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In an organization when a manager is responsible for planning incomes and expenses for the a future period, they can plan income very low and expenses very high so that this amounts gets approved by senior management.
The Manager basically does this thing to be sure of meeting the budget with a very low income goal, the manager should be able to achieve it and go over it. With a very high expense Budget the manager should be able to easily keep actual expenses within the Budget. If this happens the managers performance in the coming year will look very good, as it doesn't really give management any idea of what the coming year will actually look like because it's not realistic. And it doesn't show the actual evaluation of the manager's performance. So this is known as the Budgetary Slack.
In other words the surplus that arises when managers preparing a Budget overestimates costs or underestimates revenues. Most organizations would want to eliminate budget slack but some managers may be motivated to create it to improve their performance evaluations.
After realising the meaning and concept of budgetary slack then it points out the key questions like why, for what etc. for the occurrence of this concept. First of all coming to the reality check of why this phenomena is happening, it is evident that it happens due to the fraud action of the concerned manager, that is misrepresentation of the facts and figures in the budgetary report. With a budgetary slack the manager is capable enough to achieve if its showing a very low income target and by exaggerating a high expense budget he is able to hide the actual expense within the budget. thus even though a managers performance in the coming year may look good, the truth is the budget is not showing the original forecasts upon which major decisions should be taken. Mostly companies major decisions and strategies are based on their budgets to a great extent, even factors like firms growth,development,etc.
Causes Of Budgetary Slack :-
Budgetary Participation :-
Agency theory had been used to explain budgetary participation. Magee (1980) explained
that the anticipated payoff to principals was increased with access to information held by agents before preparing the budget. By participating in the budget preparation
process, the agent gives the principals an opportunity to access information which allows agent to communicate or reveal some of their private information that may be incorporated into the standards or budgets, against which their performance would be evaluated (Magee, 1980;Baiman, 1982; Baiman & Evans, 1983).The agents sometimes doesn,t reveal all the information which would lead to budgets with incorporated. Budgetary participation was the means by which subordinate managers influence plans and share in the decision making process with their superiors on matters that affect their areas of responsibility (Milani, 1975;Brownell, 1982a, 1982b).
Budget Emphasis :-
As Managers are under pressure to achieve there budgeted goals ,in this case there is a chance they would create budgeting slack. This pressure, applied from supervisors was budget emphasis. When the achievements of budgeted goals were emphasized, the normal tendency was to incorporate slack into the firm's budgets. The main reason for subordinate managers' efforts to build slack in their budgets was to increase their payoff chances. If subordinate managers perceived their rewards as dependent on budget attainment, they would tend to build slack into their budgets through the participation process. Therefore, budget emphasis in performance evaluation may encourage budgetary slack.
Information Asymmetry :-
Another factor that influences the budgetary slack building behaviour r is the degree of information asymmetry. Information asymmetry arises when the subordinate managers possess private information regarding division's productivity, effort level, and resource requirements that is not available to the central management. This private information can be used by the subordinates to maximize their self-interest especially when the central management cannot observe the subordinate actions. Subordinates have incentives to misrepresent their private information in order to set easy to achieve budget targets .
NEGATIVE SIDE OF BUDGETARY SLACK :-
Even though there are positives and negatives for budgetary slack, the negative effects outweigh positive effects .Some of the negative effects 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:-
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 (Smith et al, 2008, p. 460).
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 (Waller, 2002).
Budgetary Participation :-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.
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.Â 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.Â This usually means that budgeted amounts are incrementally increased.Â The alternative to incremental budgeting is called "zero-based budgeting."
With zero-based budgeting, each expenditure taxes and fees.Â This gives rise to considerable frustration in trying to control spending.Â 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.
Sometimes the slack creation increases if a tight budget is applied and the manager is expected to incur budget overruns .In othercase if managers are permitted to participate actively in the budgeting process then the chances of slack is to reduce in further stages.
Truth inducing schemes also play an important role in reducing budgetary slack. Individuals are assumed to be motivated by their self-interest; therefore, managers will not always act in the best interest of the management. Because the actions that may benefit the management might not be beneficial for mangers self interest. The main issue here is how to align the manager's interest with the management's interests. Some actions that the management can take in this case are, firstly to pay the manager a fixed salary if he takes the right action and impose a penalty if he contravenes. Another step could be to induce a compensation plan that links compensation with the mangers performance. These actions are expected to provide subordinate/managers with an incentive to communicate truthfully, thereby reduce budgetary slack.