Managing Budget Emphasis Through Explicit Design of Conditional Budgetary Slack

Accounting, Organizations and Society 30 (2005) 587608
www.elsevier.com/locate/aos
Managing budget emphasis through the explicit design

of conditional budgetary slack
Tony Davila a, Marc Wouters
b
b,*
a
Graduate School of Business, Stanford University, USA
School of Business, Public Administration, and Technology, University of Twente, P.O. Box 217, 7500 AE Enschede, Netherlands
Abstract
Budgetary slack plays an important role in the functioning of budgets in organizations. While theory has found negative as well as positive elements associated with its presence, the empirical literature has interpreted it as being dysfunctional to organizations. In this paper, we present empirical evidence on how a company purposefully budgeted
additional nancial resources with a motivation intention (Lukka. Budgetary biasing in organizations: Theoretical
framework and empirical evidence. Accounting, Organizations and Society 13 (1998) 281302) to facilitate the managers task in achieving the goals of the company. Using quantitative and qualitative data from four logistic sites of a disk
drive manufacturer for 24 months, we examine how the company accepted more slack as the demand on business processes increased and goals other than budget targetsin particular, service qualitybecame harder to achieve. By allowing this practice, headquarters made it clear to local managers that product quality and service were at least as
important as meeting budget objectives. We also nd that not only was budgetary slack purposefully built during
the budgeting process but also in the budgeting system itself through the underlying cost accounting assumptions.
The results of this paper provide empirical evidence on the positive aspects of budgetary slack and on the role of cost
accounting models used in the budgeting system to facilitate managerial work.
2004 Elsevier Ltd. All rights reserved.
Introduction
Budgets are probably the management tool
most widely used in organizations. Their relevance
Corresponding author.
E-mail addresses: adavila@stanford.edu
m.j.f.wouters@utwente.nl (M. Wouters).
(T.
Davila),
has nurtured signicant research eorts and created the only organized critical mass of empirical
work in management accounting (Brownell &
Dunk, 1991). A key variable that has traditionally
been perceived as limiting the eectiveness of
budgets is budgetary bias (Lukka, 1988) and, in
particular one of its sub-components: budgetary
slack (Dunk & Nouri, 1998; Kamin & Ronen,
1981; Merchant, 1985; Walker & Johnson, 1999;
0361-3682/$ - see front matter 2004 Elsevier Ltd. All rights reserved.
doi:10.1016/j.aos.2004.07.002
588
T. Davila, M. Wouters / Accounting, Organizations and Society 30 (2005) 587608
Webb, 2002). The presence of budgetary slack

makes budgets easier to attain and empirical work
has assumed that its presence is dysfunctionalor
even unethical (Douglas & Wier, 2000)and
should be limited (Dunk, 1995; Fisher, Frederickson, & Peer, 2000, 2002a; Nouri, 1994; Young,
1985). Budgetary slack isolates organizational
members from the motivational eects of budgets,
limits the eort that these people exert, and leads
to inecient use of the resources that the organization controls.
However, the theoretical literature indicates
that the presence of budgetary slack may also have
positive consequences (Lukka, 1988). For instance, companies following strategies that require
innovation and experimentation can benet from
budgetary slack because it allows managers to focus on relevant long-term and short-term objectives other than meeting budgets such as quality
or customer service (Van der Stede, 2000). In these
settings, budgetary slack provides operating exibility to increase the predictability of earnings, reduce the time spent on control tasks, reduce risks
of dysfunctional behavior, and give managers discretion to pursue multiple goals while dealing with
adverse exogenous factors (Lillis, 2002; Merchant
& Manzoni, 1989).
In this paper we present evidence consistent
with the purposeful use of budgetary slack to facilitate managers work when they are responsible for
pursuing multiple goals beyond achieving cost
budgets. In particular, we argue that even if budgetary slack has been presented as dysfunctional in
most of the empirical literature, in certain settingscharacterized by uncertainty and multiple
goalsbudgetary slack can be benecial to motivate the appropriate behavior.
Using a case study research design with both
quantitative and qualitative data, we present evidence on how a company uses budgetary slack to
enhance managers motivation (motivation intention) (Lukka, 1988) in the presence of multiple
goals. Specically, budgetary slack is generated
when meeting the demands on key non-nancial
performance dimensionsproduct quality and
servicebecomes more dicult. When achieving
multiple goals (including budget goals) is relevant
to success, budgetary slack allows the company
to balance these dierent goals as external conditions change. 1

The paper is among the rst to present archival
empirical evidence on the purposeful use of budgetary slack to facilitate managerial work. The
data includes budget and actual nancial performance for four logistic sites of a computer disk
drive manufacturer for 24 months and service
performance for 18 months. We also conducted
more than 70 hours of interviews with managers
in the nancial oce, quality control, supply
chain management and logistic centers to fully
understand the budgeting process as well as the
distribution of knowledge in the organization.
The case study methodology sacrices external
validity in an eort to sharpen the results and
facilitate analytical generalization (Yin, 1989,
p. 38) through the conrmation of an untested
theory. Also in contrast to previous budgeting
studies that rely on perceptual data collected
1
When tting eld observations to theoretical concepts,
some of the richness found in reality is lost. As it will become
clear when we present the evidence, the actual mechanisms used
in our research site are not constrained to the concept of
budgetary slack. Certain mechanisms, like padding the
budget numbers when external conditions are more demanding,
or modeling xed costs as variable (thus increasing the budget
more than proportionally when expected volume is higher), t
the concept of budgetary slack. Mechanisms such as budgeting
higher costs when volume is higher (simply because certain
costs are variable) are closer to exible budgeting techniques.
These mechanisms have the common goal of easing budget
pressure when non-nancial goals are more demanding and,
conversely, increasing it when these other goals are less taxing.
We label these mechanisms at our research site as budgetary
slack throughout the discussion because (1) their aim is to ease
cost targets when needed, (2) budgetary slack mechanisms
found in the site are more interesting from a theoretical
perspective than the exible budget mechanisms, and (3) the
evidence in the case speaks directly to the budgetary slack
literature and its bias to interpret it as a negative practice. In
doing so, there is the risk that the negative connotations of the
conceptwasted resources or more than enough
resourceswill obscure the interpretation of the evidence.
However, we interpret budgetary slack as some denitions in
the literature do; this is as a neutral concept without a positive
or negative tone that only its use determines. The reader should
evaluate the evidence with these qualications in mind. We
would like to thank one of the reviewers for pointing out this
important clarication.
through survey methods, we use archival data

