Participation, Negotiation of Targets and Ethics in Budgeting

A budget is a set of numbers, but it is also a message from management to people about what is expected of them, and people react to messages. A regional manager who is told her sales target for the year has been set by head office may work to hit it, or may complain that it is impossible and stop trying.

A department head who helps to set his own spending limit may feel committed to it, or may quietly add a cushion so that he is safe. A finance officer who is told to “make the numbers work” may be tempted to shift costs into next year.

The techniques of budgeting depend on how people behave, so this topic covers the behavioural side: the benefits and difficulties of participation in setting budgets, how targets are negotiated and what makes a target motivating, the problem of budget slack and other forms of gaming, and the ethical and sustainability considerations that arise when budgets are set.

It builds on the earlier topic on the beyond budgeting model, whose criticisms of budgets were largely behavioural. The next topic covers analytical techniques in budgeting and forecasting, beginning with the high-low method.

Participation in budgeting

Imposed and participative budgets

In an imposed (authoritative) budget, senior management sets the budget and tells managers what they must achieve. In a participative budget the managers responsible for carrying it out take part in setting it. In practice there is a range: from simple consultation, in which managers give information and management decides, to full negotiation, in which the manager’s agreement is needed.

The earlier topic on budgetary systems described top-down and bottom-up budgeting; participation is the behavioural dimension of the same choice.

Benefits of participation

• Better information. Managers know their operations, customers and constraints, and give more realistic figures.
• Commitment and acceptance. People are more likely to work to a target they helped to set and to see it as theirs; this is the main benefit.
• Motivation and morale. Being consulted signals trust and gives a sense of control and responsibility.
• Coordination and communication. Discussion between departments exposes conflicts and helps goals to fit together.
• Training and development. Managers learn how the business fits together and how budgets work.
• Accountability. Having agreed the number, a manager cannot easily argue later that it was unfair.

Problems of participation

• Time and cost. Many rounds of negotiation take management time and delay the budget.
• Budget slack. Managers who set their own targets may understate revenue and overstate cost to make targets easy to reach and bonuses safe.
• Pseudo-participation. Managers are consulted but their views have no effect, because the targets were already decided. It gives the appearance of consultation without the substance, and may breed cynicism and resentment, which is worse than open imposition.
• Unequal power. Strong or senior managers may negotiate better budgets than others, which is unfair and misallocates resources.
• Conflicts with corporate goals. Local managers may protect their own units, and the resulting budgets may not add up to the plan that the company needs.
• Unsuited to some people and settings. Some managers prefer to be told, and in a crisis, in a very centralised company or where managers lack the skills, participation may be too slow or ineffective.

Participation therefore works best when it is genuine, when targets are informed by evidence and when senior management can challenge proposals from a position of knowledge.

Targets, slack and ethics

Negotiating targets

A target can be easy (almost certain to be met), attainable but challenging (needs effort and has a fair chance of success) or impossible or very hard. An easy target gives no incentive to improve and wastes potential. An unattainable one demoralises, and may lead managers to give up or to manipulate the figures.

The target that motivates most is challenging but attainable, and is accepted by the manager as fair. In negotiation, both sides should argue from evidence: last year’s results, market and economic growth, the effect of planned actions (a new product, a price change), known cost increases and capacity. Where a manager’s proposal is far from the evidence, the gap must be explained.

The budget should also allow for factors the manager cannot control, or else performance should be judged separately for controllable items.

Budget slack and other gaming

Budget slack (budgetary slack or padding) is the deliberate understating of revenue or overstating of costs so that the budget is easier to meet. It arises where rewards depend on meeting the budget, where managers fear punishment for adverse variances, where information is asymmetric (the manager knows more than the superior), and where next year’s budget is based on this year’s outcomes.

Its effects are wasted resources, inaccurate plans, and poor decisions based on them. Related behaviours:

• “Use it or lose it” spending. Near the year end, managers spend what remains of their allowance, even on unnecessary items, so that the budget is not cut.
• Manipulating the timing of revenue and costs, for example shifting sales into or out of the period or delaying maintenance, to meet targets or bonus thresholds.
• Short-term focus. Cutting training, research or marketing to protect the profit target, at the expense of long-term value.
• Gaming negotiations, such as asking for more resources than needed in the hope of being cut back.
• Dysfunctional competition for resources between departments.

