Budgetary Slack

What is Budgetary Slack?

Budgetary slack is the practice of underestimating revenues or overestimating expenses when preparing a budget in an effort to make it easier to achieve. In other words, it’s a way for management to prepare a budget with built in flexibility that will allow them to meet the budgeted goals easier.

Budgetary slack refers to the deliberate adjustment of additional cash outlays in expectation of future cash flow. Budgetary slack functions by undervaluing the total income or revenue that the business expects to receive in a specified time period. These practices can also include overstating the expenses the company expects to pay out over the same time frame. The issues surrounding budgetary slack can be both functional and ethical, as these practices limit the effectiveness of budgets and often call for less-than-precise accounting methods.

Understanding Budgetary Slack

Budgetary slack is the deliberate under-estimation of budgeted revenue or over-estimation of budgeted expenses. This allows managers a much better chance of “making their numbers,” which is particularly important for them if performance appraisals and bonuses are tied to the achievement of budgeted numbers.

Budgetary slack may also occur when there is considerable uncertainty about the results to be expected in a future period. Managers tend to be more conservative when creating budgets under such circumstances. This is particularly common when creating a budget for an entirely new product line, where there is no historical record of possible results to rely upon.

Budgetary slack is most common when a company uses participative budgeting, since this form of budgeting involves the participation of a large number of employees, which gives more people a chance to introduce budgetary slack into the budget.

Another source of budgetary slack is when senior management wants to report to the investment community that the business is routinely beating internal budget expectations. This cause is less likely, since outside analysts judge a company’s performance in relation to the results of its competitors, not its budget.

Budgetary slack interferes with proper corporate performance, because employees only have an incentive to meet their budget goals, which are set quite low. When there is budgetary slack for multiple consecutive years, a company may find that its overall performance has declined in comparison to that of more aggressive competitors who use stretch goals. Thus, budgetary slack can have a long-term negative impact on the profitability and competitive positioning of a business.

Budgetary slack is less likely to occur when a small number of aggressive managers are the only ones allowed input into the budget model, since they can set expectations extremely high. Slack is also less likely when there is no link between performance or bonus plans and the budget.

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.

Preventing Budgetary Slack

Budgetary slack can be avoided by employing certain measures that should have a long-lasting positive effect on a company. The first step would be in allowing only a small number of managers to draft the budget. Too many managers working on a budget may introduce lax measures that would be easier for them to meet targets. Having a small group of trusted, motivated managers working on a budget will allow for a challenging budget, hopefully spurring employees to work harder.

Another way to prevent budgetary slack is to disassociate the budget with performance. If employees’ bonuses or other performance metrics are tied to meeting budget targets, they will prefer easier to achieve budgets. Removing this link will prevent employees from wanting to beat the numbers for monetary gain and allow them to contribute in a productive fashion.

Advantages

  • 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 the case of the creation of a budget for the new product line, then budget slack may provide flexibility to the management while performing business operations.

Disadvantages

  • It could result in a decrease in the efficiency and performance of the employees of the company because, in that case, the employees of the company will work only within their capability of attaining the goals.
  • In case of there is budgetary slack by the understating the revenue of the organization then 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.

Essential Points about Budgetary Slack

  • It is the intentional over-estimation of the budgeted expenses or under-estimation of the budgeted revenue of the company during a point of time while preparing the budget.
  • When large numbers of employees are involved in the preparation of budgets in the organization, then generally, there are more chances of introduction of budgetary slack into the budgets by them so that they can easily achieve the targets.
  • Even the senior management can introduce inventory slack into the budgets if they want to report a good picture of the achievement of their targets to the investment community. Although the analysts judge the performance of the business by comparing the actual results of the business with that of its competitors but still some organizations introduce budget slack for getting a good picture of the business, thinking it will work in favor of their organization.
  • To prevent the practice of the budgetary slack, the top management of the company should limit the manager count that is allowed to prepare the budgets and should not make the budget as the basis of the evaluation of the performance of the company.
  • It could result in a decrease in the efficiency and performance of the employees of the company because, in that case, the employees of the company will work only within their capability of attaining the goals.
  • The top-level management gets misled about the actual profitability of the business due to the budgetary slack, no matter the reason for the creation of budgetary slack is ethical or unethical. To overcome the same, top-level management should review the budget of previous years and assess variances between budgeted and actual numbers. With this, they might be able to correct the slack is any prevailing in the current budget and the future budgets of the company.

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