Asymmetry In Operational Efficiency and Managerial Ability Benchmarks

Abstract

Standard empirical models of operating efficiency (OE) and managerial ability (MA) assume a symmetric linear relation of OE and MA with firm performance. However, OE and MA metrics are likely to respond faster to a demand decrease than a demand increase due to cost stickiness and respond faster to negative returns than to positive returns due to accounting conservatism. As predicted, I find large asymmetries in the behavior of OE and MA measures. OE and MA in levels (changes) are 2.4 (1.4) times and 1.5 (1.6) times more sensitive to demand decreases than demand increases. Similarly, OE and MA levels (changes) are 1.7 (1.5) times and 3.6 (2.3) times more sensitive to negative returns than to positive returns. The incremental explanatory power of modeling asymmetry in OE and MA levels (changes) is 20.9% (39.5%) and 263.3% (27.6%), measured as incremental adjusted R2. Cross-sectionally, asymmetry in OE and MA varies with the determinants of cost stickiness: (1) asset intensity and (2) employee intensity. Moreover, the degree of asymmetry also varies with the determinants of accounting conservatism: (1) book-to-market value of equity, (2) leverage, and (3) market capitalization. In addition, demand decline (i.e., cost stickiness) and bad news (i.e., accounting conservatism) during prior and successive periods have an incremental impact on the asymmetry in OE and MA. The standard models of OE and MA do not control for these correlated-omitted variables or incorporate the cost stickiness and accounting conservatism asymmetries, which yield biased measurements and render incorrect regression estimates and inferences.