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. 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. This usually means that budgeted amounts are incrementally increased. The alternative to incremental budgeting is called "zero-based budgeting."
With zero-based budgeting, each expenditure item must be justified for the new budget period. No expenditure is presumed to be acceptable simply because it is reflective of the status quo. This approach may have its genesis in governmental units that struggle to control costs. Governmental units usually do not face a market test; they rarely fail to exist if they do not perform with optimum efficiency. Instead, governmental entities tend to sustain their existence by passing along costs in the form of mandatory taxes and fees. This gives rise to considerable frustration in trying to control spending. 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.
Business entities may also utilize zero-based budgeting concepts to reexamine each expenditure each budget cycle. While this is good in theory, zero-based budgeting can become very time consuming and expensive to implement. In business, the opportunity for gross inefficiency is kept in check by market forces, and there may not be sufficient savings to offset the cost of a serious zero-based budgeting exercise. Nevertheless, business managers should be familiar with zero-based budgeting concepts as one tool to identify and weed out budgetary slack. There is nothing to suggest that every unit must engage in zero-based budgeting every year. Instead, a rolling schedule that thoroughly reexamines each unit once every few years may provide a cost effective alternative.
The Impossible Budget and Employee Capitulation
At the opposite end of budgetary slack is the phenomena of unattainable budget standards. If employees feel that budgets are not possibly achievable, they may become frustrated or disenchanted. Such a condition may actually reduce employee performance and morale. Good managers should be as alert to this problem as they are to budgetary slack. Suffice it to say that preparing a budget involves more than just number crunching; there is a fair amount of organizational psychology that a good manager must take into account in the process.
Ethical Challenges in Budgeting
You also need to know that many financial reporting frauds have their genesis in overly optimistic budgets that subsequently lead to an environment of "cooking the books" to reach unrealistic goals. These events usually start small, with the expectation that time will make up for a temporary problem. The initial seemingly harmless act is frequently followed by an ever escalating pattern of deception that ultimately leads to collapse.
To maintain organizational integrity, senior-level managers need to be careful to provide realistic budget directives. Lower-level managers need to be truthful in reporting "bad news" relative to performance against a budget, even it they find fault with the budget guidelines. All too often, the carnage that follows a business collapse will be marked by management claims that they were misled by lower-level employees who hid the truth. And, lower-level employees will claim that they were pressured by management to hide the truth. Undoubtedly, someone reading these words today will find themselves facing this very challenge during their career. Be wise, and resolve that you will avoid the snare of this all too common destructive trap!