from a company supplemented with qualitative
information to better understand the implications
of the ndings.
Our ndings indicate that budgetary slack
(measured as favorable cost eciency variance) is
larger when the expected demand on the business
process (as measured by the budgeted volume of
product shipped) is larger, and when the unexpected demand (as measured by unexpected volume) is larger. Interestingly, the budgeting
modelthrough its assumptions about cost
behaviorcreates (removes) this budgetary slack
whenever volume is above (below) expectations.
When actual volume is higher than budgeted volume, budgeted costs increase faster than actual
costs and create budgetary slack. Thus, the mechanisms imbedded in cost accounting are not neutral to budgeting but aect how budgetary slack
is generated.
The rest of the paper is structured as follows. In
the next section we review the theory and existing
empirical evidence that lead to our propositions.
In Section Qualitative evidence: Company PCC
and its budgeting process, we describe the company, its budgeting process, and the qualitative
evidence. Section Quantitative evidence: Research design describes the research design for
the quantitative data and Section Results the
associated results. Section Discussion and conclusions discusses the ndings, future research
opportunities, and conclusions.
The structure of the paper may suggest that
the research process was linear from literature review, propositions, case selection, data gathering,
to hypothesis testing. However, this structure is
adopted to present the results of the eld study.
The research was an iterative process going back
and forth between the case study and the literature. We selected our research site because of
the detailed archival information on the budgeting process and performance. As we progressed,
we identied the richness embedded in the companys use of budgetary slack. Throughout the
research process, we kept on going back to the
literature to rene our understanding of the phenomenon, shape the propositions, inform our
observations, and guide our research eorts dur-
589
ing the interviews and the collection of archival

data.
Literature review and propositions

Budgetary bias and budgetary slack
The literature identies several characteristics
to explain managers propensity to build dysfunctional budgetary slack (Dunk & Nouri, 1998). (1)
Budget emphasis (Dunk, 1995; Hopwood, 1972;
Merchant, 1985; Otley, 1978) enhances the
importance of budget targets to responsibility
center managers social and economic rewards;
empirical evidence indicates that it is positively
related to higher levels of budgetary slack (Merchant, 1985; Onsi, 1973; Walker & Johnson,
1999). (2) Budgetary participation (Merchant,
1985) may lead to better performance because
of subordinates experience, increased morale,
sense of control, commitment (Locke & Latham,
1990), and information exchange between superiors and subordinates (Shields & Shields, 1998).
However, budgetary participation provides managers with an opportunity to intentionally inuence budget targets (Lukka, 1988) and build
budgetary slack (Young, 1985). (3) Information
asymmetry (Fisher et al., 2002a; Fisher, Maines,
Peer & Sprinkle, 2002b) describes settings where
subordinates and superiors have dierent private
information (Lambert, 2001). When subordinates
have an informational advantage, they can misrepresent the information to negotiate easier targets
and create budgetary slack (Kirby, Reichelstein,
Sen, & Palk, 1991). (4) Uncertainty refers to the
lack of information for planning (Chapman,
1997; Galbraith, 1973; Macintosh, 1985) and creates an incentive for the managers to create
budgetary slack as a way of hedging against lack
of predictability (Brownell & Dunk, 1991; Lukka,
1988; Merchant, 1985).
Previous literature describes budgetary bias as
a way of aecting the standards against which
performance will be assessed. It has been dened
as a deliberately created dierence between the
budgeting actors forecast about the future (honest budget estimate), and his or her submitted
590
budget gure (budget proposal) (Lukka, 1988).

Budgetary bias can lead to optimistic upward
biasingsetting standards higher than a neutral
estimate of performanceor to budgetary
slackwhen standards are lower than the budgeting actors honest estimate of performance.
Dunk and Nouri (1998) review the literature on
budgetary slack and by drawing the various
perspectives in the literature dene it as the
intentional underestimation of revenues and productive capabilities and/or overestimation of
costs and resources required to complete a budgeted task.
These denitions do not expressly imply a dysfunctional element, although the ideas of deviating from honest estimates, of making budgets
easier to attain, and overestimating costs somewhat suggest such an element. Nor do these definitions consider the role of uncertainty and
multiple goals.
The dysfunctional element emerges more clearly
in the presence of private information when subordinates use budgetary slack to ease their work or
obtain personal rents. Budgetary slack facilitates
appropriating excess resources (resource motivation) and simplifying performance achievement
(performance evaluation intention) (Lukka, 1988).
In agency models, budgetary slack reects a deviation from maximum eciency due to information
asymmetry (when the agent is better informed than
the principal). This is especially the case where
maximum eciency would be achieved if supervisors had all the information and they could set
the budget to provide subordinates with enough
resources to perform their activities. The deviation
from the maximum eciency translates into a
reduction of managerial eort or an increase in
perk consumption (Kirby et al., 1991). In these
models, the eciency loss associated with budgetary slack is unavoidable and part of the second
best solution. Budgetary slack can also be detrimental because it isolates the subordinate from
the motivational properties of budgets leading to
lower eort and inecient use of resources (Bourgeois, 1981).
This literature identies budgetary slack as dysfunctional. However, the presence of budgetary
slack may be benecial to the organization (Lillis,
2002; Lukka, 1988; Merchant & Manzoni, 1989;

