In this article, we will cover the budgetary slack. This includes the definition, causes, the Repercussion of budgetary slack and how to control budgetary slack. First, let’s go through the overview together before going further detail.
Typically, all businesses prepare budgets of various types; budgets are an estimation of future expenses, revenue, cash flows, etc. all types of budgets are prepared at the time of financial planning. The businesses commonly revise and compare these budgets after implementation with the actual results achieved. Any gaps in these budgets are measured through variance and deviation tools. Any under-budgeting, surplus-budgeting, or balanced-budgeting performance is then reported.
While the prime purpose of budgets is to set the financial direction of a business, another important aspect of budgets is related to performance measurement. Managers and employees get appraisals based on their performance evaluations and achieving standard budgets play an integral part in those appraisals. While financial forecasts and budgets are not merely guesswork, they cannot be estimated with perfection due to changing circumstances. We call any deliberate changes made to showcase these budget measurements favorable as a budgetary slack.
What is Budgetary Slack?
We can define budgetary slack in many ways, one of the definition is:
An artificial adjustment in budget preparation that results in cushion in budgets that can increase the actual performance in comparison to the original budget.
Businesses have to prepare multiple budgets for financial resources, inventory, marketing, and so on. The choice of a budgeting approach varies from industry to industry and from company to company. Budgeting methods include activity-based budgeting, zero-based budgeting, performance-based-budgeting, etc. all modern budgeting methods link budget variances with management performances. Companies using a bottom-up or participative budgeting approach require managers to take part in the budgeting process. These budgetary approaches call for active inputs from operational managers that create a window of budgetary slacking.
What Causes a Budgetary Slack?
Before we list down a few of the causes for budgetary slacks, it is important to note that budgetary slack is different from financial misrepresentation. Financial misrepresentations lead to fraudulent activities, whereas a budgetary slack is more of a planning tactic. Sometimes inevitable situations force managers to create a cushion in the budget proposals too; however, there can be many factors that cause a budgetary slack:
Level of Participation in Budgeting
The Increase of budget participation result in budgetary slacks. Typically manager and staff always want to set budget that is easily to achieve in order to get performance bonus. Thus, if there is an increase level of participation from lower level staff to manager or the company uses the participative budgeting approach, there would the possibility of creating a budgetary slack.
Uncertainty of Economics Condition
Generally, the uncertainty in economic conditions, such as market slump or recession can force managers to deliberately create a budget cushion. This is because manager tends to prepare the budget at the cautionary level so that they can achieve the target.
Budgetary Slack as a Risk-Hedging Tool
Some managers create budgetary slack as a risk-hedging tool. Similarly to the level of participative budget above, generally, budgetary slack occurs when a manager submits a budget that is highly achievable budget targets. Typically, manager tends to set budget for the lower revenue so that it is easily to achieve. In addition, they would also set a bit high costs so that they would be able to proof that they would try to manage the costs effectively.
Performance Reward on Achieving the Budget
Similar to the points mentioned above, when there is no further performance measures or KPIs and the performance bonus or reward is heavily link to the budget, then it is highly probable that manager tends to want to set the easy budget to achieve.
Performance-based budgets tempt managers to create a budgetary slack to later claim positive performance
Lack of Past Data and Information Asymmetry
A budgetary slack may be caused due to lack of past financial data, guesswork in budget planning may lead to a budgetary slack later.
This lack of financial data as well as other critical information from the lower level to departmental level manager would create the information asymmetry.
The common notion a budgetary slack is negative, often rightly as the increasing burden of competitions and performance measurement control compel managers to do so. There are three prime uses of a budget:
- Planning and forecasting
- Communication and resource allocation
- Evaluation and performance measurement
So a budgetary slack can also affect an organization with all these three aspects.
The Repercussion of Budgetary Slack
Increased participation in budget planning increases a budgetary slack; this leads us to identify any link in budgetary planning, performance, and slacking. It is commonly perceived that a budgetary slack is directly linked with managers’ performance. If it goes unchecked and it continues for years it may cause a business severe financial damage. This approach as we discussed can affect all three aspects of budgets, and overall the business operations:
- It leads to inefficient operational and planning performance
- It creates a lack of motivation for managers and operational staff
- If it goes unchecked can result in mediocre performance and low target achievements in comparison to industry standards
- In budgetary slacking is orchestrated by managers, it may lead to demotivated lower staff and labors as their performances levels will remain inefficient
- Intense budget evaluations increase chances of budget slacking
- It results in decreased resource allocations for managers as budget planning targets are set flexible and easier
- Fewer resources due to a budgetary slack could also result in job loss for some labor and skilled workers
Although there are no quantifiable measures to assess the impact of budgetary slack, it can lead to negative consequences for businesses. For example, we should basically understand that budgets are planned to allocate resources, slacking would result in decreased performance. Eventually, the business will lose its competitive advantage and the business may go bankrupt. Budget slacking could also result in employee conflicts, with limited resources shared between departments.
The conflict of managers planning for their performance and appraisals and shareholders’ value creation isn’t new. The agency theory of the business focuses on the same point too. A budget slacking approach in operations and productions will eventually lead to decreased revenues and lower profits. Shareholders will rightly hold business managers responsible for that.
In some cases though, the budgetary slack can be justified. Uncertainty surrounds markets around the globe, and business environments are unstable. With participative approach, the management may decide to keep the budget targets flexible and easier to achieve the targets under tough market conditions. Managers often show conservatism when it comes to target and standard-setting, as softer targets can increase their performance.
How to Control Budgetary Slack?
As there are no quantifiable metrics to measure a budgetary slack, it is difficult to describe its true effects on a business. Its negative impacts still overweight the positive outcomes if any. For any business, the slacking approach in longer-term leads to fateful results. Top management can adopt two main approaches to eliminate the budgetary slacks:
Consider Top-Down Approach to Budgeting
A different budgeting approach such as a top-down can lead to a less participative approach. With that approach, only the top management can participate in budgeting planning and final decisions. Operational managers should only participate with feedback and planning inputs.
Budget Achievement is not a Sole Performance Measure
Top management can also decide to soften the intensity of performance measurement linked with budgetary controls. There should be other KPIs both financial and non-financial factors that each company should consider in rewarding the performance bonus.
Evaluate the Budget Proposal in Detail
Top management should evaluate the budget proposals in detail, comparing with industry standards to identify any slacks.
They should also look at the past data or trend as well as consider both internal and external environment affecting the business.
Identify to the True Causes of Performance Using other Measurement Tools
Similarly to point 2 above, shareholders should also evaluate the performance measurement metrics beyond ratios and percentage figures. It will enable them to identify true causes of performance for both positive and negative impacts.
The company may consider using Balance Scorecard as a performance measurement tool. Typically, the balanced scorecard approach is successful in reducing budgetary slack because it considers various aspects of evaluating the performance. This includes four perspectives as below:
- Customer Perspective
- Financial Perspective
- Internal Business Perspective
- Innovation and Learning Perspective
The word balance here refers to the equal measure of each perspective as mentioned above.
Intensified market competition, intense operational performance targets, and linked performance appraisals are all primary drivers of a budgetary slack. Participative budgeting approach results in increased budgetary slacks, although the converse doesn’t guarantee the total elimination of budgetary slacks either. A management team with higher integrity and moral standards, prioritizing the business benefits ahead of personal gains would avoid intentional budget slacking anyway. A more authoritative budget planning approach and less intensified performance appraisal can both help in reduced budgetary slacking.