Implications of Prospect Theory for the Stickiness of Costs

Accounting literature on cost stickiness documents an asymmetric behavior of costs, meaning that costs rise more in response to sales increases than they drop for sales decreases. This asymmetric behavior of costs is ascribed to managerial decisions on resource commitment. In this study, we apply prospect theory to further explore this asymmetry. More specifically, we build on core components of prospect theory to examine how cost stickiness may be affected by risk preferences in managerial decision-making when firms face declining (increasing) activity. In particular, we hypothesize how risk taking (aversion) in the domain of losses (gains) as well as industry performance as a reference point for firm performance act as determinants of managerial decision-making on resource commitment decisions. To test these hypotheses, we use secondary unbalanced panel data on 3,558 companies across nine industry sectors from 26 countries around the world over the period of six years (2008-2013). By introducing a behavioral perspective rooted in prospect theory, we contribute to existing cost stickiness literature in considering the role of risk preferences in different domains (losses and gains) as well as the aspect of industry performance as a reference point for managerial decisions on resource commitment.