The performance implications of financial slack during economic recession and recovery: observations from the software industry (2001-2003) *.

Much has been written in the strategic management literature on whether slack resources help or hinder the successful management of the firm (e.g., O'Brien, 2003; Cheng and Kesner, 1997; Nohria and Gulati, 1996, 1995; Singh, 1986; Bourgeois, 1981; Cyert and March, 1963). In general, scholars have identified four major functions of firm slack (Tan and Peng, 2003). First, it alleviates goal conflict within the firm by providing necessary means to solve resource problems (Cyert and March, 1963). Second, it improves information processing within the organization by reducing interdependences between subunits (Galbraith, 1973). Third, slack represents a catalyst for strategic change by facilitating innovation, including new product development and new market entry (Nohria and Gulati, 1995; Hambrick and Snow, 1977; Bourgeois, 1981). Lastly, slack smoothes a firm's environmental adaptation by offering a buffer in face of environmental turbulence (Cheng and Kesner, 1997; Meyer, 1982; Bourgeois, 1981; Thompson, 1967).

While all four perspectives have received ample attention, some scholars have recently returned focus on furthering an understanding of how organizational slack affects the firm in different environments (Martinez and Artz, 2006; O'Brien, 2003; Cheng and Kesner, 1997). When considering the relationship between slack and firm performance, these researchers maintain, context matters. As in the more general literature on slack resources, these environment-specific arguments indicate that slack can be a double-edged sword. On one hand, it provides what Bourgeois (1981: 30) refers to as a "shock absorber" that can help firms cope with shifting environmental demands (Tan and Peng, 2003; Cheng and Kesnet, 1997; Cyert and March, 1963). On the other, however, this cushion can slow a firm's reaction by insulating managers from the immediate requirements relating to environmental discontinuities (Yasai-Ardekani, 1986; Litschert and Bonham, 1978). A particular situation representing one of the most significant environmental threats to a firm's viability and continued profitability and purported to make critical use of slack is economic recession (Pearce and Michael, 2006; Mascarenhas and Aaker, 1989). As sales decline, margins decrease and credit dries up, a firm's slack is deemed to become increasingly scarce and thus critically valuable; in fact, Cheng and Kesner maintain that "the presence of slack resources serves a positive role by helping firms withstand severe economic recessions" (1997: 3).

While Cheng and Kesner's assertion may seem intuitively apparent, its empirical validation is warranted for the following reasons. For one, findings on the impact of organizational slack on firm performance remain inconclusive (see meta-analysis by Daniel et al., 2004). As a consequence, researchers (Tan and Peng, 2003; Cheng and Kesner, 1997) suggest a contingency approach that stipulates the potential influence of certain environments on the nature of the slack performance relationship. Thus, while any given firm may indeed have an optimal level of organizational slack (Sharfman et al., 1988), it may be that these levels vary depending on specific circumstances encountered by the firm. Also, previous empirical studies on the slack-performance relationship gravitate toward cross-sectional inquiries, with less emphasis on its changing characteristics over the course of environmental disruptions. By drawing attention to the role of firm slack over the course of context-specific time periods, research on the link between firm adaptability, decision making, and performance can be greatly enhanced.

Our study is an attempt to better understand the previously proposed role of slack under circumstances of extreme environmental duress. We investigate the interplay between slack and firm performance during economic recession to answer the following research question: To what extent, if at all, does organizational slack at the onset of a recession help or hinder the subsequent performance of the firm during the recession and recovery? In accomplishing our study, we treat organizational slack as a financial indicator: financial slack. In that regard, we follow suit with Herold et al. (2006), Cheng and Kesner (1997), Sharfman et al. (1988), and Bourgeois (1981) who maintain that firm slack, as a solution to organizational workflow problems, should be visible, measurable, and manageable. We do this because our interest with this inquiry is to move beyond a basic depiction of the slack-performance relationship by providing guidance to managers on how to effectively govern slack resources during times of economic turmoil.

Our study contributes to strategic management research on three fronts. First, we build upon and extend previous work on the role of financial slack in firms by offering an empirical examination of the relationship between financial slack and firm performance during hostile environmental conditions. Second, we respond to recent calls by Pearce and Michael (2006) and Navarro (2005) that strategies for successfully navigating recessions are extremely limited. By understanding the role of discretionary resources--in this particular case, financial slack--managers can favorably position their firm to survive an economic recession. Third, our study offers a unique and innovative application of a multilevel trend analysis that enables us to longitudinally examine the impact of slack on firm performance throughout the recession and initial stages of recovery.

This study will read as follows. Below, we summarize the extant literature on the role of financial slack in firms from which we develop competing hypotheses that can help us understand the competitive advantage or disadvantage of financial slack in the context of recessions. We then proceed to describe our sample, variables, and methodology, followed by a presentation of our empirical results. In the final section of the article, we discuss the research and practical implications of our findings and offer directions for future research.

LITERATURE REVIEW AND HYPOTHESES

Framing the Theoretical Debate on Financial Slack

Scholars have traditionally viewed strong financial resources as a primary source of competitive advantage (Amit and Schoemaker, 1993; Grant, 1991; Cyert and March, 1963). In the extant literature, financial resources have been broadly classified, including strong cash flows, low levels of debt, a superior credit rating, and high market valuation relative to competitors. While financial resources typically are not rare or unique--in the sense that many firms possess them--they do offer a high level of competitive advantage in two regards. First, a firm's possession of financial resources represents a path-dependent outcome of past success which is difficult to imitate (Barney, 1991; Dierickx and Cool, 1989). That is, a firm earns a healthy balance sheet or strong cash flow management. Thus, a firm's financial resources cannot be acquired in the same fashion that a firm may attain a patent or new technology. Second, financial resources offer a broad range of strategic options in their application since, according to Amit and Schoemaker (1993), they offer a high level of transferability to profit-yielding activities. For example, capital can be used to hire sales people, build a factory, acquire a company, invest in new technology development, and/or increase product marketing.

One type of financial resource, and the focus of our study, is financial slack. As mentioned previously, we treat financial slack as a resource under the discretion of management that can be managed to respond to discontinuities in the environment, create innovation and change, and thus improve a firm's response to environmental shifts (Bourgeois, 1981; Carter, 1971; Mohr, 1969). However, as in the general literature on slack resources, scholars have highlighted several types of financial slack that vary in the degree of discretion they afford managers (e.g., Cheng and Kesner, 1997; Singh, 1986). For instance, unabsorbed slack, also referred to as available slack, represents resources that remain uncommitted to system operations, and thus are readily accessible to managers. On the other hand, absorbed resources, consisting of excess operational costs (recoverable resources) and external resources in the form of debt and equity financing (potential resources), may require more managerial effort and time to retrieve (Geiger and Cashen, 2002). In similar fashion, Sharfman et al. (1988) propose a simple dimension of slack discretion ranging from high to low that can be used to match resource needs in changing environments. Accordingly, high-discretion slack includes highly liquid resources such as cash, credit lines, and raw inventory. On the other hand, low-discretion slack takes into account dedicated resources such as finished goods and excess capacity. Making the case that specific market conditions dictate certain slack resource needs, Sharfman and colleagues submit that for firms in rapidly changing environments, "the faster that changes come, and the larger those changes are, the more high discretion slack the firm will need" (1988: 606). This view is reaffirmed by Martinez and Artz (2006) who conceptualize available slack as the level of accessible liquid funds needed to safeguard the firm from the negative consequences of environmental uncertainty.