Question

Budgetary Slack with Ethical Considerations

Karen Bailey was promoted to department manager of a production unit in Parkway Industries three years ago. She enjoys her job except for the evaluation measures that are based on the department’s budget. After three years of consistently poor annual evaluations based on a set annual budget, she has decided to improve the evaluation situation. At a recent budget meeting of junior-level managers, the topic of budgetary slack was discussed as a means to maintain some consistency in budgeting matters. As a result of this meeting, Bailey decided to take the following steps in preparing the upcoming year’s budget:

1. Use the top quartile for all wage and salary categories.

2. Select the optimistic values for the estimated production ranges for the coming year. These are

provided by the marketing department.

3. Use the average of the three months in the current year with poorest production effciency as benchmarks of success for the coming year.

4. Base equipment charges (primarily depreciation) on replacement values furnished by the pur-

chasing department.

5. Base other fixed costs on current cost plus an inflation rate estimated for the coming year.

6. Use the average of the ten newly hired employees’ performance as a basis of labor efficiency for the coming year.

Required

a. For each item on Bailey’s list, explain whether it will create budgetary slack. Use numerical

examples as necessary to illustrate.

b. Given the company’s use of static budgets as one of the performance evaluation measures of

its managers, can the managers justify the use of built-in budgetary slack?

c. What would you recommend as a means for Bailey to improve the budgeting situation in the

company? Provide some specific examples of how the budgeting process might be improved.

Answer 1

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Budgetary slack takes place when the persons responsible for creating a budget deliberately underestimate revenues to be generated or overestimate expenses to be incurred during the budget period. Whether the items on B's list will create budgetary slack or not can be discussed as follows: 1. Use of top quartile for all wage and salary categories will result in an exaggerated estimate of expense for wage and salaries. This will create a budgetary slack. 2. Selection of optimistic values for the estimated production ranges for the coming year will not create a budgetary slack as it is neither underestimation of revenues nor overestimation of expenses. 3. If the average of the three months in the current year with poorest production efficiency is used as benchmarks of success for the coming year, it would result in underestimation of production and will create budgetary slack. 4. If the equipment charges are based on replacement values, it will result in overestimation of expense and consequently create budget slack. 5. Fixed costs based on current costs plus an estimated inflation rate, it will not result in overestimation of expenses and thus will not create budgetary slack. 6. Using the average of newly hired employees' performance as a basis of labor efficiency for the coming year would result into underestimation of labor efficiency. This creates budgetary slack. The use of static budgets as one of the performance evaluation measures of the managers is not a good practice. When static budgets are used as one of the performance evaluation measures of the managers the deliberately create budgetary slack in order to show good numbers and high performance. However, even if static budgets are used as one of the performance evaluation measures of the managers, creating budgetary slack is an unethical practice and cannot be justified.

The following should be recommended to B in order to improve the budgeting situation in the company: . Separation of performance evaluation process from the achievement of budget. If performance evaluation is separated from achievement of budget, the managers would not indulge in creating budgetary slacks. Use of external benchmarking in order to set cost control targets. It helps in setting realistic targets and avoids setting up of lowest cost averages as benchmarks in order to show improvements over prior periods. Direction should be set using both financial and non-financial measures. An explicit link should be built between the major non-financial activities and the resulting financial performance. Also, the change in these relationships should be efficiently managed. •

ALTERNATIVE ANSWER:

a) Budgetary slack refers to the deliberate adjustment of additional cash outlays in expectation of future cash flow. Budgetary slack functions by undervaluing the total income or revenue that the business expects to receive in a specified time period. These practices can also include overstating the expenses the company expects to pay out over the same time frame. The issues surrounding budgetary slack can be both functional and ethical, as these practices limit the effectiveness of budgets and often call for less-than-precise accounting methods.

b) A static budget is one that is not adjusted for changes in activity. Using a static budget for control can be a real problem. For example, suppose that the master (static) budget is based on the production and sale of 100,000 units but only 90,000 units are actually produced and sold. Further, suppose that the budgeted variable cost of goods sold was $2,000,000 and that the actual variable cost of goods sold was $1,890,000. It looks as if the company spent less than expected for variable manufacturing costs. However, the budgeted variable cost was $20 per unit ($2,000,000/100,000), and the actual variable cost per unit is $21 per unit ($1,890,000/90,000). Not adjusting the budget for changes in activity level can mislead managers about efficiency.

c) Efficiency is achieved when the business process is performed in the best possible way. Effectiveness means that a manager achieves or exceeds the goals described by the static budget. Yes, one can exist without the other. For example, suppose that 100,000 units are supposed to be produced, but, due to materials shortages and a work stoppage, only 80,000 units are produced. If the 80,000 units are produced with little or no waste, the manager has been efficient, but not effective. Alternatively, a manager can achieve greater than planned production, but not at the lowest planned cost. This manager is effective, but not efficient.

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