SSRN_ID688473_code149402

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Further Evidence on the Sticky Behaviour of Costs

Kenneth Calleja

Goldman Sachs

102 Fleet Street

London EC4A 2QQ

Michael Steliaros

FGS Capital LLP

20 St James’s Street

London SW1A 1ES

Dylan C. Thomas

Cass Business School

106 Bunhill Row

London EC1Y 8TZ

(contact author: d.c.thomas@city.ac.uk)

MARCH 2005

Key words: cost behaviour, cost stickiness

Acknowledgements to follow

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Further Evidence on the Sticky Behaviour of Costs

ABSTRACT

Contemporary studies on cost behaviour find that costs increase more with activity increases than they decrease in response to equivalent activity decreases. This sticky cost behaviour contradicts the traditional model which assumes that costs behave symmetrically for activity increases and decreases. Using a sample of US, UK, French, and German firms, we find that operating costs are sticky in response to changes in revenues; operating costs increase, on average, by 0.97% per 1% increase in revenues, but decrease by only 0.91% per 1% decrease in revenues. However, costs of firms that are subject to code-law systems of corporate governance (France and Germany) are more sticky than costs of firms which are subject to common-law systems of corporate governance (US and UK). Firm-specific and industry characteristics also impact on levels of cost stickiness.

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1 INTRODUCTION

Traditional cost behaviour models in the accounting literature distinguish between fixed and variable costs with respect to changes in the level of activity. Fixed costs are assumed to be independent of the level of activity whereas variable costs are assumed to change linearly and proportionately to changes in the level of activity. Underlying the traditional cost behaviour model are a number of assumptions which, apart from simplifying the real world, distance the model from the way costs behave in reality.

Research by Anderson, Banker, and Janakiraman (2003) suggests that selling, general and administrative costs respond differently to upward or downward changes in activity, a property they refer to as ‘sticky’ costs. These costs increase more when revenues increase than they fall when revenues decrease by an equivalent amount. Subramaniam and Weidenmier (2003) confirm and extend the evidence on sticky costs to include the behaviour of the cost-of-goods-sold expense. This stickiness has been attributed to aspects of managerial behaviour where managers have entered into contracts for the supply of resources but, in the event of a decline in revenues, decide to retain underutilised resources rather than incur the costs of renegotiating the contracts.

In this study, we test whether costs are sticky using data for a sample of companies traded on the UK, US, French, and German markets. We find that costs of companies from the four countries share common characteristics: costs are sticky but are, in general, less sticky when aggregated over longer intervals and when firms suffer larger falls in revenues. Cost stickiness is affected both by industry- and firm-specific features and also by market-wide economic conditions. Costs are, however, markedly more sticky for French and German companies than for US and UK companies. We attribute this to differences in the corporate governance regimes across the countries.

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The remainder of the paper is organised as follows. Section 2 presents an overview of prior literature and develops the hypotheses. Section 3 describes the sample selection process, section 4 the research methodology and section 5 presents the empirical findings. Concluding comments are set out in section 6.

2. REVIEW AND HYPOTHESES

Most management accounting texts assume that unit variable costs are linear and proportional to changes in activity and that fixed costs are fixed. The proportionality and symmetry between costs and activity implies that a 1% increase in activity results in a 1% increase in costs, and a 1% decrease in activity results in a 1% decrease in costs.

That costs might not be linear and proportional is now acknowledged in the literature. Although Noreen and Soderstrom (1997) find no evidence of stickiness, Anderson, Banker and Janakiraman (2003) find that selling, general and administrative costs are sticky and increase, on average, by 0.55% per 1% increase in revenues, but decrease only 0.35% per 1% decrease in revenues. Subramanian and Weidenmier (2003) confirm cost stickiness, finding that total costs increase 0.93% per 1% increase in revenues but decrease by 0.85% per 1% decrease. Both Anderson et al. (2003) and Subramanian and Weidenmier (2003) also find that the level of stickiness is influenced by economic conditions and by firm characteristics.

A number of conjectures based on managerial considerations have been advanced to explain this cost behaviour (Cooper and Kaplan (1998a, 1998b)). The basic premise is that cost stickiness arises because managers enter into contracts for resources that are costly to break. In the event of a subsequent decline in demand, managers might decide to retain under-utilised resources. Thus, while the firm might report a drop in revenues, costs will not fall in the same proportion as the fall in revenues. Stickiness might also be 4

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conditioned by existing capacity. Balakrishnan, Peterson and Soderstrom (2003) find, for example, that an organisation working at full capacity and faced with a reduction in activity responds less than if it is facing an increase in activity.

Slack in resources usually results from swings in demand. During periods of positive sales growth, companies expand with increasing manpower, capital expenditure and a general increase in the level of committed resources. Such increases might, for example, be particularly marked for those companies where managerial remuneration is tied to turnover or firm size. As indicated above, cost stickiness in responding to declines in levels of activity might be driven by external frictions in the form of potential costs-of-adjustment which would be incurred in cutting back on previously committed resources. However, apart from the issue of external frictions, three reasons can be advanced to account for management failure to cut back costs following a fall in the level of activity. First, managers might be uncertain about the permanence of the decline and defer cutting back resources until they have more information. Second, the firm may not wish to incur adjustment costs, such as dismissing employees, as a result of organisational policies or fear that such activities will taint the firm’s public image or negatively affect the morale of remaining employees. Third, managers may not wish to make such reductions to resources because of personal considerations. Managers, for example, may be unwilling to dismiss their colleagues, or reluctant to downsize their department since this may affect their status within the firm.

In this paper, we test various aspects of cost stickiness using a sample of US, UK, German, and French companies. Previous empirical work on this topic has been carried out using exclusively US data. This extension also allows us to examine the potential impact of a differing system of corporate governance on managerial cost behaviour. Evidence exists to suggest that the system of corporate governance impacts on financial 5