of future and current periods’ adjustment costs attributed to the SG&A expenses and to exhibit SG&A cost anti-stickiness.

The published study, employing a sample of US-listed firms for the period 1991–2014, provides empirical evidence that a firm’s strategic orientation determines the direction and intensity of the asymmetric cost behavior of SG&A expenses. Documenting the relation of SG&A cost asymmetry with strategy is timely in the context of strategy-constituted management accounting. Our main findings suggest that firms classified as “prospectors” exhibit increased SG&A cost stickiness whereas firms classified as “defenders” exhibit slightly increased SG&A cost anti-stickiness. Furthermore, we highlighted the role of managerial ability as a source of additional variability on the intensity of cost stickiness across firms share similar strategic attributes; we provide evidence on how the level of managerial ability influences the sticky cost phenomenon within groups of firms implementing two diverse types of business strategy (innovative and exploratory firms compared with firms focusing on efficiency).

Our study emphasizes that the examination of asymmetric cost behavior should take into consideration firms’ perspective to be innovative market leaders in numerous domains, compared with firms that maintain a narrow and stable product focus to compete based on price, service, or quality. Further, given a firm’s strategic positioning, managers’ ability to be more knowledgeable about the firm and the industry, as well as to be better able to synthesize information into reliable forward-looking estimates, is crucial regarding their deliberate commitment decisions that affect cost stickiness. Consequently, a hasty conclusion that a disproportionate increase/decrease in SG&A expenses compared to net sales across time or within an industry is a negative signal of firm’s operation, may be a misleading because this cost behavior may be due to firms’ orientation combined with managers’ skills.