The effect of management control mechanisms through risk-taking incentives on asymmetric cost behavior

Abstract

We investigate the relationship between management control mechanisms, specifically risk-taking incentives targeted at mitigating moral hazard, and cost behavior during periods of sales declines relative to periods of sales growth. We find that incentive vega of both chief executive officers and top five paid executives is associated with expedited reductions in selling, general, and administrative cost in periods of sales declines. These results are consistent with the Sedatole et al. (J Account Res 50(2):553–592, 2012) finding that incentive vega induces managers to adopt a more elastic cost structure, presumably because managerial operational decisions, particularly outsourcing, increase firms’ total risk. We conduct an additional analysis to rule out an alternative explanation that the expedited cost cuts may be driven by incentives to manage earnings. Finally, our results are robust to alternative measures of risk-taking incentives. Overall, our findings support the view that management control mechanisms through risk-taking incentives are an important determinant of management cost adjustment decisions in periods of demand declines relative to periods of demand growth.

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Notes

  1. 1.

    In general, transactions risks associated with outsourcing include loss of control, diminishing organizational trust, unexpectedly high transaction costs, and deterioration in innovation. Examples are (1) potential interruptions of the flow of product or service between a firm and its suppliers or customers in cases of production or distribution outsourcing, (2) lower quality of hired employees in cases of human resources outsourcing, (3) possible impediments of information security in cases of payroll outsourcing, and (4) declines in innovation in cases of information technology outsourcing.

  2. 2.

    In untabulated robustness tests, we allow SUC_DECit to affect the change in SG&A costs in response to sales increases. Results are not sensitive to the inclusion of the interaction variable between SUC_DECit and ΔlnSALEit.

  3. 3.

    Professor Naveen makes the data available on her website at http://sites.temple.edu/lnaveen/data/. For a detailed description on how she calculates the incentives data, please refer to Coles et al. (2013) available at http://ssrn.com/abstract=2296381.

  4. 4.

    In cases where none of the top five executives are labeled as CEO, or where the CEO is not among the top five executives with highest total compensation, we keep these cases as firm-year observations in the TOP5 sample. However, these instances are excluded from the CEO sample. Consequently, the number of observations in the TOP5 sample is greater than that in the CEO sample.

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Acknowledgements

We appreciate the comments from workshop participants at University of Wyoming College of Business and Weber State University Goddard School of Business AND Economics as well as conference participants at the 2017 American Accounting Association Western Region Meeting and the 4th AIMA World Conference on Management Accounting Research.

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Correspondence to Kenneth Zheng.

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Li, W., Natarajan, R., Zhao, Y. et al. The effect of management control mechanisms through risk-taking incentives on asymmetric cost behavior. Rev Quant Finan Acc (2020). https://doi.org/10.1007/s11156-020-00891-z

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Keywords

  • Risk-taking incentives
  • Demand uncertainty
  • Cost behavior
  • Cost stickiness
  • Cost elasticity

JEL Classification

  • D22
  • D25
  • D81
  • M41
  • M52