02 Nov 2010Working Paper Summaries

Making the Numbers? ‘Short Termism’ & the Puzzle of Only Occasional Disaster

by Nelson P. Repenning and Rebecca M. Henderson

Executives at public companies are always under pressure to "meet the numbers" each quarter, often so much so that they sacrifice long-term investments in order to make everything look rosy in the short term. In this paper, Harvard Business School professor Rebecca M. Henderson and Sloan School of Management professor Nelson P. Repenning set out to reconcile the apparently contradictory strategies of short-term results and long-term investments. Key concepts include:

The capability of a company is similar to that of stock, in that managers cannot influence it directly but can only control its rate of change.
A company's tendency to focus almost solely on short-term earnings can have very different consequences depending on how close a firm's capability is to a critical "tipping threshold".
Above this threshold, focusing on short-term earnings has little effect on long-term performance. Below it, the firm's performance may begin to spiral downward.

Author Abstract

Much recent work in strategy and popular discussion suggests that an excessive focus on "managing the numbers"--delivering quarterly earnings at the expense of longer-term investments--makes it difficult for firms to make the investments necessary to build competitive advantage. "Short termism" has been blamed for everything from the decline of the U.S. automobile industry to the low penetration of techniques such as TQM and continuous improvement. Yet a vigorous tradition in the accounting literature establishes that firms routinely sacrifice long-term investment to manage earnings and are rewarded for doing so. This paper presents a model that can reconcile these apparently contradictory perspectives. We show that if the source of long-term advantage is modeled as a stock of capability that accumulates gradually over time, a firm's proclivity to manage short-term earnings at the expense of long-term investment can have very different consequences depending on whether the firm's capability is close to a critical "tipping threshold." When the firm operates above this threshold, managing earnings smoothes revenue with few long-term consequences. Below it, managing earnings can tip the firm into a vicious cycle of accelerating decline. Our results have important implications for understanding managerial incentives and the internal processes that lead to sustained advantage.