Budgetary slack occurs in a business when one or more people with budgetary responsibility create a budget that overestimates expenses and / or underestimates projected income or revenue.
Why budget slack occurs
Some cases of budget relaxation are intentional, others are not, and many more fall somewhere in between. Some examples clarify the differences:
Intentional budget failure
An intentional budget decrease can occur because a manager feels under pressure to “do their numbers,” often in response to previous quarters in which revenue fell below projections and, most importantly, they did not meet the expectations of the owners or the shareholders.
An easy way, if the unethical way to remedy the problem is for the manager to simply come up with a budget that overvalues expenses for the time period or deliberately hides likely sources of income. Since the budget was a bogus budget, the manager will now have little trouble exceeding it. On a large scale, the publication to analysts of quarterly revenue projections that the company’s internal auditors know the company may have already exceeded is one example.
Behind it is the same reason: allowing the company’s next report to show that revenue “has exceeded expectations.” As the company’s executives expected, this false “good news” sometimes translates into a brief and unjustified rise in the share price.
Involuntary decrease in budget
Sometimes the involuntary lack of budgetary rigor may be due to insufficient internal controls. If there is insufficient data to make appropriate data-based sales and cost projections, managers may produce an unrealistic operating budget based on honest expectations that are little more than “the best assumptions”, or that are imperfectly based on previous quarterly budgets. that, for various reasons, do not reflect the income and costs of the coming quarters.
This can happen, for example, if the internal controls of the company do not reflect the acceleration of sales of a new product. If instead of looking at the acceleration in sales of the new product during the previous quarter and taking into account your continued sales momentum, the manager simply notes the total sales figure for the quarter, and then applies that same figure to the quarter. Next, the result will be an unintentional underestimation of sales and profits.
Budgetary slack that is partially intentional and partially involuntary
This type of budgetary slack has two common causes: uncertainty of prospects in a new sales or cost environment and decentralized budgeting procedures. If, for example, the company is introducing a new product that is unlike any of those already on the market, who can tell what the sales will be? Even if the company has properly investigated the market, some uncertainty may persist.
The natural human tendency when such situations occur is to “play it safe” and make a sales projection unlikely to be embarrassingly optimistic. This is not exactly an intentional understatement, nor is it a totally innocent mistake. The other common situation involving a mix of intent and fallibility arises from a budget process that relies excessively on decentralized data entry.
The fact that each department is responsible for its own contribution to the budget may be good in the sense that the managers involved in each department base their budget projections on first-hand knowledge, but the quality of these projections can vary dramatically from one department to another. The best solutions to this problem are better budget oversight for each department and a greater emphasis on top-down budget management.