Onsi, 1973). It facilitates managerial performance
in the presence of high budgetary emphasis and
uncertainty (Dunk, 1995), isolates risk-averse subordinates from excessive risk, and increases job
satisfaction as budgetary slack avoids the performance consequences of missing the budgetsuch as
loss of bonuses, loss of job (Merchant & Manzoni,
1989), or the social pressure associated with
underachievers.
More importantly, budgetary slack may reduce
budget emphasis and allow subordinates to allocate attention to goals other than meeting the budgetsuch as quality or customer servicewhen
meeting the budget becomes harder. In work settings with multiple goals, such as cost, eciency,
productivity, quality, customer service, and
responsiveness, tradeos between these goals exist
(Lillis, 2002). When these multiple goals cannot be
simultaneously attained, managers may sacrice
goals that should have priority. Budgetary slack
facilitates pursuing objectives other than meeting
the budget without fully ignoring the relevance
of budgets. For example, budgetary slack may ease
(but not eliminate) the constraint imposed through
the budget and give the manager the ability to
meet non-nancial goals when production volumes
are unexpectedly high.
The notion that organizations may use budgetary slack purposefully leads to a more elaborate
understanding of how budgetary slack may be created. It is not always the case that organizations
prefer an easily achievable target; the objective is
not to make cost targets always easily achievable,
but only when it is particularly dicult to meet
nancial and non-nancial goals simultaneously.
The process of creating budgetary slack becomes
subtler than just using relatively higher levels of
allowable costs. The deliberate design of easier
cost targets when conditions are demanding conceptually represents budgetary slack; although this
budgetary slack is purposeful, motivational, and
contingent on the environment. This concept of
budgetary slack, which includes a performanceenhancing element in a setting with multiple goals,
incomplete performance measures, and uncertainty, is used in the development of our
propositions.
Propositions
The manager of a department pursuing multiple
nancial and non-nancial objectivessuch as
operational costs, customer service, and product
qualitydecides how to trade o these multiple
goals when they cannot be achieved simultaneously. The organization may inuence these decisions through the budgetary slack available to
the manager. Organizations may purposefully increase budgetary slack when external conditions
are more demanding, in an attempt to ease meeting budget goals and freeing up managers attention to achieve alternative organizational goals
like service or quality. Conversely, organizations
may decrease budgetary slack when conditions
are such that budget emphasis becomes more
relevant.
Unexpected events such as unplanned surges in
demand are likely to lead to decision points where
the manager cannot simultaneously meet multiple
goals. To react to these events, the manager may
choose to increase operating costs in order to
maintain customer service or meet the budget at
the expense of delaying some of the shipments.
The company can inuence these trade-o decisions through the budgetary slack that it allows
when these unexpected events happen. A large
budgetary slack encourages the manager to focus
on non-nancial objectives; conversely a low
budgetary slack focuses attention on nancial
objectives. The following proposition reects this
argument:
591
tant, the company may decide to increase budgetary slack when demand is expected to be large.
Increasing budgetary slack reduces budget emphasis and allows managers to focus more attention to
meeting these alternative goals. 2 The larger the
budgetary slack, the lower is the priority of budgets. The following proposition captures this
argument: 3
Proposition 2. Increased level of activity is associated with larger budgetary slack.
The previous propositions focus on how cost
budgets can be managed in the presence of
demanding conditions. However, these conditions
also aect the rms ability to achieve non-nancial objectives such as customer service. This holds
unless the company is willing to meet one of its
goals at any price (requiring the company to provide enough extra resources to completely meet
this alternative goal in any state of the world)
and then we would not expect any eect of increased level of activity on this particular goal.
In our research setting, one of the alternative goals
is customer service. If demanding conditions also
hamper the ability of the company to meet these
alternative goals, then we expect the following
propositions to hold:
Proposition 3a. Lower customer service is associated with unexpected higher levels of activity.
Proposition 3b. Lower customer service is associated with increased levels of activity.
Proposition 1. Unexpected higher levels of activity

are associated with larger budgetary slack.
Another situation where managers may face
trade-o decisions is when the expected demand
is large. As demand gets closer to capacity, managers may have to rely on more expensive variable
costssuch as overtime, temporary employees, rework, and express shipments. The closer to full
capacity, the more often the sites will need to use
these expensive resources. While it is uncertain
how often these resources will be needed, higher
expected demand increases the number of times
that the site hits capacity constraints. If goals such
as product quality or customer service are impor-
2
An alternative reason why budgetary slack may be present
at higher volumes is higher uncertainty about costs when
volume is higher. The company may protect the manager
through budgetary slack. The evidence that we gathered does
not allow us to test this alternative argument. We thank one of
the reviewers for suggesting this argument.
3
It is important to notice that our empirical study was
conducted in a cost center setting, where increasing budgetary
slack does not necessarily lead to lower prots, the reason being
that meeting non-nancial performance measures may enhance
the revenue line. This focus on cost centers is in contrast to
other empirical studies that have focused on prot centers
(Otley, 1978). We thank one of the reviewers for pointing out
this important distinction.
592
Qualitative evidence: Company PCC and its