Ways to reduce it:

• use evidence and benchmarks when negotiating
• review budgets above the manager
• use flexed budgets and rolling forecasts so that targets adjust to conditions
• link rewards to a mix of measures, not to the budget alone, and not penalise honest forecasts
• do not base next year’s allowance only on this year’s spend
• create an open culture where bad news is welcome
• use audit and review of unusual patterns

Ethical considerations

The professional accountant is bound by the fundamental principles of the professional code: integrity (honesty and straightforwardness), objectivity (no bias or undue influence), professional competence and due care, confidentiality and professional behaviour. In budgeting these have practical consequences. Building slack into a budget is dishonest if it is concealed from the person to whom the budget is presented.

Pressure from a superior to alter figures so that a target appears achievable, to hide a variance, or to boost a bonus, threatens integrity and objectivity, and the accountant should resist and, if necessary, follow the organisation’s procedures for raising concerns. Information from budget discussions should be treated as confidential. A culture in which only targets matter encourages wrongdoing; leaders set the tone by rewarding honesty and challenging manipulation.

The accountant should also be aware of conflicts of interest where their own bonus depends on the budget.

Sustainability considerations

Budgets set for the short term may conflict with the long-term health of the organisation and of its environment and community.

Sustainability considerations include:

• building the costs of environmental compliance, emissions, waste and energy into the budget, and not leaving them as unplanned future liabilities
• setting targets for non-financial performance such as emissions, energy use, safety and community investment alongside financial targets
• resourcing long-term investments (such as energy efficiency or training) that may reduce short-term profit
• considering the interests of stakeholders beyond shareholders
• avoiding targets that reward environmental damage or cutting corners on safety

Budgets that reward only short-term profit can drive decisions that harm the long-term sustainability of the business.

Why behaviour in budgeting can be harmful, and how to respond

Budgets can motivate: they give managers targets, and managers who feel part of the planning identify with the plan.

In practice behaviour often does harm, for four main reasons: misunderstanding and worry about cost-cutting (managers see the budget as an excuse to cut their spending, and may resent the whole process even when senior management has no such plan); opposition to unfair targets set from above; sub-optimisation; and budget slack or bias.

• Aspirational and expectational budgets. An aspirational budget is based on what senior managers would like to achieve and may be thought unfair, especially if those affected were not consulted. An expectational budget is based on what they realistically expect, using current performance, and so provides no improvement. The best budget has realistic targets that include some improvement.
• Sub-optimisation. A manager’s targets may not be in the interests of the whole organisation. A production manager who budgets to use all capacity builds up unwanted stock if sales are lower. Coordination is needed, but is not always achieved.
• Slack and bias. Slack is the intentional overestimating of expenses or underestimating of revenue. A manager with slack in a spending budget will also try to spend up to the limit: under-spending must be explained, and the slack must be kept for next year. It is linked with overhead spending and incremental budgeting, and zero-based budgeting should remove much of it. Bias can also run the other way: a sales manager may budget unrealistically high sales to win approval.

Imposed budgets and the effect of participation

Imposed budgets save time, let seniors apply their knowledge of cash limits and shareholder expectations, and are easier to coordinate; but they may set unachievable targets, which demotivate, and they lose the knowledge of junior managers.

Participation is not always beneficial:

• junior managers may not grasp the overall objectives
• the quality of planning depends on the skill and experience of those involved
• targets may be set low, with managers arguing for current performance
• seniors may pretend to consult but ignore the ideas, so participation must be real and carefully managed

Hopwood suggested that its effect depends on three factors:

• the nature of the task (little to offer in highly programmed, technically constrained work, more where flexibility and innovation matter)
• the organisation structure (better where responsibility is decentralised)
• the personality of the employees

The budget as a performance contract

When managers are judged against the budget, several problems arise, each with a possible remedy. Managers may be blamed for items they cannot control or for targets made unrealistic by changed circumstances (separate controllable from uncontrollable items and flex the budget). They may aim only to meet the lowest target, because beating it brings no reward (pay higher bonuses for budget-beating, and train staff in total quality techniques).

They may use the whole allowance of resources (reward cost per unit below standard). They may do whatever it takes to earn a bonus, including bending the rules (use several bonus targets). Departments may compete with each other, including over transfer prices (refer disputes to head office). They may spend the whole allocation to avoid a cut (reward fixed costs below budget).

