What is Budgetary Slack?
Budgetary slack is the practice of overestimating the expenses and/or underestimating the projected revenues when preparing a budget statement for the next financial period. It is a cushion created by management or lower-level managers to prepare budget estimates that will not be hard to achieve.
In other instances, budgetary slack may be a result of the management adding unverified numbers, especially in highly competitive industries where changes are common. A true budget statement must be honest; it should reflect actual anticipated revenues and expenses.
introduction of Budgetary Slack
Budgetary slack is generally frowned upon because the perception is that managers care more about making their numbers to keep their seats and to game the executive compensation system rather than to push the company’s performance to its potential.
For example, if a senior manager’s bonus is tied to meeting certain budget targets, then adjusting the budget for a more favorable outcome would be incentivized. Managers putting a budget together could low-ball revenue projections, pump up estimated expense items, or both, to produce numbers that will not be hard to beat for the year.
However, sometimes it is genuinely the case that management is unsure of the numbers. Economic forecasts are fuzzy, industry changes are rapid, or a new slate of products is about to be launched. In these instances, the future performance of the company is uncertain and managers prefer to be conservative. Management could be exonerated in such cases for publishing a lazy-looking budget. The best way to avoid budgetary slack is to install a management team with integrity.
Causes of Budgetary Slack
The following are some of the common causes of a budgetary slack when preparing an annual budget for the company:
1. Uncertainty on results expected
The managers of a company may face a lot of uncertainty over the results expected in a future period. For example, when the company is introducing a new product line, the managers lack actual data on the kind of results to expect.
As a result, they will be conservative when setting up the budget for the coming financial year to avoid promising beyond what they can achieve. Budgetary slack may occur when the managers underestimate the expected revenues to remain in a range that is easy to achieve for a new product line.
2. Information asymmetry
Information asymmetry occurs when one party possesses more information about the subject than the other. In such a case, departmental-level managers may be able to access private information about resource requirements, employee productivity, and expenditures which the senior management may not be privy to.
The lower-level managers may take advantage of the information asymmetry to advance their self-interest without the knowledge of the top management. They can set easy-to-achieve revenue targets so that they can be seen to be working hard by the management, even when they are guaranteed to outperform the previous year’s results.
3. Rewards dependent on budget attainment
In organizations where employee awards and payoffs are dependent on budget attainment, lower-level managers may create budget slacks to make the target easy to achieve. The subordinate managers are often under pressure from top management to make sure that the set goals are achieved, which means that they can influence the process to work in their favor.
As the managers perform supervisory roles, they know what is achievable and what resources are required. They would, therefore, present a high budget for expenses while low-balling the expected revenues target at a level that is easily attainable. This would make it easy for them to beat the set targets in every period and enjoy the promised rewards, salary hikes, and job promotions.
The Harm of Budgetary Slack
Budgetary slack year after year can lead to business mediocrity. If management is intentionally creating soft targets for the company, it will not drive the business forward in competitive markets.
Shareholders hold management and the board responsible for creating value. If management is not working hard, they are not working hard for shareholders. Such leadership will eventually manifest itself in the stock price of the company, and among the rank-and-file there will be a growing concern that their company is losing competitiveness.
Jobs at the company will be at stake. Star employees may choose to leave for a stronger competitor, which would place the company at a further disadvantage.
Underestimating revenues can also signal to analysts and investors that a company is performing poorly or undergoing some other unforeseen difficulty, raising concerns about the health of the company, which in turn could actually negatively impact the company.
Underestimating revenues could also lead to a reduction in expenses, such as employee payroll or advertising expenses, which might actually be needed to grow the company, further cementing a downward spiral of company performance.
Negative Side of Budgetary Slack
Even though there are positives and negatives for budgetary slack, the negative effects outweigh positive effects. Some of the major negative effects of budgetary slack are the following:
1. During good years managers tend to depend on budgetary slack and at bad years these managers tend to convert budgetary slack to profit. That is if a manager behind the profit for the year, the manager will rely on the budgetary slack built into the budget to make the profit goal anyway. But if manager is ahead of profit for the year then the manager will use up the additional money left in the budget because of the budgetary slack built into at the beginning of the year.
