Managerial Flexibility, Capacity Investment, and Inventory Levels

Authors:
Karca D. Aral, Whitman School of Management, Syracuse University, Erasmo Giambona, Whitman School of Management, Syracuse University  and Luk Van Wassenhove, INSEAD



Journal:
Production and Operations Management, Forthcoming

Summary:
We study the effect of managerial time-horizon on two key operations decisions: inventory levels and capacity investment.

Research Questions:
1) Can the frictions between the shareholders and managers impact operational investments? 

2) How do managerial time horizons affect operational capacity investment and inventory levels? 

3) Can managerial long-termism improve operational performance?

What We Know:
Managerial short-termism is defined as a managerial preference for cutting long-term investments to meet short-term performance targets (Porter, 1992). Theoretically, it is well established that stock market scrutiny forces managers concerned with their career prospects to focus on short-term performance (e.g., Narayanan, 1985; Stein, 1989; Bolton et al., 2006). There is also evidence that short-termism leads executives to cut investments (e.g., Poterba and Summers, 1995; Asker, Farre-Mensa, and Ljungqvist, 2015; Ladika and Sautner, 2020) in order to meet short-term earnings-per-share and dividend payment targets. In a survey setting, Graham, Harvey, and Rajgopal (2005) similarly find that executives would bypass positive net present value investments to meet analysts’ consensus earnings, with a staggering 78% admitting that they would sacrifice long-term value to reach earnings-per-share targets. This is because cutting investments increases earnings by reducing depreciation expenses, leading to an increase in the earnings-per-share (EPS) ratio (by increasing its numerator). Additionally, lowering investments frees up cash that firms can use to repurchase their own shares outstanding, which leads to a higher EPS ratio, by reducing its denominator (e.g., Asker, Farre-Mensa, and Ljungqvist, 2015; Almeida, Fos, and Kronlund, 2016).

Novel Findings:
While these studies suggest that managerial short-termism might adversely affect firms’ long-term performance, its effects on operations decisions are under-explored. 

In this paper, we study empirically whether and how reducing managerial short-termism affects two key operations decisions: capacity investment and inventory levels. On the one hand, we can expect operations decisions concerning capacity and inventory levels to be unaffected by any potential frictions between shareholders and managers, given that in theory they are both optimizable to meet the target service levels. On the other hand, expanding operations capacity requires significant financial resources, takes a long time to come to fruition, and faces demand uncertainty (see, for example, Van Mieghem, 2003, for a review), hence investing in operations capacity may be deemed as prohibitively risky by short-term oriented executives facing shareholder pressure for higher earnings-per-share. Further, managerial short termism could suppress inventory levels directly as short-term oriented managers may underinvest in inventory to signal low demand uncertainty to shareholders (Lai and Xiao, 2018), or indirectly due to capacity constraints. Consequently, if years of ongoing managerial short-termism have caused chronic operational underinvestment, capacity constraints, suboptimal inventory levels, and underserved demand, then we can expect both capacity investment and inventory levels to increase following a reduction in managerial short-termism. Which of these two forces would prevail in shaping a firm’s capacity investment and inventory levels following a reduction in managerial short-termism is an empirical question.

In order to study this question, we exploit the quasi-natural experimental setting provided by the staggered adoption of constituency statutes by 35 U.S. states over the period 1984-2007. Using a staggered difference-in-differences approach, we find that, after the reforms, firms incorporated in constituency states (treated firms) increased inventory and capacity investment by 5.2% and 15.4%, respectively, relative to firms not incorporated in constituency states (control firms).  We also find that these increases are gradual and persist over time, suggesting that these changes are structural in nature. We further show that the effect of constituency statutes on inventory levels and capacity investment are stronger for firms with ex-ante higher level of managerial short-termism, such as firms with low institutional ownership, which arguably benefit more from the shift to long-termism spurred by constituency statutes.

Importantly, we also find that performance increased post reform especially for firms that are ex-ante more likely to benefit from higher flexibility. Notably, while constituency statutes were intended to grant managerial flexibility and legal protection to executives making long-term decisions, our empirical findings suggest that constituency statutes, by alleviating short-term stock market pressures, ultimately benefited not only executives, but also potentially the long-term interest of shareholders.