budgeting process
This section describes the company, its budgeting process, and qualitative evidence informing the
previous propositions. As part of the data collection process, we interviewed and e-mailed managers in the following departments: budgeting,
nancial accounting, quality control (including
non-nancial data management), logistics performance measurement, supply chain engineering,
and logistic sites. The initial interviews lasted between 30 and 60 minutes and we had several additional interviews and e-mail exchanges throughout
the course of two years to clarify our understanding of the data and the processes, and to help us
interpret the results.
The company
The study focuses on the four logistic centers of
company PCC (a disguised name) located in North
America, Europe, Asia, and Southeast Asia between April 1998 and March 2000. Company
PCC designs and produces disk drives for computers. The industry grew rapidly during the 1980s
and went through a period of intense competition
and restructuring during the 1990s. Out of the 43
companies that received venture capital, less than
10% survived into the year 2000. The market is
highly competitive in several dimensions. According to PCCs director of Supply Chain Engineering: Consistently advancing technology through
product development is one of the most critical aspects; battles are won at the product development
stage. This point is further illustrated by the fact
that manufacturing is outsourced.
Once a new product has been introduced, PCC
subcontracts the manufacturing process to an
OEM that delivers the products to the logistic centers. At the logistic centers, about 50% of the units
undergo a small customization and testing, such as
adding customer labels or adjusting switches to the
requirements of each client. The rest of the units
are simply repackaged. Units are then shipped to
the customer. When a product enters the production stage, competition happens in three dimensions: quality, cost, and customer service.
Quality
The importance of quality is highlighted in the
following quote from PCCs director of Supply
Chain Engineering:
Our largest customers include Dell, IBM, Apple,
HP, and Compaq. They all require the highest
level of product and service quality because they
manufacture under JIT systems where the cost of
low quality is very high. . . . We identify each single
unit with a unique serial code and we carefully
document its movement through the supply chain.
Whenever a customer rejects a unit because of
quality problems, we test the unit and use individual unit information to trace back the problem. . . .
The importance of quality puts a lot of emphasis
on having a clear understanding of the whole
cause-eect relationships through the supply chain
from the component suppliers, the OEM manufacturer, our own logistic centers, and the delivery to
the client. When units with quality problems come
back we determine what kind of failure occurred
and our new diagnostic software nds 32 dierent
error codes.
The company tracks the number of failed products per million units, where in the supply chain
the failure occurred (within the manufacturing
partner, the logistic centers, the customer during
the assembly process, or the end user), and what
type of failure happened.
For warranty costs we accrue a certain amount
per unit that goes out of the door, and the actual
costs are incurred because of repairs, replacements, and credits. We do not have cost data deeper than product family, but the systems track
serial numbers of returned products, when it was
shipped, and to which customer, explained a
member of the controllers oce. We followed this
up with a director of the quality department who
explained that using the serial number we trace
when it was built, in what factory, and on which
line.
Operational costs
Cost is the second competitive dimension in a
market characterized by intense competition and
small gross margins (less than 20% for scal year
2000). Because product costs are mainly determined at the product development stage, once
the product is launched, PCC focuses on reducing
the cost of operating its supply chain. According
to the director of Supply Chain Engineering:
We have seen large price reductions over the last
years, while at the same time we and our competitors have increased product performance dramatically. . . . Cost reduction is vital and we have very
rigorous cost targets to design costs out of the
product; not just material cost, but manufacturing cost and logistics have also become very
important. . . . At the logistic sites we focus on
controlling the costs of operating the sites and
inventory costs. Good inventory management is
particularly important because of the rapid price
erosion that requires a negative inventory revaluation every quarter. We use the unique serial
number of each unit not only to trace quality
problems, but also to monitor how many days
each unit stays at each phase of the supply chain,
and improve throughput . . . We are currently
implementing a supply chain initiative to reduce
the small customization tasks that we do at the
logistic sites. These tasks are costly because we
have to unpack, make a small change like adding
stickers, and repack. The simple task of unpacking and repackaging also aects quality. We
expect that by shipping generic (non-customized)
products, we will improve customer service and
take advantage of cost reduction opportunities
at the logistic sites.
Thus, cost management discipline within the
supply chain goes as far as tracing the time each
single unit spends in the supply chain. According
to a business analyst in the quality control department, Every month we measure for each unit that
we shipped to customers how long did we have it?
and we report the average number of days and the
standard deviation by part number and by site.
Logistic centers are managed as cost centers and
the importance of costs makes budgets a key control system. While small variances do not attract
signicant management attention, the budget ofce carefully investigates large unexplained variances that also impact the performance
evaluation of logistic center managers. The cost
593
of moving a unit through the supply chain (cost

per unit) is also carefully monitored as an important performance measure.
In addition to the quality control procedures
that give a lot of information about the actual actions performed at the logistic sites, additional
control systems complement the budget. These
controls include approval for new investments
and new hires, monthly reports on headcount per
department, and the negotiation at headquarters
of freight contracts. The budgeting manager described their discretion regarding freight: All the
freight carriers are pre-negotiated with (the company). Site managers cannot choose the carrier.
If there are any deviations from carriers and terms,
it is due to meeting customers needs. Freight costs
are determined based on a few dierent variables
. . . weight, size (bulk), type of freight (overnight,
ocean liner, air, etc.) that the site manager decides. According to the controller: We do not rely
only on the budget, but have additional tight controls over decisions that may have a signicant impact on costs.
Customer service
In addition to quality and costs, delivering a
high level of service to customers (most on JIT
manufacturing systems) is the third, albeit more
intangible, piece to the competitive landscape. As
the director of Supply Chain Engineering
described:
We measure customer service using two objective
performance measures, one reecting the on-time
delivery of products compared to the conrmed
date, and one reecting the conrmation of delivery dates compared to the initial request of the customer. . . . We also have every quarter a quarterly
business review (QBR) where the top eight customers evaluate the level of service received from
PCC and from the logistic centers in particular.
The evaluation includes dierent service dimensions and the overall customer satisfaction. The
QBR is the main criterion to evaluate the logistic
centers performance and determine the bonus of
logistic center managers and other executives in
the company involved in the supply chain. . . .
The QBR is very visible for everyone.
594
Logistic centers pursue multiple objectives

