Budget padding aims to inflate the proposed budget; it can be done by artificially increasing estimates that favor managers. This results in the room to cover unexpected expenses the business may have to face during the project. Artificial increment/budget padding can be perceived as unethical, but sometimes it’s logical in times of inflation when there is financial instability for the overall working environment. So, it can be difficult to complete the project with the original estimate. Hence, this budget is justified in certain environmental conditions.
This budget can be done by artificially decreasing expected revenue and increasing expenses. This helps the business manager to present the project with prudence and keep expectations within the limit. However, that’s not considered to be an ethical move.
Incentives for budget padding
Following are some of the incentives for padding the budget.
- Economic factors are incorporated in the process of budget formation. For instance, environmental factors like adverse changes in the exchange rate can significantly impact project completion. Hence, managers have an incentive to cover unexpected amounts in the process of budgeting.
- Breathing room/slack is available for unexpected expenses. So, uncertain expenses can be met, and there is no impact on the project’s success.
- It helps to give a good impression in front of superiors. For instance, if the project is completed under agreed cost, it gives an impression that managers succeed in meeting the purpose of the project. It can also result in financial incentives for the managers (However, budget padding to gain personal financial interest is unethical).
- Often this budget is done to compensate for the budget cuts. For instance, if it’s expected that there is a routine 10% cut in the budget proposal. So, it can be done to dilute the impact of the cut in the budget.
Consequences of budget padding
Ideally, budget padding should not be part of the budget process. However, the real world is different, and there can be positive and negative consequences of including padding in the budget.
The positive consequence can be the successful completion of the project leading to a win-win situation for the business owners and manager. On the other hand, padding might lead to negative consequences on the overall budget process. For instance, in the case of a recurring project, the manager may be using inflated resources. Hence, leading to a loss for the business owners.
It means padding can prove to be a gap/weakness for the business. However, that’s not always the case.
Ethical consideration of budget padding
Budget padding can be perceived as unethical and subject to deception. It can lead to a harmful corporate atmosphere where it can be difficult to cultivate a culture of integrity and cooperation. It’s important to note that padding may not be unethical forever. In other words, padding may be genuine. However, that’s in rare cases.
Purpose of budget padding
Risk management
Budget padding carries features of the contingent method of budget formation. It’s flexible to include unforeseen expenses like changes in the price of input materials, changes in the cost structure, and any other unseen factors that have not been included in the process of budgeting.
Easy achievement of the task
By budget padding, the business managers may be inclined to achieve easy project results and avoid innovation in the process. For instance, they might continue to purchase expensive materials due to the easy availability of the funds.
Budget performance
Some businesses compensate employees based on their performance linked with the budget. So, artificially inflated budget/padding can help them in performance achievement.
Causes of the budget padding
Informational asymmetry
Information asymmetry is when one party in the hierarchy has access to more information than another part. So, the party with more access to information is seen to artificially inflate the budget. In the context of business, the departmental manager is expected to have more information about processes like employee productivity, resource requirements, and other expenditures than a senior manager. Hence, the departmental manager seems to be in a position to artificially inflate the budget.
Performance-related compensation
If the managers’ compensation is dependent on the budget-related performance, they’ll be motivated to artificially boost the performance for the sake of personal benefit. Hence, the manager may decide to go for budget padding.
Availability of limited information
At the time of budgeting, limited information is available to the managers responsible for estimating the transaction balance. So, they may opt to remain safe side with an artificial increment of the funds.
How to control budget padding?
It may result in a negative impact on the productivity and profitability of the business. By using this practice, the managers may be willing to attain personal incentives and goals rather than looking for the interest of the business.
Hence, there is a need to control budget padding for the financial interest of the business. Implementation of the following procedures can help to control the budget padding.
1. The performance measurement of the managers should not be based on the budget.
Organizations often assess the performance of the managers via the completion of projects within budget. So, the managers achieving desired results are given performance bonuses and other incentives. This motivates the employees to window dress their performance, and budget padding can be one of them.
It’s important to note that motivation to do fraud is one of the major reasons for fraud. Hence, the mechanism of performance-related pay in context to budget needs to be revised.
2. Reducing the number of contributing managers in the process of budgeting
It has been generally observed that if more managers are allowed to contribute to budgeting, they are highly like to do budget padding. This will put them in a comfort zone, and not much effort will be required to complete the work.
On the other hand, some aggressive managers’ budget contributions can help set reasonable budget figures and avoid budget padding. Further, this process can be aided by implementing top to a down approach of budgeting where top management directs the targets and other metrics.
Impacts of budget padding on the organization
Following are some of the business impacts of budget padding.
- It results in portraying the business as an under-performing entity; however, it can earn higher profits, gaps in management (budget padding) may lead to compromise on the overall profitability of the business. The psychosocial impact of the padding can be significant. For instance, the managers may not think to control the cost as excess cost remains at the slack limit. The underperformance may lead to divestment from investors and stop of credit supplies from suppliers.
- Understatement of business revenue as part of budget padding can lead to impairment in the overall process of budget setting. Many components of the budget like marketing, production plan, research, and administrative expenses depending on the revenue. So, if revenue is understated, these figures are expected to be understated.
Conclusion
Budget padding means setting the budget at an efficiency below the potential of the business. It leads to an artificial decrease in revenue and an increase in expense. It puts managers responsible for achieving the budget in the comfort zone because targets have been set below potential, and they do not need to put much effort to achieve the preset targets.
The incentives of doing such a budget include showing better managerial performance, compensating the budget cut, and covering unexpected environmental fluctuations in the budget. This budget is perceived as unethical due to deceptive behavior required to execute the same.
Managerial performance is aided by budget padding as targets can be achieved without putting greater efforts into the project. Similarly, in some organizations, budget cut is the norm; managers justify artificially inflating the budget in such a situation.
Mostly, negative consequences have been observed with the budget padding; these consequences include a compromise on the attainment of full employee’s potential, reduced efficiency of the business productivity, and reduction of the business profits.
Further, there can be different causes of the budget padding that include information asymmetry, performance-related pay, and limited information availability to the business’s senior management.
Information asymmetry refers to the availability of more information to departmental managers than senior management, leading to budget padding by the departmental manager. Likewise, the incentive to get financial benefits can be the cause of the budget padding.
Frequently asked questions
Which approach of budgeting can be more suitable to avoid budget padding?
The top-down strategy of budget setting is more suitable for the organization when it comes to the prevention of this budgeting. That’s because the input of the lower management is minimized, and top management uses its experience in the process to produce a budget.
Why is budget padding unethical?
Budget padding is considered unethical, that’s because it involves deceptive practices to artificially change original estimates. Hence, it’s considered to be unethical practice.
Why do managers do budget padding?
Mostly, managers do budget padding to get personal incentives and goals. For instance, their performance and bonuses may be dependent on the budgeted achievement of the project. Hence, the manager can do budget padding for achieving results.
How to prevent budget padding?
This can be prevented by implementing the following practices.
- The system of budgeting should not be used as the base of the performance evaluation.
- An organization can introduce truth inducing pay scheme.
- A participative approach to form the budget can be adopted.
- Adopting zero-based budgeting can be helpful.
