Business Strategy and Labor Investment Efficiency*

• Published date: 01 March 2021
• Author: Ahsan Habib,Mostafa M. Hasan
• Date: 01 March 2021
• DOI: http://doi.org/10.1111/irfi.12254

Business Strategy and Labor

Investment Efficiency*

AHSAN HABIB

†

AND MOSTAFA M. HASAN

‡

†

School of Accountancy, Massey University, Auckland, New Zealand and

‡

School of Economics and Finance, Curtin University, Perth, Australia

ABSTRACT

This paper examines the relation between business strategy and labor invest-

ment efficiency. Since business strategy affects both the agency problem and

firm-level uncertainty, as well as the overall shape of corporate behavior, we

would expect the efficiency of labor investment to vary with the particular

business strategy a firm pursues. Using a large sample of US data, we find that

firms having a prospector-type business strategy are associated with ineffi-

cient labor investment, while those having a defender-type business strategy

are associated with efficient labor investment. We provide evidence that

uncertainty, rather than the agency problem, causes prospector-type firms to

exhibit inefficient labor investment. Finally, we document that inefficient

labor investment by prospectors leads to relatively low profitability in subse-

quent periods. These findings are robust when subjected to a series of sensi-

tivity tests.

Accepted: 4 February 2019

INTRODUCTION

In this paper, we investigate the association between firm-level business strate-

gies and labor investment efficiency, as measured by the difference between

actual and expected net hiring of labor. Although a substantial body of aca-

demic research has investigated the determinants of nonlabor investment effi-

ciency (e.g. Biddle et al. 2009; Chen et al. 2011), scant evidence exists on the

determinants and consequences of labor investment efficiency.

Labor, an important factor of production, is instrumental for economic

growth. Labor costs typically represent roughly two-thirds of economy-wide

value added (Hamermesh 1993). For example, the US Census Bureau’s Annual

Survey of Manufacturers reports show that payroll and employee benefits in the

manufacturing sector totaled $923 billion for 2015, compared to $240 billion

in capital expenditures.

1

In addition to their direct labor cost, companies incur

substantial costs to ensure work-place health and safety for labor. Given the

substantial direct and indirect labor-related expenses, efficient investment in

* We thank the Associate Editor and an anonymous reviewer for many helpful comments.

1 https://www.census.gov/library/publications/2017/econ/2015-aces-summary.html

© 2019 International Review of Finance Ltd. 2019

International Review of Finance, 21:1, 2021: pp. 58–96

DOI: 10.1111/irfi.12254

labor is of paramount importance if a firm is to remain competitive and profit-

able. In this vain, Merz and Yashiv (2007) show that the value of a firm cap-

tures the value of hiring and investment over and above the capital stock.

However, suboptimal labor investment may occur owing to managerial self-

serving interests and/or uncertainty associated with labor investment. For

example, overinvestment in labor (e.g. overhiring or underfiring) could be

motivated by managers’desire to engage in empire-building activities by retain-

ing underperforming projects (Williamson 1963). Underinvestment in labor

could occur if information asymmetry between managers and investors gives

rise to an adverse selection problem. Investors may price-protect themselves

from their information disadvantage by offering to pay lower prices for securi-

ties offerings and, thus, lack of requisite capital for firms may make investment

in labor prohibitively costly, leading to underinvestment (Jung et al. 2013). In

addition, managers may also over- or underinvest in labor because of uncer-

tainties associated with accurately predicting labor demand. Arguably, accurate

forecasting of labor demand is a complex and daunting undertaking, since such

demand depends on many factors at firm-level (e.g. level of consumer demand

for a product/service, the amount of capital investment, firm-level labor pro-

ductivity, etc.), industry-level (e.g. product market competitive pressure, rate of

technical change, etc.), and macro-economic level (the state of macroeconomic

health of the domestic and world economies; government policy changes, etc.)

(Addison et al. 2014).

