Why did we discuss the master budget and responsibility accounting in the same chapter? Primarily to emphasize that human factors are crucial in budgeting. Too often, budgeting is thought of as a mechanical tool because the budgeting techniques themselves are free of emotion. However, the administration of budgeting requires education, persuasion, and intelligent interpretation.
As we discussed earlier in this chapter, budgeting is most effective when lower-level managers actively participate and meaningfully engage in the budgeting process. Participation adds credibility to the budgeting process and makes employees more committed and accountable for meeting the budget. But participation requires “honest” communication about the business from subordinates and lower-level managers to their bosses.
At times, subordinates may try to “play games” and build in budgetary slack. Budgetary slack is the practice of underestimating budgeted revenues or overestimating budgeted costs to make budgeted targets easier to achieve. This practice frequently occurs when budget variances (the differences between actual results and budgeted amounts) are used to evaluate the performance of line managers and their subordinates. Line managers are also unlikely to be fully honest in their budget communications if top managers mechanically institute across-the-board cost reductions (say, a 10% reduction in all areas) in the face of projected revenue reductions.
Budgetary slack provides managers with a hedge against unexpected adverse circumstances. But budgetary slack also misleads top managers about the true profit potential of the company, which leads to inefficient resource planning and allocation and poor coordination of activities across different parts of the company.
To avoid the problems of budgetary slack, some companies use budgets primarily for planning and to a lesser extent for performance evaluation. They evaluate the performance of managers using multiple indicators that take into account various factors that become known during the course of the year, such as the prevailing business environment and the performance of their industry or their competitors. Evaluating performance in this way takes time and requires careful judgment.
One approach to dealing with budgetary slack is to obtain good benchmark data when setting the budget. Consider the plant manager of a beverage bottler. Suppose top managers could purchase a consulting firm’s study of productivity levels—such as the number of bottles filled per hour—at a number of comparable plants owned by other bottling companies. The managers could then share this independent information with the plant manager and use it to set the operations budget. Using external benchmark performance measures reduces a manager’s ability to set budget levels that are easy to achieve.
Rolling budgets are another approach to reducing budgetary slack. As we discussed earlier in the chapter, companies that use rolling budgets always have a budget for a defined period, say 12 months, by adding, at the end of each quarter, a budget for one more quarter to replace the quarter just ended. The continuous updating of budget information and the richer information it provides reduce the opportunity to create budgetary slack relative to when budgeting is done only annually.
Some companies, such as IBM, have designed innovative performance evaluation measures that reward managers based on the subsequent accuracy of the forecasts used in preparing budgets. For example, the higher and more accurate the budgeted profit forecasts of division managers, the higher their incentive bonuses.* Another approach to reducing budgetary slack is for managers to become knowledgeable about what subordinates do by having in-depth dialogues about budgets and performance goals. Managers should not dictate decisions and actions of subordinates. Rather, managers should provide support, challenge assumptions to motivate performance, and enhance mutual learning. Subsequently, managers evaluate performance using both objective measures and subjective judgment. Of course, using subjective judgment requires that subordinates trust their managers to evaluate them fairly.
In addition to developing their organization’s strategies, top managers are responsible for defining a company’s core values and norms and building employee commitment to adhere to them. Norms and values describe acceptable and unacceptable behavior. For example, Johnson & Johnson (J&J) has a credo that describes its responsibilities to doctors, patients, employees, communities, and shareholders. Employees are trained in the credo to help them understand the behavior that is expected of them. J&J has a strong culture of mentoring subordinates. J&J’s values and employee practices create an environment where managers know their subordinates well, which helps to reduce budgetary slack.