They may give inaccurate forecasts to win resources (build a no-blame culture, so that honest forecasts are given). And they may avoid risk and unplanned initiatives (reward beating a range of targets, while remembering that the banking crisis of 2007 to 2009 showed that managers should never be encouraged to take excessive risks).

Hopwood’s management styles

Hopwood’s research into how managers with cost-centre responsibility are judged found three styles. In the budget-constrained style, performance depends on meeting short-term budget targets: stress is high and managers may manipulate accounting data.

In the profit-conscious style, managers are judged on their success in raising the general effectiveness of operations in the long term. Budgets and variances are used with caution, pressure is lower, relations with subordinates are better and there is less manipulation. In the non-accounting style, budget information plays a much smaller part and other measures are given more weight.

Research by Hopwood and Otley suggests that the best style depends on the circumstances.

Ethical issues and the sustainability budget

Ethical problems in budgeting arise from:

• lack of accuracy, fairness and transparency
• manipulation of financial data
• budget padding
• deceptive or false information in budget reports or presented to mislead investors, employees or the public
• budgets that put short-term gains before long-term sustainability
• discriminatory resource allocation
• ignoring environmental and social responsibility
• conflict between planning and control functions
• dishonesty arising from performance evaluation
• conflict from sub-optimisation
• unattainable targets
• concealing a budget deficit to promote the organisation falsely

A sustainability budget is a financial plan that provides resources for environmentally friendly and socially responsible initiatives such as energy-efficient processes, waste reduction, sustainable product design and community engagement. Its performance information can be aligned with the UN Sustainable Development Goals. Issues to address include climate change, pollution, resource depletion, waste, water scarcity, social inequality and the lack of basic infrastructure.

Regulatory and investor pressure is making such investment more attractive, despite concern about lower returns.

Layouts for slack and target negotiation

1. Slack = proposed budget − honest estimate (cost), as a percentage of the honest estimate.
2. Variance and bonus under each budget: budget − actual (cost); bonus = rate × favourable variance.
3. Evidence-based target = prior result × (1 + market growth) + effect of planned initiatives.
4. Compare the negotiating positions with the evidence and propose a target in between, with reasons.

Money is in naira and each answer is rounded once, at the end.

Worked examples

1. Padded budget.
   Variance 5.6 − 5.1 = ₦0.5m favourable
   bonus 20% × 500,000 = ₦100,000.
2. Honest budget.
   Variance 5.0 − 5.1 = ₦0.1m adverse; bonus ₦0, and perhaps criticism.
3. Comment. The reward system pays the manager for padding, and penalises honesty. The company loses ₦100,000 in bonus and also budgets ₦0.6m more cost than needed, which ties up resources. A system that rewards accurate forecasts, or judges against a flexed, benchmarked target, would reduce the incentive to pad.

1. Market growth.
   96 × 1.08 = ₦103.7m (to one decimal place; 103.68).
2. Add the new product.
   103.7 + 4 = ₦107.7m.
3. Assess the positions. The division’s ₦100m is below last year plus market growth, so it contains about ₦7.7m of slack. Head office’s ₦120m needs 25% growth, in a market that grows by 8%, which is unlikely without special action.
4. Proposal. Agree about ₦108m, explain the basis to both sides, and add a stretch element (for example a bonus for sales above ₦112m). A target based on stated evidence is more likely to be accepted as fair.

Expect variants: a case describing pseudo-participation and asking for the effects, a manager whose bonus is based on a budget she set, or a question that asks about ethical pressure to alter a forecast.

Common mistakes

• Saying participation is always good. It has costs and can be false.
• Treating a hard target as always motivating. It must be attainable.
• Describing slack without its causes and the remedies.
• Ignoring ethics in a case that mentions pressure on the accountant.
• Listing sustainability without linking it to the budget (costs, targets, long-term investment).

Quick revision

• Participation: commitment, information, motivation; versus time, slack, pseudo-participation, power.
• Targets: challenging but attainable; negotiated on evidence.
• Slack, use it or lose it, timing games; remedies: evidence, flexed budgets, balanced rewards, open culture.
• Ethics: integrity, objectivity, competence and due care, confidentiality, professional behaviour. Sustainability: environmental and social costs and long-term targets in the budget.

How the marks are earned

• Explain each benefit or problem with its effect.
• Apply to the case in the question.
• Recommend remedies.

Practice questions

These are original questions, written in the style of the Skills examination. Work each one before you open the answer.

Recall check: multiple choice

Section B style: written questions

Model answers

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