Budgetary Slack

What Is Budgetary Slack?

Budgetary slack is the intentional overestimation of expenses or underestimation of revenues in budgets by managers to create a cushion or attain personal benefits.

Budgets are the quantitative plans of the business activities for the forthcoming accounting year or quarter. The senior managers usually create the budgets to implement the strategic long-term company plans. 

When the senior managers are actively involved in the budget creation process, they create a master budget that consolidates budgets for every functional division in the organization. This type of budget-setting process is known as top-down budgeting. 

The middle and lower managers are not involved in its creation and are instead given a budget to adhere to strictly. It is authoritative and was ridiculed by many as it created stringent budgets. 

In response, the managers believed involving the middle and lower levels in the process would be more beneficial. This approach creates a more flexible budget and accurately reflects revenues and expenses. The process of associating the budget with the lower managers is known as bottom-up or participative budgeting. 

When divisional managers are free to create their budgets, they can set them to maximize their benefits. This phenomenon exists in a casual principal-agent relationship. The agent could keep their best interests in mind, sidelining organizational goals. 

When divisional managers create budgets that support their goals, it creates budgetary slack. Managers may also be tempted to create an incentive-based budget. The difference between realistic revenue and costs and estimated revenue and costs leads to budgetary slack.

Budgetary Slack Motivations

Budgetary Slack is created by padding the budget. The budget can become fictitious by either:

• Underestimating the revenue and or
• Overestimating the expenses. 

By employing both these techniques, managers can deflate the budget and showcase extraordinary performance. A budgetary slack may be created for the following reasons. 

Rewarding Performance

Budgetary slack is created to deflate budgetary or standard performance. This way, the management has worked exceptionally well when the actual performance exceeds the budget. The management would be suitably rewarded for this achievement.

For example, if a manager's bonus is associated with the profit they create in a year, they would reduce the sales revenue target and increase its related expenses.

The manager would be rewarded for exceeding the performance when they have adequately performed. 

Withstand Uncertainties

Another circumstance when managers have padded the budget is safeguarding and coping with the uncertain business environment. Managers could also provide a higher estimate of the expenses to adjust to unforeseen events.

For example, if a manager is confident that the raw material prices would increase considerably, they could budget a higher expense due to inflation. 

Similarly, a manager may develop a conservative budget while introducing a new product. The manager will be prudent in estimating the revenues and expenses. 

Budget Cuts

Managers may also be tempted to pad the budget when they believe senior managers may not approve their estimates. This could occur when the company runs with limited resources or a resource slack. 

When the managers believe their actual estimate of resources would not be approved, they will likely demand a higher resource that would most likely be cut. This way, the budgeted resources would be approved closer to their requirements.

Budgetary Slack Repercussions And Avoidance Methods

Budgetary slack is an unethical practice run by managers to create easily achievable targets. This slack is viewed as a behavioral issue in the budget-setting process. The following are the disadvantages and consequences of budgetary slack.

Underperformance

A direct negative consequence of padding the budget is to provide average performance. The senior managers may also reward the functional division for meeting their targets. In reality, they have yet to utilize their full potential. 

In the long run, this creates minimal performance, and the company’s growth stagnates. The company would be underperforming, reflected in its stock prices.

Investors and analysts would doubt the future profitable growth of the company.  The stakeholders, similarly, would not receive any value created and could divest in the company. 

Reduced Spending For Other Activities

Every company is required to spend on promotional activities. These activities include advertisements, sponsorships, etc. Through these activities, a company benefits through increased awareness and better customer reach.

These activities are considered sales and marketing expenses requiring a significant allocation. However, when managers underestimate the budgets, the senior managers feel it's beneficial to save costs by not spending on such marketing activities.

They may also reduce expenses such as research, development, and administrative costs. Due to this, the business growth becomes stagnant, impacting the company’s sales and overall stability.

Budgetary slack is avoidable if the company implements appropriate measures to do so. This includes internal control measures whereby the manager's budget is evaluated by other personnel before sending them for approval. 

1. Integral Managers: Creating Budgetary Slack is not an unintentional practice. The managers are well aware of their activities and their consequences. The company can avoid such a doing by employing managers with high integrity who would refrain from indulging in such activities.
2. Reduce Employee Participation In Setting Budgets: The primary reason that Slack exists is that managers are free to create their own budgets. If there is reduced participation by the number of employees, the budget will likely not exist with a slack.
3. Provide Other Incentive Measures: Most companies link rewards with performance. A manager would be tempted to create a budget with an easily achievable target so they can earn the maximum rewards. This can be avoided by detaching performance and rewards.

Researched & Authored by Astrid Dsouza | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Balanced Budget

• Imposed Budgeting

• Incremental Budgeting

• Participative Budgeting

• Top-Down Budgeting