Uncertainty, Real Options, and Cost Behavior: Evidence from Washington State Hospitals

Variable costs need not be incurred unless a firm wants to produce goods or services; the opportunity to incur variable costs is therefore a real (European) option (McDonald and Siegel 1985). Moreover, fixed investments can usually be postponed; the ability to wait before investing is also a real (American) option (McDonald and Siegel 1986). Decision-makers usually have more accurate information available when choosing to incur subsequent expenditures (variable costs) than when committing to fixed costs for long-term projects. Therefore, decision-makers have greater flexibility to respond to changes in business conditions when upfront (fixed) costs are lower in relation to subsequent expenditures. Because the value of flexibility increases with uncertainty, technologies with high variable and low fixed costs become more attractive as uncertainty increases. We argue that real-options theory therefore implies that the ratio of variable to fixed costs should increase with higher uncertainty.