Thus the managers will rarely, if ever exceed the goals although they will almost always meet their goals but the meeting of the goals will not be real since the goals are not real due to budgetary slack.
2. A deliberately understated sales budget might have serious consequences in planning other activities. For instance, production might be too low; the advertising program and distribution expense budgets may be planned incorrectly; the cash flow plans might be inaccurate.
Ways to Prevent Budgetary Slack
1. Evaluation System
Organizations can reduce budgetary slack when they stop using budget as a negative evaluative tool. For instance, instead of criticizing subordinates every time a budgeted target is not achieved, if the subordinates are allowed some discretion to exceed costs when unavoidable, there will be a lesser tendency to create budgetary slack.
2. Truth-Inducing Pay Scheme
A problem occurs in participative budgeting when a subordinate has private information about factors that influence his or her performance and the pay scheme is budget or standard-based. The employee has an advantage to keep away this information from superiors so that a relatively easy standard is set, thereby creating slack.
To eliminate this problem, research proposes a truth-inducing pay scheme to motivate subordinates to accurately communicate private information and maximize performance, thereby reducing budgetary slack.
3. Participative Budget
Participative Budget is an ideal budgetary process. Most companies deviate from this ideal budgetary process. Typically top managers initiate the budget process by issuing broad guidelines in terms of overall target profits or sales. Lower level managers are desired to prepare budgets that meet those targets.
The difficulty is that the target set by top managers may be unrealistically high or may allow too much slack. If the budgets are too high and employees know they are unrealistic, motivation will suffer. If the targets allow too much slack, waste will occur. And unfortunately top management is often not in a position to know whether the targets they have set are appropriate.
Admittedly, however, a pure self imposed budgeting system is not without limitations. It may lack sufficient strategic direction and lower level managers may be tempted to build into their budgets a great deal of budgetary slack. Nevertheless, because of the motivational advantages of self imposed budgets, top managers should be cautious about setting inflexible budgets.
4. Zero-Based Budgeting
The problem of budgetary slack is particularly acute when the prior year’s budget is used as the starting point for preparing the current budget. This is called “incremental budgeting”. It is presumed that established levels from previous budgets are an acceptable baseline, and changes are made based on new information.
This usually means that budgeted amounts are incrementally increased. The alternative to incremental budgeting is called “zero-based budgeting.”
With zero-based budgeting, each expenditure taxes and fees. This gives rise to considerable frustration in trying to control spending. Some governmental leaders push for zero-based budgeting concepts in an attempt to filter necessary services from those that simply evolve under the incremental budgeting process.
Advantages of Budgetary Slack
- If the budgeted cost in the company is overestimated, then the expenditures can be shifted to future years.
- When there is uncertainty about the future, as possible in creating a budget for the new product line , then budget slack may provide flexibility to the management while performing business operations.
Disadvantages Budgetary Slack
- It could result in a decrease in the efficiency and performance of the company employees because, in that case, the company employees will work only within their capability of attaining the goals.
- In case there is budgetary slack by the understating of the revenue of the organization. Due to this understatement of revenue, there are chances that the management will also cut the budgeted expenses of the vital function of the company, such as the research and development expenses, advertisement expenses, production expenses, or administrative expenses , etc. this reduction of the expenses may also be responsible for hampering the company’s long-term viability.
In a business, when the management deliberately over-estimates the budgeted expenses or under-estimates the budgeted revenue, then that cushion created by the management to increase the probability of achieving the better targets than the budgeted is a budgetary slack.
It is done by the management, especially when their bonuses or performance appraisals are based on their targets. Moreover, when large numbers of employees are involved in the preparation of budgets in the organization, there are more chances of introducing budgetary slack into the budgets by them.
One more reason for budgetary slack can be the uncertainty of the expected results shortly. Under those circumstances, managers of uncertainty managers generally tend to follow the conservative approach while preparing budgets.
The top-level management gets misled about the actual profitability of the business due to this slack, no matter if the reason for the creation of budgetary slack is ethical or unethical. Top-level management should review previous years’ budgets and assess variances between the budgeted and actual numbers to overcome the same.