Rise of Cost Stickiness: Experimental Evidence of the Effects of Decision Horizons and Incentive Contracts on Production Decisions

• In Event: Doctoral Student Faculty Interchange II

Abstract

Firms employ different lengths of decision horizons based on numerous factors, such as their production processes or resource needs. Managers often make decisions for future outcomes based on their firms’ production cycles. This study examines the effect of different lengths of decision horizons on production decisions in a lab experiment setting. Further, this study investigates how different types of incentive contracts affect production decisions and, in turn, alleviate cost stickiness. Cost stickiness describes the phenomenon where costs decrease and increase asymmetrically. Cost stickiness can be problematic, as firms with sticky cost behaviors have less accurate analysts’ earnings forecasts or have higher credit risks. Balakrishnan et al. (2014), however, question the validity of the cost stickiness literature and express concerns that the findings thus far may reflect the effect of fixed costs. The current study considers these concerns by assuming complete variable costs in a controlled lab setting. The expected results of this study will provide evidence that different lengths of decision horizons affect individuals’ optimism, thus affecting their production decisions. As a result, individuals with long decision horizons make more asymmetric upward and downward production decisions, and this decision pattern gives rise to cost stickiness. Further, the results will demonstrate that when individuals’ incentives are tied to the future outcomes of their production decisions, their decisions lead to stickier cost behaviors. This study provides several important contributions to practitioners and the literature. First, this study shows that cost stickiness is not entirely derived from the cost structure of a firm but occurs when there are no fixed costs. Second, previous studies in this area were conducted using archival methods, so we could not observe how simultaneous upward or downward production decisions induce cost stickiness. Third, this study offers direct evidence of the human psychological factor on cost stickiness by conducting a lab experiment.

Author

• Sohee Kim, University of Kentucky