simultaneously: cost, service, and quality. Even if
PCCs products rely on advanced technologies
and accordingly the industry is considered hightech, the technology is well-known and the product is considered to be in the mature part of its life
cycle (Foster, 1986). Production tasks at the logistic centers are simple, well-understood repetitive
processes, with a large amount of non-nancial
information available for quality purposes. This
environment signicantly reduces the information
asymmetry among dierent hierarchical levels in
the company. The challenge for sites managers becomes dicult performance goalson-time delivery, product quality, and cost controlas well as
demand uncertainty. Fig. 1 plots the percentage
dierence in actual volume compared to budgeted
volume. The dierence is close to 50%.
The budget setting process
The budgeting process is on a yearly cycle.
However, the budget for the second half of the
year is updated during the second quarter. According to the manager in charge of the budgeting
process, the objective of this update is to include
new market information available through the
early part of the year as well as to update nancial
expectations, maintain the accuracy of the budget,
and include the impact that unexpected changes in
the environment may have on the budget. We want
the budget to be as useful as possible as a guide for
performance expectations.
The budgeting process for the logistic centers
starts with an estimate of quarterly and monthly
Percentage difference
50
30
10
-10
10
15
20
25
-30
-50
Months
Fig. 1. Percentage dierence in actual versus budgeted volume.
volume from the Fulllment Planning Group that

brings together customers needs, OEM capacity,
and market expectations. According to the controller, Supply teams work with each major customer to learn about expected demand and the
fulllment people work with the manufacturer to
know about capacity problems. The budget manager described it as follows:
At the Financial Planning Group, we use the estimations from the supply teams, fulllment people,
and industry statistics to dene expected demand.
Then we have analytical models to estimate workforce loads, freights, and costs trends together with
the prot expectations that come from the top of
the organization (and given as a guide to Wall
Street) to delineate the rst draft of the budget
for the logistic centers. At the same time, the logistic centers receive the volume estimates from the
Fulllment Planning Group and prepare their
own detailed cost budget based on their understanding of the cost of activities. We review the
cost budgets that the logistic centers submit, and
compare them with our own budget numbers,
looking at trends, comparing with the actual numbers of last quarter, and by confronting the budgets with a target for maximum spending based on
aordability, which we do not reveal to the logistic
centers in advance. Finally, we talk with the logistic sites to reconcile both budgets . . . This last step
is not dicult, because we have done this exercise
many times and we all have a pretty good idea
about how things work at the logistic sites . . .
The focus of the exercise is to give an expense budget to site managers, but also to keep a tight control on the costs of delivering one unit of product
. . . The last line in the budget is the (logistic) cost
per unit that we follow very closely.
In order to maintain customer satisfaction during peak demands or during periods when quality
problems require additional conguration and
testing activities, budgetary slack is common and
accepted. According to a senior manager of
Worldwide Operations, we typically allow overbudgeting at the logistic sites to plan for emergency overtime to maintain customer satisfaction
during something like a quality issue or crisis, even
if it is not usually needed. Thus budgetary slack is
not usually used and translates into a favorable

budget variance. One of the logistic managers conrmed the idea of including budgetary slack to react to emergencies: We budget enough resources
to be able to keep our service level even in emergency situations. The budget setting process
incorporates budgetary slack to react to emergencies, which happen more often for months with
higher expected volumes. The budget manager described her awareness about the existence of this
budgetary slack:
When budgets are put together in Logistics, the
volume and cost structures are set some time in
advance based on forecasted information. The
costs usually come in lower than forecasted on a
regular basis. We have about a 5-cent pad (per
disk drive) in the numbers on a regular basis. This
is for unforeseen events that might come up. In
addition to that, the volume that we use in the
budget is a low-risk volume. So, if the actual volume comes in higher than the budgeted volume,
the cost per drive is lower.
This padding does not mean that the company systematically adds 5 cents per disk to the
budget, but that on average actual cost per unit
comes 5 cents below budgeted cost per unit. In
fact, because emergency situations are more
likely in high demand months, budgetary slack is
larger in these months and lower in low volume
months.
Budget reports for the logistic sites separate
xed from variable costs. The main items in the
xed cost category are indirect labor, facilities,
and equipment. The two main items in the variable
cost category are direct labor and freight; the rest
of the items are comparatively smaller. Logistic
center managers have some discretion over variable costs and can inuence them to a larger extent
than xed costs. For example, site managers can
decide to keep people, even if there is not enough
work, to quickly react to unplanned demand.
The budget review process
During the year, the budget oce issues
monthly budget control reports detailing itemized
595
quarter-to-date actual expenses, quarter-to-date

static budget, and the variance between the two.
The report also includes actual and budgeted logistic costs per unit, which is an additional important
criterion to evaluate the logistic sites nancial performance, and actual and budgeted units shipped.
This monthly feedback cycle helps to quickly detect variances and correct them by the end of the
quarter, when performance evaluation happens.
Variances go back to zero at the end of each quarter to start a new cycle. According to a member of
the controllers oce, Variances are an important
indication of how we are going to exit the quarter. The logistic site manager described how he
used the budget reports: I follow closely the
monthly budget reports, I look at the actual costs,
the variances and the cost per unit. If I see large
variances I quickly call my controller to understand where they come from and what we can do
to make sure that they go back to a reasonable
level before the end of the quarter. Costs are an
important part of our job, although not the only
one; I also keep track of customer service that
impacts my QBR and make sure that it does not
suer even in peak demand periods.
The monthly control reports are homogeneous
for all sites with the same format and accounts.
The accounts are classied as xed and variable
costs. For purposes of the quantitative analysis,
we grouped xed (or indirect) labor cost accountssalary and fringe benets and other employee benetsas one variable and other xed
coststravel expenses, engineering, supplies, consulting, equipment, facilities, and recruitingas a
separate variable. For variable costs we dene
three variables: variable labor costssalary and
fringe benets, freightsum of all freight accounts, and other variable costsmanufacturing
expense, rework and scrap, miscellaneous.
The budgeting model
The importance of costs, the fact that the
logistic sites are one of the few steps in the supply
chain that PCC directly controls, treating these
sites as cost centers, and the relevance of variance
analysis for performance evaluation indicate that
596
budgetary emphasis is relevant. Note from the previous sections, that variance analysis is focused on
(1) the dierence between actual total cost and the
static total cost budget, as well as (2) the actual
versus budgeted cost per unit, the latter being the
more important measure for evaluating the performance of the sites. However, customer satisfaction and quality are also very relevant to the
performance of the logistic sites. To manage these
multiple objectives, budgetary slack is acknowledged and accepted in the organization to react
to unforeseen events and demanding conditions.
During the research process, as we examined
qualitative and quantitative evidence (described
in Section Results), the budgeting model
appeared as a key element to generate slack only
under demanding conditions. The budgeting model makes certain assumptions regarding cost
behavior that do not reect the actual cost behavior (as the quantitative analysis that we present in
Tables 5 and 6 conrms). In particular, variable
costs are assumed to be fully variable and linear
in the budget model, while in reality they have a
xed cost component and are likely to be nonlinear, with higher variable cost per unit as volume
increases. This latter behavior is consistent with
comments from various interviewees regarding
the need for overtime, express shipments, and temporary employees as volumes reached the capacity
of the site.
These disparities create a mechanism, illustrated in Fig. 2, that speaks to Proposition 1.

