Demand Uncertainty, Cost Behavior, and the Asian Financial Crisis: Evidence from Korea

Abstract

The mix of fixed and variable costs in response to environmental changes is important for the sustainability of a firm. This study examines how demand uncertainty affects managers' cost structure decisions. Using data on Korean firms from 1982 to 2015, my study provides evidence that cost rigidity increases in demand uncertainty. This finding implies that managers under higher uncertainty will increase the committed capacity to reduce congestion costs, resulting in a more rigid (less elastic) cost structure with higher fixed and lower variable costs in the short term. I also investigate the effect of the 1997 Asian financial crisis on cost rigidity. I predict that the massive structural changes entailed by the crisis, such as the deteriorated access to external funds, increase in the tendency of loss aversion, and expansion of outsourcing and temporary job positions, will reduce the magnitude of cost rigidity following greater demand uncertainty. Consistent with the prediction, the positive relation between demand uncertainty and cost rigidity becomes weaker in the period following the crisis, compared to the pre-crisis period.