Implications for Practice:
Our results have important implications for executives and policymakers. At a corporate level, managers should intensify communication efforts on how specific operational decisions and investments would be beneficial to the company. In fact, such examples already exist. In “investor calls” executives could discuss, explain, and substantiate their managerial decisions. Currently, these calls are mostly in a question & answer format where the investors retrospectively interrogate the executives on past decisions. During such calls, executives can instead take a more proactive role, and take the initiative to clearly demonstrate and advocate for future operational investment plans. In the same vein, executives can use various media channels (e.g., blogging, social media, open letters, etc.) to help shape retail investors’ attitude towards operational investments that may create future value. Relatedly, when appointing high ranking executives, corporate boards can offer a higher level of job security for the prospective executives by contractually acknowledging the risky nature of long-term value-generating operational investment decisions.

Implications for Policy:
Given the benefits of managerial flexibility, policy makers can consider additional regulatory tools to increase managerial flexibility perhaps at a federal level. Relatedly, states without constituency statutes should consider adopting them.

Implications for Society:
Notably, while constituency statutes were intended to grant managerial flexibility and legal protection to executives making long-term decisions, our empirical findings suggest that constituency statutes, by alleviating short-term stock market pressures, ultimately benefited not only executives, but also potentially the long-term interest of shareholders.





Implications for Research:
Our findings offer several opportunities for future research. First, our empirical design can be used to study how specific operational policies related, for instance, to trade credit, strategic sourcing, or corporate social involvement may be impacted by short-termism. Second, researchers could rely on a similar empirical strategy to study the effect of managerial horizons on operational risk related, for example, to supply chain disruption or supplier unreliability. Third, research could benefit from detailed data on quantity, pricing, maturity, and other terms of contract relationships involving firms and customers, to study how these terms change when firms adopt a longer-term perspective. Fourth, future research could study how changes in the relation between the board of directors and the CEO can affect inventory policies, production efficiency, and firm value. Fifth, it would be interesting to investigate how the dynamics of the relationships between the board, the CEO, and shareholders affect operational performance across sectors with a different emphasis on operational outcomes (e.g., banks vs. pharmaceutical firms, which could give different emphasis to operations and financing decisions). Sixth, future studies could more generally consider the effect of managerial flexibility on other operations decisions, including the supply base size or the types of contractual relationships with suppliers. Finally, the theoretical operations management literature could benefit from an increased focus on agency problems between managers and shareholders, which, as we show in our paper, can be important determinants of operations decisions.

Full Citation:
Aral K.D., E. Giambona, L.N. Van Wassenhove, 2023, Managerial Flexibility, Capacity Investment, and Inventory Levels, Production and Operations Management

Abstract:
We study the effect of managerial time-horizon on two key operations decisions: inventory levels and capacity investment. For identification, we exploit a quasi-natural experiment provided by the staggered adoption of constituency statutes, which alleviate managerial short-termism by providing legal protection to executives adopting a long-term approach in their corporate decisions. Using a staggered difference-in-differences design, we find that, after the reforms, firms incorporated in constituency states (treated firms) increased inventory and capacity investment by 5.2% and 15.4%, respectively, relative to firms not incorporated in constituency states (control firms). We also find that these increases are gradual and persist over time, suggesting that they are structural in nature. We further show that the effect of constituency statutes on inventory levels and capacity investment are stronger for firms with ex-ante higher level of managerial short-termism, such as firms with low institutional ownership. Performance also increases relatively more for affected firms with higher ex-ante managerial short-termism. Our results pass a battery of robustness and validity tests. Interestingly, while constituency statutes are intended to protect executives from short-term oriented shareholder sanctions, our findings suggest that these statutes ultimately benefited not only executives, but also potentially the long-term interest of shareholders. Even in the absence of regulation, executives facing short-term pressure could intensify communication efforts with shareholders on how specific operational decisions and investments would be beneficial to the company. Notably, executives could use various media channels to help shape retail investors’ attitude towards operational investments that may create future value.