An Additional Source of Financial Analysts' Earnings Forecast Errors: Imperfect Adjustments for Cost Behavior

Abstract

We test a hypothesis that financial analysts use a simple algorithm of an equal growth rate for expenses as is for sales when they forecast corporate earnings by examining the errors in analysts' earnings forecasts. If expenses change at a lower rate than sales in absolute terms due to the fixed portion of expenses, then analysts' forecasted expenses will be higher (lower) than actual when they forecast an increase (decrease) in sales, resulting in lower (higher) forecasted than actual earnings assuming that analysts have perject sales forecasts. Using 3,220 individual financial analysts' sales and earnings forecasts during the period of 1996-2005 for which sales forecast errors are close to zero, we find that the errors in analysts' earnings forecasts are positively related to their expected sales growth rate. This result is consistent with the hypothesis that analysts' imperject adjustments of cost behavior result in systematic errors in their earnings forecasts.1. Francis (1997) summarizes three possible explanations for analysts' optimistic forecasts examined by prior studies: an information-processing bias, a reporting bias, and a selection bias. Analysts may report their true earnings expectations but make predictable processing errors as a result of their decision heuristics (Affleck-Graves, Davis, and Mendenhall [1990]). Analysts also may have an incentive to report higher forecasts than their expectations when trying to attract lucrative investment banking deals (Dechow, Sloan, and Sweeney [2000]) or wanting to obtain further access to private information from managers (Francis and philbrick [1993]). Another possibility may be that the observed optimistic forecasts reflect analysts' reluctance to issue unfavorable forecasts (McNichols and O'Brien [1997]).2. For example, Noreen and Soderstrom (1994) show that overhead costs do not change in proportion to cost drivers of activity-based costs because of the fixed portion of overhead costs.3. Gu, Jain, and Ramnath (2006) make the same assumption on cost behavior. 4. To increase the possibility of satisfying the first assumption, we present supplementary test results in Section 4, in which we use a subset of our sample, including only those firms with the actual growth rate of operating costs (the sum of cost of goods sold, selling and administrative expenses, and depreciation expense) lower than that of sales in absolute terms.

The influence of the trade-off between profitability and future increases in sales on cost stickiness

“…: Koh and Killough, 1990;Simnett, 1996, Gadenne andIselin, 2000;Bhimani et al, 2009) 1 , and the recognised human bias in business prediction and judgement (e.g. : Furnham and Boo, 2011;Kim and Prather-Kinsey, 2010;Louis et al, 2013), our variable is a plausible proxy for manager's expectations for future sales.…”

Implications of Cost Behavior for Analysts' Earnings Forecasts

“…Focusing on the symmetry of the ratio, thus, enables our analysis to test an important assumption that is implicit in Weiss [2010]; i.e., do analysts perfectly understand cost stickiness? Another study, Kim and Prather-Kinsey [2010], aims to examine whether analyst 16 forecast errors are due their use of a cost model in which they assume an equal growth rate for expenses and sales. However, their analysis is based on examining the relationship between analyst forecast errors and sales growth rates.…”

Respon Investor Terhadap Pengumuman Laba Industri Perbankan Yang Menghadapi Kos Stickiness

“…Pemahaman yang lebih baik tentang variabilitas kos dan kos stickiness akan meningkatkan ketepatan prediksi laba (Bu et al, 2015). Sebaliknya, kurangnya pemahaman terhadap perilaku kos menyebabkan rendahnya penyesuaian terhadap perubahan kos sehingga menimbulkan kesalahan yang sistematis dalam prediksi kos (Kim & Prather, 2010).…”