Budgetary slack: The Effects of Truth-Inducing Schemes on Slack and Performance

In large organizations, division managers are not necessary solely motivated by profit maximization goals but rather by some self – interest motives. These self-interest motives may explicit itself in the organization budgeting process. A control problem arises usually when division managers use their private information to make decision consistent with selfinterest rather than the interest of the organization. In the budgeting process this can happen in two ways. Division managers may either understate revenues or overstate costs. When the division managers understate the expected output, they will be able to create a lower performance target or benchmark relative to their true performance capabilities. When these targets are used as a basis for performance evaluation this will result in favorable evaluation. On the other hand, the division managers may overstate their resource requirements by setting cost and expense targets at higher levels compared to actual needs. Both kind of behavior result is less profit for the organization. When such bias occurs in the budgeting process, It is referred to as budgetary slack. The objective of this study is to discuss the concept of budgetary slack and the theoretical and empirical evidence regarding the role of truth-inducing schemes in controlling budgetary slack. In addition, this paper will introduce a multiple period truth-inducing budgetbased scheme. The suggested scheme has the potential of providing incentives for division managers to reveal their private information and thereby reducing division managers motives to slack.