Despite the potential for the firm to deviate from optimal labor investment,

all firms are not likely to exhibit similar inefficient labor investments. We pro-

pose firm-level business strategy as a suitable context that may explain cross-

sectional variation in labor investment efficiency. Extant studies show that

business strategies play a crucial role in shaping investment decisions, informa-

tion environments, financial performance, and managerial compensation

(Bentley et al. 2013; Navissi et al. 2017). Miles and Snow (1978, 2003)) detail

three viable business strategies that may exist simultaneously within industries:

Prospectors, Defenders, and Analyzers; because of differences in the magnitude

and direction of change in their products and markets (Hambrick 1983). Pros-

pectors, being innovation-oriented, change their product market mix rapidly,

while defenders compete on the basis of price, service, or quality, focusing more

on a narrow product base. Firms that constitute the middle of the continuum

are analyzers, and these have attributes of both prospectors and defenders.

Prior research on organization theory has demonstrated that prospectors are

plagued with poor corporate governance, as reflected in financial reporting

irregularities, informational opacity, internal control weakness, and corporate

overinvestment (Bentley et al. 2013; Habib and Hasan 2017; Navissi et al. 2017;

Bentley-Goode et al. 2017b). For prospectors, ‘rapid growth’becomes the main

tool for better performance. Such growth opportunities encourage executives to

expand their business units, their staffing levels (overhiring and underfiring)

and the dollar value of assets: the so-called empire building, which benefits

executives at the expense of shareholder value. Thus, the agency perspective

© 2019 International Review of Finance Ltd. 2019 59

Strategy and Labor Investment

suggests that prospectors are more likely to deviate from optimal labor invest-

ment. An alternative to this “agency”argument relates labor investment ineffi-

ciency to prospectors’inherent difficulties in predicting optimal labor demand.

In particular, given that prospectors constantly search for market opportunities

and regularly experiment with potential responses to changing environmental

trends to generate wealth for shareholders, the transaction costs associated with

dealing with different business markets may make it difficult for prospectors to

predict the optimal labor demand, leading to inefficiencies in labor investment.

Conversely, firms following a Defender strategy, operate within a narrowly

defined product set, investing in single-core technologies to enable cost-

efficient production on a continuous and predictable basis (Miles and Snow

1978, 2003; Hambrick 1983). Defender firms exhibit firm-level characteristics

opposite to those of prospectors: gradual growth, less complexity, and more

consistent profitability. Studies suggest that defenders tend to be associated

with fewer financial reporting irregularities and less internal control weakness:

a manifestation of relatively better corporate governance that is likely to curb

managerial opportunistic behavior and, therefore, inefficiency in labor invest-

ment stemming from the agency problem. Moreover, since defenders offer a

stable set of products with no or little product development and focus on a

strong defense of their existing marketplaces (Miles and Snow 1978), demand

for the products of defender firms is stable and predictable. This allows

defenders to make more accurate predictions of labor requirements, and is more

likely to generate an optimal level of labor investment. Therefore, we contend

that defenders are less likely to be associated with inefficient labor investment.

In order to measure labor investment efficiency, we regress firms’net hiring

(percentage change in the number of employees) on variables that explain nor-

mal hiring practices, such as sales growth, liquidity, leverage, and profitability,

following Pinnuck and Lillis (2007) (see Section III.B. for details). We then sub-

tract actual net hiring from this expected net hiring to derive an abnormal net

hiring value that captures the amount of net hiring not attributable to underly-

ing economic factors. We also use a discrete business strategy score (Bentley

et al. 2013), to classify firms into three strategy groups: prospector, defender,

and analyzer.

Using a large sample of US data, we document a positive and significant asso-

ciation between business strategy, as a discrete score, and abnormal net hiring.

We then extend the baseline case by including prospectors and defenders in

the same regression model, and use analyzers as the benchmark group. Our

results show that, compared to firms with analyzer-type business strategies,

those with prospector-type business strategies are associated positively with

abnormal net hiring, while the association is negative and significant for firms

with defender-type business strategies. We then test whether prospector-type

firms exhibit more or less inefficient labor investment when they are subject to

agency problems and firm-level uncertainty. We proxy the former by the

growth in capital expenditure; growth in property, plant, and equipment

(Giroud and Mueller 2010; Chhaochharia et al. 2012), and the existence of

© 2019 International Review of Finance Ltd. 201960

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