Economic uncertainty, risk-taking incentives and production management

Purpose

This study aims to validate the link between production manipulation and a firm’s performance variability (fundamentals and stock returns). It explores whether executives' risk-taking incentives encourage production deviations around the normal level during uncertainty.

Design/methodology/approach

Utilizing panel data of manufacturing firms from Compustat over three decades, the study investigates production management practices during economic uncertainty. The Economic Policy Uncertainty Index (EPU) is employed as a key metric. The empirical strategy involves documenting the effect of economic uncertainty on overproduction and underproduction, examining the role of executive compensation and assessing the impact on risk.

Findings

The research finds that risk-taking incentives increase over/underproduction, particularly amplifying the extent of underproduction during uncertainty. Production deviation rises, indicating that firms take greater risk by engaging in abnormal business operations. The study’s results are robust against various econometric methods, emphasizing the influence of risk-taking incentives on corporate production decisions.

Research limitations/implications

While providing valuable insights, the study acknowledges inherent limitations, including factors influencing production decisions beyond risk-taking incentives. Further research could explore additional determinants for a comprehensive understanding.

Practical implications

The findings highlight the potential dark side of executive compensation that motivates suboptimal risk-taking decisions, impacting risk, cost of capital and firm performance. Policymakers and compensation committees can use these insights to design efficient systems that mitigate moral hazard problems associated with productivity changes.

Social implications

The study emphasizes the broader social implications of production manipulation under uncertainty. It prompts discussions on the ethical considerations of managerial opportunism, its potential consequences for stakeholders and market dynamics.

Originality/value

This study contributes to the literature by examining the role of economic uncertainty on production manipulation and the influence of risk-taking incentives. It extends the earnings management literature by considering real activity manipulation and emphasizing the importance of decomposing production deviation into positive and negative values.