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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 Focus

The study examines how firms' operating flexibility - their ability to quickly adjust operational costs - helps them survive economic downturns and reduce stock price crash risks.

Study Scope

Analysis covers U.S. public firms between 1961-2020, examining how operational adjustments like layoffs and asset sales impact firm resilience during recessions.

Methodology

Uses real options modeling and empirical analysis to measure how firms' ability to downscale operations affects their stock crash risk during economic challenges.

Impact of Operating Flexibility on Stock Crash Risk During Recessions vs Non-Recessions

  • Firms with greater operating flexibility show significantly reduced stock crash risk, especially during recessions
  • The effect is twice as strong during recession periods (-0.148) compared to non-recession periods (-0.074)
  • Demonstrates operating flexibility acts as a valuable protection mechanism during economic downturns

Operating Flexibility Effects Across Industry Types

  • Heavy production industries show highest operating flexibility
  • Retail and consumer-focused industries demonstrate lowest flexibility
  • Industry differences reflect varying abilities to adjust operational costs

Operating Flexibility Benefits Increase with Recession Duration

  • The benefit of operating flexibility increases with longer recession exposure
  • Effect more than doubles from 1-month to 12-month exposure
  • Shows increasing importance of flexibility during prolonged economic challenges

Operating Flexibility Impact by Firm Profitability Level

  • Operating flexibility provides greatest benefit to firms with lower profitability
  • Effect is particularly pronounced during recession periods
  • Demonstrates flexibility acts as a crucial safety net for struggling firms

Upscale vs Downscale Flexibility Effects During Different Economic Periods

Recession Period
Stock Crash Risk
Expansion Period
Stock Return
Downscale Flexibility Significantly Negative ✅ Insignificant
Upscale Flexibility Insignificant Significantly Positive ✅
  • Downscale flexibility is most valuable during recessions
  • Upscale flexibility becomes important during economic expansion
  • Different types of flexibility provide benefits in different economic conditions

Contribution and Implications

  • Provides first comprehensive empirical evidence that operating flexibility helps firms survive economic downturns by reducing stock crash risk
  • Develops new measures for evaluating firm operational flexibility that can guide managers in building resilient operations
  • Demonstrates the specific conditions under which different types of operational flexibility are most valuable

Data Sources

  • Recession vs Non-recession comparison based on Table 4, columns 2-3
  • Industry flexibility rankings derived from Table 1
  • Recession duration effects from Table 6
  • Profitability analysis based on Table 7
  • Flexibility type comparison constructed from Table 8