Budgetary slack refers to the practice of under or overestimating the revenue or expenditure in order to create a financial cushion in order to increase the likelihood of achieving budget and performance targets and therefore make the actual performance look better than it actually is.
Budgetary slack can be considered as a practice associated with creative accounting practices. Budgetary slack does not necessarily have a negative connotation, how it is seen depends on the context of its usage.
However, it generally is seen as a strategy used by managers to make it appear as if they are meeting performance targets when in reality they have simply used budgetary slack to skew the budget to make their not-so-good performance look better than it actually is.
Having said that, budgetary slack can be used positively as well and it certainly does have its uses, which we shall look upon in further detail.
Budgetary slack can be introduced to a budget in two of the following ways
- Underestimating the budgeted revenue target
- Overestimating the budgeted expenditures
Managers responsible for preparing budgets, may at times incorporate budgetary slack into a budget by underestimating the revenue target.
For instance, the financial manager of a company tasked with preparing the master budget for the organization may decide to understate the revenue target from $1 million to $900,000, thereby understating revenue by $100,000.
What this would do is that firstly, it would take the pressure off from the sales department to meet the higher target of $1 million sales. Secondly, if sales activity in the past was not very good this would bring the sales target down to a realistic level.
Therefore it can be understood that in a condition of uncertainty where there is no clarity about the correct targets that need to be set, incorporating budgetary slack into the budget can be a way to set realistic targets.
These targets can be revised, if they are met during the year and new higher targets can be set by analyzing the performance. If the management decides to incorporate budgetary slack into the budget, it reflects a conservative mindset that may be required under certain circumstances.
The current economic situation of the world is a perfect example, organizations setting up their revenue targets have to be conservative due to the looming threat of an economic recession in many countries, it would therefore be realistic to understate revenue.
Budgetary slack can be effectively incorporated ethically if the management is competitive. However, there are also instances where the managers may feel more inclined to introduce budgetary slack for more selfish reasons.
For instance, if the payor promotion of a manager is tied to certain performance targets then the manager in charge of preparing the budget may be more inclined to set budgetary targets that are easier to achieve, thereby increasing the chances of meeting the said performance targets.
For instance, if we look at the example quoted above, by underestimating the revenue target by $100,000 the manager has reduced the monthly sales target by almost $8333, thus making it easier to achieve a lower target.
The problem with incorporating budgetary slack for such selfish reasons is that it makes the team responsible for achieving performance targets take a more leisurely approach. When a target is more easily achievable, the team will not have to work hard.
The technical term for personnel not working as hard as they should be in an organization is called inefficiency and wastage. Thus the downside of budgetary slack is that it may make an organization inefficient and wasteful, thereby losing a competitive edge.
Another way of incorporating budgetary slack is to overstate the expenditure. Managers responsible for creating a budget may simply decide in favor of overestimating the expenses.
The reasons for estimating the expenditures are the same as the ones discussed above. Competent management may decide to overstate the expenses if they are uncertain about the expenditure targets that should be set.
This may be required if the organization is carrying out research and therefore may be unsure about the actual expenditure that may need to be incurred.
Similarly, it may be appropriate to overstate expenditures if a new product line is being launched. The management may not have a clear estimate of how much budget should be allocated for the launch of a new product.
Managers, as stated above may overstate expenditures to make the attainment of budgeted expenditure target easier and thus attain performance related goals in order to make their performance look better than it is. It is also possible for both of these ways of budgetary slack to be combined together.
Budgetary slack for selfish reasons is unethical and a way to prevent managers from doing this is to appoint professionally competent managers.
A small team of competent managers can also be made responsible for creating the budget so that any single manager does not have the power or incentive to incorporate budgetary slack for personal gain.
Why is Budgetary Slack dangerous?
If used sparingly by competent management under uncertain conditions, budgetary slack can be a useful strategy but if it becomes a norm and is used repeatedly by the management, then it can very well be classified as creative accounting or window dressing to make the performance of the company look better than it actually is.
This however is not the only drawback of repeatedly using budgetary slack. Over time, it will make the company less competitive because the workforce will become used to achieving targets that do not completely test their abilities.
When the management becomes easy-going, they are not likely to strive for hard work and take on challenges, which is important for keeping efficiency levels up.
This may make the more hardworking personnel leave the organization thus resulting in the loss of talented and hardworking individuals.
Furthermore, if the management keeps on low balling like this, then this will eventually affect the financial performance of the company because the board of the company is responsible for creating shareholder value.
By deliberately understating the profit targets or overstating the expenditures, the management will cause the financial performance of the company to slacken because the managers simply will not be striving to achieve high targets.
The end result of continuously slacking the budget year after year may be a loss of share value and reduced market valuation of the company.
It can be conclusively stated that budgetary slack has both positive and negative connotations attached with it, depending on how it is used.
A competitive management can be justified in using it in uncertain conditions, however there is also a tendency for managers to use it for personal gain and this is where organizations need to implement internal controls, so that improper use of budgetary slack does not result in inefficiency and loss of competitiveness.