Sticky and Biased Costs in China's Manufacturing Industry

1. Are costs really sticky and Biased? Evidence from manufacturing listed companies in China Source: Applied Economics. Nov2017, Vol.49 Issue55, p5601-5613 Authors: Xu, Jian & Sim, Jae Woo

2. Contents 01 03 02 04 05 06 Methodology and sample Conclusion and Shortage Introduction Results Hypotheses Literature review

3. Introduction • Traditional accounting cost models assume that fixed costs are independent of the level of activity and variable costs change proportionately with changes in the level of activity. • But some argue that costs rise more with the increase in activity than they fall with decrease. • Specifically, costs are sticky if the magnitude of the increase in costs associated with an increase in volume is greater than the magnitude of the decrease in costs associated with an equivalent decrease in volume. • Understanding sticky cost behavior has direct benefits to managers making decisions on cost control and external stakeholders assessing firm performance.

4. Introduction • However, there is little empirical evidence on how costs behave in China’s manufacturing industry. • Conducting a study in China’s manufacturing industry is important as the majority of previous studies on cost behavior were carried out using US data. • In the article, authors address sticky cost behaviors in China’s manufacturing listed companies over the period 2010–2014. • In particular, authors examine whether costs in China’s manufacturing industry are sticky and biased, whether the degree of cost asymmetry varies across industries and in different regions, whether the degree of cost asymmetry changes over time and what factors affect cost stickiness.

5. Literature review Based on previous foreign theories, following three reasons for cost stickiness have been summarized: 01 02 Agency cost Efficiency mechanism Adjustment cost asymmetry: 03 Agency costs arise when agents try to maximize their utility functions even when it would not be in the best interest of the principals. For instance, when sales decline, managers (agents) may be reluctant to reduce their salaries and attempt to take control of some resources in order not to undermine their future career. It assumes that some small fluctuations during the business operation are temporary and an immediate resource allocation can result in huge adjustment costs. Another explanation might be manager’s lack of capacity and competency. Facing a decrease in activity levels, managers are more likely to expect a trend reversion in the future. Adjustment are relatively high frictions in the process that prompts management to show restraint in cutting variable costs during a downward trend which duration is uncertain

6. Hypotheses • H1a. Costs of manufacturing listed companies are sticky. That is, the rate of increase in costs exceeds the rate of decline in costs as sales revenue changes. • H1b. The degree of cost stickiness is different across industries. • H1c. The degree of cost stickiness is different indifferent regions. • H2a. Cost stickiness is influenced by changes in the GDP growth rate. • H2b. The impact of the GDP growth rate on cost stickiness is different across industries. • H2c. The impact of the GDP growth rate on cost stickiness is different in different regions. • H3. Cost stickiness of manufacturing companies reverses in subsequent periods. • H4. Cost stickiness of manufacturing companies declines with the aggregation of periods. • H5. Cost stickiness of manufacturing industry is biased. That is, resource adjustments made intentionally to meet earnings targets diminish cost stickiness. • H6. Cost stickiness is influenced by asset intensity (assets to sales) and employee intensity (employee to sales).

7. Methodology • β1 measures the percentage rise in costs with a 1% increase in sales revenue. Since the value of D variable is 1 when sales revenue decreases, the combined estimation of β1 + β2 measures the decrease in costs following a 1% decrease in revenue. • If there is no asymmetric cost behavior, β2 will equal 0. If costs are sticky, β2 will be negative and statistically significant. • To test H1b and H1c, the samples are divided into several subunits by industry or region, model (1) is run for each of the individual subunits and the results can be analyzed to verify whether cost stickiness exits in each subunit.

8. Methodology • If macroeconomic condition increases cost stickiness, β2 and β3 will be both negative, otherwise β3 will be positive. To test H2b and H2c, the samples are divided into several subunits by industry or region. • Model (3) is used to test H3. If there is supportive evidence, β4 will be positive and the value of β4 is less than the absolute value of β2. • If H4 is accepted, it is expected that β2 is significantly negative and the absolute value of β2 decreases with aggregation of years per period.

9. Methodology • Model (5), introducing a new variable Loss to test whether incentives to meet earnings targets affect the degree of cost stickiness. Loss is a dummy that takes the value of 1 if net profit is negative in year t, and 0 otherwise. • In model (6), where Assets stands for the asset intensity (the ratio of total assets to sales); Employee stands for the employee intensity (the ratio of the number of employees to sales).

