Management Accounting Section Midyear Meeting

Operating Leverage and Discretionary Investment

• In Event: Firm Behavior

Abstract

This study examines the association between firms’ operating leverage (proportion of fixed operating costs to total operating costs) and their investment behavior. Operating leverage measures the sensitivity of operating income to changes in sales revenue and hence serves as a way for a firm to adjust its risk-return tradeoff. Consistent with operating leverage influencing earnings volatility and the risk of liquidity constraints, we find that firms with higher operating leverage tend to have lower discretionary investment. The negative effect of operating leverage is primarily due to a reduction in overinvestment rather than its impact on underinvestment. We also find that firms with higher operating leverage tend to carry larger cash reserves. Finally, operating leverage mitigates the well-documented investment cash flow sensitivity by moderating managers’ incentive to overinvest excess cash. Overall, our findings suggest that firms’ choice of cost structure has disciplining effects on managers’ overinvestment and extend the literature on cost structure.

Authors

• Kyonghee Kim, Michigan State University

• Sangmok Lee, Michigan State University