Two forces are at play in Fig. 2. First, budgeted
costs are modeled as fully variable costs, while actual costs contain a xed element. This assumption
generates a favorable eciency variance when actual volume is higher than budgeted volume
(demanding conditions): because the budgeted
variable costs actually contain a xed element,
budgeted total costs grow faster with volume than
actual total costs do. This favorable eciency variance has two purposes. First, it compensates the
unfavorable volume variance that the higherthan-expected volume generates, as indicated in
Fig. 2. Second, and most important, it eases meeting this cost-per-unit targetthe main focus for
performance evaluation. The organization accepts
that total variable costs are higher as long as the
cost per unit does not exceed the budgeted cost
per unit, hence the static budget is not the only reference point, and it is used in combination with a
form of exible budgeting for variable costs. The
mechanism engineers slack into this performance measure through the favorable eciency
variance. Conversely, this mechanism engineers
slack out of the budget when volume is unexpectedly low to tighten the budget.
A second force that works in the opposite direction (tightening cost targets) is the linearity
assumption for variable costs. Actual variable
Total direct labor costs
Unfavorable
Volume variance
Budgeted costs line

Actual costs line
Flexible budget
Actual cost
Favorable
Efficiency variance
Static budget
Vo l um e
Expected volume
Actual volume
Fig. 2. Creation of budgetary slack in the budget setting process.
costs per unit are likely to increase with volume

(the actual cost line in Fig. 2 bends upward as
the site reaches full capacity). Therefore, the linearity assumption creates an unfavorable eciency
variance. The quantitative evidence suggests that
this eect is small compared to the xed cost eect,
otherwise the favorable eciency variance with
higher-than-expected volume would disappear
completely.
This evidence indicates that when unexpected
demand makes meeting quality and customer service goals harder to achieve, the company eases eciency goals. This mechanism aects the standards
against which performance is assessed in such a
way that meeting eciency targets becomes easier
only when managers are faced with unexpected demand surges.
When confronted with this analysis of the budgeting model, the budgeting manager mentioned,
We knew that although we labeled variable costs
as variable, they were semi-variable costs with a
xed component. You cant reduce direct labor
to zero even if volume goes down to zero; but we
still assumed so in our budget. Other managers
from the controllers oce were also aware that
part of what was called variable costs had a
xed component and that this assumption in unexpectedly busy times helped logistic managers to
pay attention to customer service and quality while
keeping the variable costs per unit at an acceptable level. In discussing the results, it became clear
that managers in the controllers oce knew the
benets to the logistic managers of the xed component of the so-called variable costs but they had
not walked through the actual functioning of
the mechanism (as described in Fig. 2). In a sense,
the knowledge of how the system worked was tacit
(Nonaka, 1994).
Quantitative evidence: Research design

Besides the qualitative data gathered through
interviews and company visits, we also collected
the monthly budget control reports (described in
Section The budget review process) for each of
PCCs logistic centers from April 1998 to March
2000 and customer service statistics from Septem-
597
ber 1998 to March 2000. Customer service statistics come from 58,528 transactions capturing
each shipment that occurred during the period
for the seven main product families (that account
for 91% of the volume).
Budgetary slack has been equated with budgets
being achieved more than 50% of the time (Merchant & Manzoni, 1989). 4 The assumption is that
uncontrollable factors follow a symmetric random
distribution where the median is an unbiased estimation of performance. However, this measure
does not take into account how far away from
the original budget actual results are. Variance
analysis facilitates the inclusion of this additional
information,
Variance
Budget cost Actual cost

Budget cost
A positive variance indicates a favorable variance because actual costs are below budgeted
costs. 5 Even if PCC does not estimate volume,
price, and eciency variances, the reports generated allow us to identify variances due to changes
4
Studies using questionnaire data usually measure slack
based on managers perception of how easily their budgets are
achievable (Dunk, 1995; Van der Stede, 2000). For example, the
items used by Van der Stede (2000) include: I succeed to
submit budgets that are easily attainable, Budget targets
induce high productivity in my business unit (reverse coded),
Budget targets require costs to be managed carefully in my
business unit (reverse coded), Budget targets have not caused
me to be particularly concerned with improving eciency in my
business unit, and a question ranging from whether the budget
is (1) very easy to attain to (5) impossible to attain. In our
study we measure budgetary slack as the dierence between
actual and budgeted costs as a measure capturing how easy it
was to attain the budget. Only in laboratory experiments can
budgetary slack be directly measured as the dierence between
subjects best estimates of performance with the targets set in
the budget (Fisher et al., 2000, 2002a, 2002b; Young, 1985).
5
An unfavorable variance indicates that prots are negatively aected. Conversely, a favorable variance makes actual
prots better than budgeted prots (Horngren, Foster, &
Datar, 2000). Following traditional variance analysis, variances
are estimated at the cost account level and do not include their
impact on revenues. So, for example, a higher volume
compared to budget increases costs and this is labeled an
unfavorable variance, even though the additional revenues may
cause the overall prots to be higher than budgeted. Logistic
centers were treated as cost centers, thus revenue implications
were not included in their reports and evaluation.
598
in expected volume and variances due to price and

eciency (jointly). Because prices are stable, we label this latter variance as eciency variance and
we dene it following the common denition
(Horngren et al., 2000) and standardize it:

