Working Paper: NBER ID: w16367
Authors: Nelson P. Repenning; Rebecca M. Henderson
Abstract: Much recent work in strategy and popular discussion suggests that an excessive focus on "managing the numbers" --delivering quarterly earnings at the expense of longer term investments--makes it difficult for firms to make the investments necessary to build competitive advantage. "Short termism" has been blamed for everything from the decline of the US automobile industry to the low penetration of techniques such as TQM and continuous improvement. Yet a vigorous tradition in the accounting literature establishes that firms routinely sacrifice long-term investment to manage earnings and are rewarded for doing so. This paper presents a model that can reconcile these apparently contradictory perspectives. We show that if the source of long-term advantage is modeled as a stock of capability that accumulates gradually over time, a firm's proclivity to manage short-term earnings at the expense of long-term investment can have very different consequences depending on whether the firm's capability is close to a critical "tipping threshold". When the firm operates above this threshold, managing earnings smoothes revenue with few long-term consequences. Below it, managing earnings can tip the firm into a vicious cycle of accelerating decline. Our results have important implications for understanding managerial incentives and the internal processes that lead to sustained advantage.
Keywords: No keywords provided
JEL Codes: L25
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| short-term earnings management (G35) | long-term capability investment (D25) |
| capability above critical threshold (C24) | managing earnings smooths revenue (D25) |
| capability below critical threshold (C24) | vicious cycle of decline (E32) |
| emphasis on revenue generation (H27) | decline in long-term performance (P27) |
| manager's willingness to shift investment (G31) | risk of tipping into decline (F44) |
| demand variability increases (C69) | likelihood of tipping into disaster (H12) |
| aggressive shift in investment (E22) | tipping into disaster (H84) |
| conservative response to revenue stabilization (E63) | lower risk of disaster (H84) |