10. Sample • Authors use China Stock Market Accounting Research (CSMAR) and RESSET Finance database to collect accounting information over the period 2010–2014 for all manufacturing companies listed on the SZSE and SSE. • They eliminate firms with negative total assets or missing data, firms listed after 2010, firms issuing other kinds of shares, like B, H, S, ADR, etc. • The total number of final sample is 3672 for 918 manufacturing listed companies from 2010 to 2014.

11. Results • Table 3 presents descriptive statistics of selected sample. The average and median value of Δlog(Rev) is 0.129 and 0.117, respectively, indicating that sales increases are more common in China’s manufacturing firms than sales declines. Similarly, the average value of Δlog(Cost) is 0.139, with a median value of 0.122. In fact, increases in sales account for 74% of all firm-years, compared to 26% for decreases. • Managers tend to expect sales to increase in subsequent years, resulting in optimistic anticipations of future revenues on average. About 7% of our sample reports a loss in accounting earnings during our sample period. The average firm has an asset intensity of 210.4% of sales and an employee intensity of 0.00000179.

12. Results • For multivariate analysis, we estimate the six models by running OLS. The variables in the models initially tested for multicollinearity. We evaluated serial correlation in the data on a firm-by-firm basis. • The results in Panel A of Table 4 support H1a, indicating that costs increase more for an increase in sales than they decrease for an equivalent decrease in sales. • The results in Panel B of Table 4 suggest that costs are not sticky across industries, supporting H1b. • The results in Panel C of Table 4 lend support to H1c and H2c. The coefficients of β2 are −0.060, 0.072 and −0.098, respectively, suggesting that cost stickiness exists in eastern and western provinces and is less pronounced in central provinces. • The result of rejecting H3 is presented in the second column of Table 5, indicating that managers do not delay decisions to make reductions to committed resources.

13. Results • The other columns in Table 5 present the results of rejecting H4. It indicates the costs are anti-sticky with the aggregation of periods. In the long run, managers will pay more attention to the sustainable growth of the company and avoid implementing the short-sighted management. • In the third column of Table 6, It is found that for the operating costs that increase by 0.991% with a 1% increase in sales revenue, but they decrease by 0.983% with a 1% decrease in sales revenue. Therefore, H5 is supported. • The result of testing H6 indicates that cost stickiness is not affected by asset intensity and employee intensity, so H6 is rejected.

14. Results • A possible inference from the rejection of H3, H4 and H6 is that Chinese managers are more lenient towards the necessity to further reduce costs after a period of revenue drops, and to proceeding to the adjustment of resources in a longer term, with respect to American managers. • The following are several explanations: • First, China’s manufacturing listed companies are still in their infancy and division managers bonuses are directly related to the company’s performance, so managers are less inclined to reduce costs and expenses before revenues begin to decrease. • Second, skilled workers are still not abundant in the Chinese labor market, and the firms usually have to train their own staffs if extra skillful manpower is needed. • Third, as an emerging country, China has not yet reached the status of fully fledged capitalism. • Finally, with the low level of the company’s management, corporate governance cannot keep pace with the expansion speed. Under the circumstances, the magnitude of an increase in cost is greater than the magnitude of an increase in revenue, which in turn reduces the product profitability.

15. Conclusion • This article finds that costs are sticky and biased in China’s manufacturing firms. However, cost stickiness does not reverse in subsequent years. • That is, cost stickiness is likely to be less during the subsequent periods of a downturn, when managers may have fulfilled their positive expectations. • It may also suggest that manager’s earnings management is associated with an upward bias in the estimates of asymmetric cost behavior (i.e. cost stickiness). Finally, this article finds that cost stickiness is affected by the economic growth.

16. Conclusion • Implications for management: • Managers in different industries will have a better understanding of goal orientation of different firms and establish the differentiated management constraint mechanism. Based on sticky cost behavior in different industries, top managers can predict the future earnings and improve cost control measures and performance measurement system in rapidly changing environment of each industry • In addition, understanding how costs behave can enable managers to identify the internal governance problems and provide reliable information for governance structure and corporate operation. • Finally, given the impacts of macroeconomic growth on cost management in different industries, the government should actively adjust the industrial policies to accelerate the development of China’s central and western regions.

17. Shortage • The time horizon of our study covers only 5 years, whereas other empirical analyses span over 10 years. Because cost stickiness reveals a behavior that appears over time, the time horizon could be a limitation affecting our findings. • Given that the rapid development of China’s securities market in recent years, future studies should explore the association between cost stickiness and corporate performance. Moreover, other factors affecting adjustment costs and non-economic factors affecting cost stickiness should also be taken into consideration.