Please rotate your device to landscape mode to view the charts.

Survive the economic downturn: operating flexibility, productivity, and stock crash

Journal: Journal of Operations Management

Date: 2024

Author: Yang Li, Xiaojun Wang, Fangming Xu, Tuan Ho

Abstract:
Operating flexibility supports a firm's resilience strategy during challenging times by enabling them to promptly cut down operating costs associated with unproductive resources. We employ a real options model to formalize this insight. Our empirically grounding analytics motivate a firm-level proxy for downscale operating flexibility (FLEX), which effectively captures the adjustment frictions across different contexts of firms' operations. Using U.S. data between 1961 and 2020, we show that operating flexibility mitigates the risk of stock price crashes, especially during periods of economic recession. Consistent with the loss-curtailment mechanism, the operating flexibility effect is more pronounced for firms with lower productivity/profitability or higher operating leverage and is further amplified during longer and more severe recessions. Managers may avail themselves of our well-tested empirical measure of operating flexibility to guide their efforts in building a more resilient operations structure.

Link: Google Scholar

Background and Context

Research Question

This study examines how operating flexibility helps firms survive economic downturns by quickly reducing costs associated with unproductive resources.

Methodology

The authors developed a measure of operating flexibility using a real options model and tested it using U.S. data from 1961 to 2020.

Key Concept

Operating flexibility acts as corporate insurance during recessions, allowing firms to promptly adjust their operations to limit losses.

Operating Flexibility Significantly Reduces Stock Crash Risk

Recession Flexible firms Inflexible firms
  • Flexible firms (green line) experience less severe drops in value during recessions compared to inflexible firms (red line).
  • The study found that operating flexibility has a statistically significant negative association with stock crash risk.
  • Operating flexibility serves as a form of insurance during economic downturns by enabling rapid cost adjustments.

Heavy Production Industries Show Greater Operating Flexibility

  • Heavy production industries like shipbuilding and coal mining demonstrate the highest operating flexibility.
  • Retail, pharmaceutical, and apparel industries show the lowest operating flexibility due to higher labor relationship costs.
  • Industries with greater operating flexibility can more easily scale down during recessions through mass layoffs or asset sales.

Operating Flexibility Becomes More Valuable During Longer Recessions

  • The protective effect of operating flexibility more than doubles during prolonged recession exposure (12 months vs. 1 month).
  • Firms exposed to recessions for longer periods face greater pressure to adjust their operations quickly to avoid losses.
  • Operating flexibility provides increasing value as economic downturns persist, enhancing firm resilience over time.

Flexibility Benefits Vulnerable Firms More During Economic Downturns

  • Firms with lower productivity or profitability gain significantly more protection from operating flexibility during downturns.
  • Operating flexibility particularly benefits firms with high operating leverage, providing a safety cushion against fixed costs.
  • The loss-curtailment mechanism of flexibility is most valuable for firms closest to their operating thresholds.

Different Types of Flexibility Matter at Different Economic Phases

Recession Phase Downscale Flexibility Recovery Phase Upscale Flexibility
  • Downscale flexibility helps firms reduce crash risk during recessions by enabling rapid cost cutting.
  • Upscale flexibility becomes valuable during recovery periods, enabling firms to capitalize on growth opportunities.
  • The study found that firms need both types of flexibility for comprehensive resilience throughout economic cycles.

Contribution and Implications

  • Firms should build operating flexibility through easily adjustable labor arrangements and disposable production factors.
  • Managers can use the authors' flexibility measure to assess their firm's resilience against economic downturns.
  • Lower productivity or profitability firms should especially prioritize operational flexibility to mitigate crash risk.
  • Downscale flexibility serves as corporate insurance during recessions, while upscale flexibility drives recovery growth.
  • Different industries have natural advantages in operational flexibility, which influences their recession resilience.

Data Sources

  • Industry flexibility comparison (Chart 2) is based on Table 1 showing operating flexibility across different industries.
  • Recession length effect (Chart 3) is based on Table 6 showing how flexibility impact increases with recession duration.
  • Firm characteristics effect (Chart 4) is based on Table 7 demonstrating varied impacts across different types of firms.
  • Charts 1 and 5 are conceptual visualizations based on the study's theoretical framework and empirical findings.