Efficiency variance
Change in volume
Budgeted volume Actual volume
Budgeted volume
Actual volume
1
Budgeted volume
Budgeted variable cost

Actual volume Actual variable cost
Budgeted volume
A positive number indicates a favorable eciency variance. 6 Because eciency variances ease
the achievement of budget goals when demand is
higher (as illustrated in Fig. 2) and allow managers

Notice that this variable is negative when actual

volume is greater than budgeted volume. Notice
further that this variable is equal to volume variance as traditionally dened:

Actual volume
Volume variance Budgeted variable cost
Budgeted volume
to focus on achieving goals other than costs, we

use this variable as our measure of budgetary
slack. Note that eciency variances are not reported separately, so local managers can compensate unfavorable volume variances with favorable
eciency variances to absorb cost increases due
to higher volumes.
We measure the expected level of activity in a
particular month through the budgeted volume
of units shipped (budgeted volume). Months with
higher expected volume are those with increased
level of activity (Propositions 2 and 3b). Because
of the dierences in size across sites, we normalize
this variable by the average units shipped over the
period studied per site. We measure unexpected
levels of activity as the dierence between budgeted and actual units shipped (change in volume)
(Propositions 1 and 3a):
6
Standardizing the variance leads to empirical tests of the

relative importance of budgetary slack. In other words, the tests
of Proposition 1 and Proposition 2 are tests of whether the
relative budgetary slack increases with expected and unexpected
levels of activity.
Customer service is measured as on-time delivery. For each of 58,528 transactions, we code
whether the shipment is shipped before or on the
commit date. For each month, we measure on-time
delivery as the number of shipments shipped before
or on the commit date (late shipments) over the
total number of shipments.
On-time delivery
Shipments on or before commit date
Total number of shipments
Results
Table 1 presents descriptive statistics for the
four logistic sites. The sites are signicantly dierent in size, with North America being the largest
and Asia the smallest. To control for size eects,
all variances are scaled by budgeted amounts.
The largest expense account is freight; otherwise
the cost structure diers mainly in terms of xed
and variable labor. We also include non-nancial

measures of performance. On-time delivery is
close to 100%, except for Europe where it is
74%.
Table 2 presents further descriptive statistics on
how the sites succeed in meeting the budget. Total
variance is positive for 63 out of 96 logistic center-
599
month variances (65.6%) and on average is 5.9%

(actual cost below budgeted cost) although after
controlling for serial correlation this number is
only signicant at the 15% level. Looking at the
cost components, we nd that the overall xed cost
variance and its components are not signicantly
dierent from zero, either using a binomial test
Table 1
Descriptive statistics
Budgeted costs (in thousands of dollars or units per month)
North America
Europe
Asia
Southeast Asia
Fixed costs
Mean
Standard deviation
711
218
439
58
85
6
489
50
Fixed labor costs

Mean
Standard deviation
479
166
179
22
50
5
151
35
Other xed costs

Mean
Standard deviation
231
68
259
51
35
3
338
29
Variable costs
Mean
Standard deviation
5036
1101
2512
396
293
74
1189
319
Direct labor costs

Mean
Standard deviation
1701
423
471
118
117
37
152
46
Freight costs
Mean
Standard deviation
2608
531
1595
287
137
42
888
252
Other variable costs

Mean
Standard deviation
728
354
446
207
38
12
150
67
1174
231
772
159
163
35
753
201
Budgeted volume (in th.)

Mean
Standard deviation
970
210
638
144
135
32
622
182
On-time delivery
Mean
Standard deviation
0.92
0.02
0.74
0.14
0.94
0.05
0.96
0.03
Operational measures (per month)

Actual volume (in th.)
Mean
Standard deviation
Cost gures have been multiplied by a constant to preserve condentiality.
600
Table 2
Meeting the budget
Variable description
# of favorable variances
a
Mean
Standard deviation
Z-statistic
Min.
Max.
Total variance
63
0.059
0.29
1.43
1.23
0.70
Fixed cost variance

Fixed labor cost variance
Other xed costs variance
41
51
50
0.005
0.024
0.025
0.25
0.25
0.44
0.29
0.47
0.12
0.76
0.86
1.65
0.44
0.93
0.95
Variable cost variance

Direct labor variance
Freight variance
Other variable costs variance
63a
67a
50
70a
0.061
0.155
0.068
0.125
0.38
0.38
0.47
0.69
1.41
5.59
0.78
1.41
1.86
1.71
2.21
2.94
0.92
1.77
0.73
1.52
Volume varianceb
42
0.027
0.29
1.42
0.71
0.74
Eciency variance
Direct labor eciency variance
Freight eciency variance
Other variable costs eciency variance
63a
64a
51
67a
0.102
0.182
0.041
0.152
0.42
0.49
0.47
0.71
1.97
3.43
0.16
1.54
2.10
1.96
2.46
2.53
1.21
2.07
0.99
1.82
We run four separate regressions (one per site) with a constant and an AR(1) error term to control for serial correlation. The mean and
standard deviations reported
are the average pooled all observations; the Z-statistic is the average Z-statistic, its signicance is assessed
p
using Z z=stdevz= N 1 where N is the number of regressions (N = 4).
# observations: 96.
***
Signicant at 1% (2-tailed test); **Signicant at 5% (2-tailed test).
a
Signicant at 1% level (binomial test).
b
By construction, volume variance is equal for all accounts.
or a means t-test. On the other hand, variable cost

variance and two of its componentsdirect labor
and other costsare signicant using the binomial
test. The eciency variance and two of its components are signicant, also using the binomial test.
The rest of the paper focuses on the analysis of
variable cost variances where budgetary slack appears to be created. Fixed costs appear to be estimated accurately. 7
Table 3 presents the correlation matrix. Change
in volume is positively correlated with various variable cost variances and negatively with eciency
variances. This correlation suggests that as unexpected volume increases (and change in volume is
negative) eciency variance improves, thus reect7
For completeness we analyzed xed costs. None of the
results were signicant. Notice also that even if there is no
budgetary slack in xed costs, the conservative volume that
they use for their budgets means that the actual cost per unit
will be lower than the budgeted cost per unit, thus facilitating
the achievement of cost-per-unit targets.
ing the creation of budgetary slack (Proposition 1).

