Budgetary slack occurs in a company when one or more persons with budgetary responsibility create a budget that over-estimates expenses and/or underestimates projected income or revenues.
Why Budgetary Slack Occurs
Some instances of budgetary slack are intentional, others are not, and many more fall somewhere in between. Some examples make the differences clear:
Intentional Budgetary Slack
Intentional budgetary slack may occur because a manager feels under the gun to "make his numbers," often in response to earlier quarters where income fell below projections and, importantly, did not meet the expectations of the owners or stockholders.
An easy, if the unethical way of remedying the problem is for the manager simply to propose a budget that over-estimates expenses for the time period or that deliberately hides probable revenue sources. Since the budget was a phony budget, to begin with, the manager will now have little problem in exceeding it. On a grand scale, the release to analysts of quarterly revenue projections that the company's internal auditors know the company may have already exceeded is an instance of this.
Underlying it is the same motive: to allow the company's next report to show that revenues "have exceeded expectations." As company executives may have hoped, this trumped-up "good news" sometimes results in a brief, unjustified bump up in the stock price.
Unintentional Budgetary Slack
Unintentional budgetary slack can sometimes result from inadequate internal controls. If there is insufficient data to make appropriate data-based cost and sales projections, managers may produce an unrealistic operating budget based on honest expectations that are hardly more than "best guesses," or are imperfectly based on past quarter budgets that for any number of reasons do not reflect revenue and costs for coming quarters.
This can happen, for instance, if the company's internal controls do not reflect accelerating sales from a new product. If instead of noting the sales acceleration of the new product during the previous quarter and taking its continued sales momentum into account, the manager simply notes the overall sales figure for the quarter, then applies that same number to the coming quarter, the result will be an unintentional underestimation of sales and profits.
Budgetary Slack That's Partially Intentional and Partially Unintentional
This kind of budgetary slack has two common causes: outlook uncertainty in a new sales or cost environment and decentralized budgeting procedures. If, for example, the company is introducing a new product unlike any products now on the market, who is to say what the sales will be? Even if the company has adequately researched the market, some uncertainty may remain.
The natural human tendency when this kind of situation occurs is to "play it safe" and to make a sales projection unlikely to be embarrassingly optimistic. This isn't exactly an intentional underestimation, nor is it an entirely innocent mistake. The other common situation that involves a mix of intentionality and fallibility rises from a budget process that relies excessively on decentralized data inputs.
Having each department responsible for its own contribution to the budget can be good in the sense that the managers involved in each department are basing their budget projections on firsthand knowledge, but the quality of these projections may vary radically from department to department. The best cures for this problem are better budgetary oversight for individual departments and more emphasis on top-down budgetary management.