Implications of Cost Behavior for Analysts' Earnings Forecasts

Abstract

Recent work in management accounting offers several novel insights into firms' cost behavior. This study explores whether financial analysts appropriately incorporate information on two types of cost behavior in predicting earnings - cost variability and cost stickiness. Since analysts' utilization of information is not directly observable, we model the process of earnings prediction to generate empirically testable hypotheses. The results indicate that analysts "converge to the average" in recognizing both cost variability and cost stickiness, resulting in substantial and systematic earnings forecast errors. Particularly, we find a clear pattern - inappropriate incorporation of available information on cost behavior in earnings forecasts leads to larger errors in unfavorable scenarios than in favorable ones. Overall, enhancing analysts' awareness of the expense side is likely to improve their earnings forecasts, mainly when sales turn to the worse.