Budgeted volume is positively correlated with several variances suggesting that when higher volumes are expected, favorable variances increase
(Proposition 2). The correlation matrix is uninformative about Propositions 3a and 3b. Direct
labor and direct labor eciency are positively
associated with on-time delivery consistent with
logistic sites being better at meeting its customer
service objectives when having budgetary slack in
direct labor. Also of interest is the lack of correlation between budgeted volume and change in volume. This observation suggests that the expected
level of activity is not associated with unexpected
changes in the level of activity. Other signicant
correlations are engineered relationships.
The propositions indicate that budgetary slack
and customer service change with expected volume
and changes in volume. Fig. 1 illustrates the significant variation in changes in volume. Fig. 3 plots
budgeted units over time. Starting in month 10, expected volume increases signicantly at the end of
Correlations
Change in
volume
Variable
cost variance
Direct labor
variance
Freight
variance
Other variable
costs variance
Eciency
variance
Direct labor
eciency
variance
Freight
eciency
variance
Other
variable
costs
eciency
variance
On-time
delivery
Budgeted volume
Change in volume
0.03
0.20*
0.26**
0.02
0.02
0.28**
0.30**
0.35**
0.13
0.16
0.46**
0.03
0.61**
0.26***
0.30**
0.32**
0.28**
0.16
0.05
0.89**
0.25***
0.66**
0.41**
0.47**
0.74**
0.57**
0.61**
0.52**
Variable cost variance

Direct labor variance
Freight variance
Other variable
costs variance
Eciency variance
Direct labor
eciency variance
Freight eciency
variance
Other variable
costs eciency
variance
Person correlation reported.
# of observations: 96.
*
Signicant at 10% (two-tailed).
**
***
0.60**
0.32**
0.81**
0.02
0.25***
0.73**
0.27**
0.82**
0.39**
0.54**
0.41**
0.33**
0.92**
0.01
0.25***
0.09
0.04
0.72**
0.89**
0.39**
0.69**
0.49**
0.04
0.22*
0.50**
0.07
0.02
Table 3
Correlation matrix
601
602
Units (normalized)
1. 6
1. 4
1. 2
1
0. 8
0.6
0
10
15
20
25
Months
Fig. 3. Budgeted volume over time.
each quarter suggesting that logistic processes may

be reaching their full capacity in these months. 8
Table 4 reports the formal test for the propositions advanced in Section Literature review and
propositions using the following regression
model:
Variance or on-time delivery
X
b0
bi logistic centers dummies b4
budgeted volume b5 change in volume
X
bj control variables e
The dependent variable is the various variable
cost variances or on-time delivery. We include
both total variance as well as eciency variance. 9
Total variance includes volume variancethe variance due to actual volume being dierent from
budgeted volumethat is equal to the variable
change in volume, thus the positive sign for the
regressions with total variance as dependent variable. Total variances are included for completeness.
8
The pattern of the budgeted volume changes signicantly
over the last four quarters, becoming a lot more seasonal. The
company mentioned that it was due to their customers demand
pattern. Customers started to emphasize end-of-quarter targets
more towards the end of the observation period that coincides
with the year 1999 and the rst quarter of 2000.
9
As one of the reviewers pointed out, if actual costs increase
when meeting alternative goals becomes more dicult, these
additional costs will reduce the extra budgetary slack created
and accordingly will reduce the power of our tests. The reviewer
also pointed out that standardizing the variables might potentially reduce the power of the tests.
Eciency variance excludes the eect of volume

changes on actual costs and thus is a better measure of budgetary slack as used at PCC.
We include three dummy variables to control
for dierences in the intercept across sites. For
the variances regression, we include the number
of months to the end of the semester as a control
for potential loss in accuracy as the planning horizon increases (we use the semester because the
budget is updated at the end of the sixth month
period). This variable takes a value of 1 for the
rst month in the semester, 2 for the second, 3
for the third month and so forth. For on-time
delivery, we control for months that are the end
of the quarter because shipments in these months
are much higher. 10 This dummy variable takes value of one for the third month of each quarter and
0 otherwise. For on-time delivery, we also control
for the percentage of generic products (products
that are not manipulated in the logistic sites) because a higher percentage of generic products
makes on-time delivery simpler. 11 To control for
autocorrelation in the dependent variables we use
an AR(1) model in the error terms. We also use
a generalized least squares approach to allow for
dierent variances across sites (Greene, 2000).
Results for Proposition 1
Proposition 1 relates favorable eciency variance (higher budgetary slack) with unfavorable
changes in volume (note that higher-than-expected
volumes lead to a negative value for the changes in
volume variable). The evidence in Table 4 for direct
labor, freight, and other variable costs is consistent
with the proposition.
10
We also used end of quarter instead of months to end of
semester in the variance regressions; the results were comparable. We also ran the eciency regressions dening eciency
variance on a per-unit basis (rather than total eciency), and
the inferences remained unchanged.
11
The reason being that generic products allow consolidation of the demand of dierent customers. Holding inventory of
a generic product requires less safety stock (for a particular
service level) compared to holding inventories of several
customer-specic products (because of risk-pooling); or the
same amount of safety stock makes it possible to oer a higher
service level (Lee & Tang, 1997).
Table 4
Drivers of budgetary slack and on-time delivery
Independent variables
Dependent variable
Variable cost
variance
0.059
0.99
Freight
variance
Other variable
costs variance
Eciency
variance
0.044
0.61
0.177*
1.86
0.098
0.98
0.059
0.99
0.126
0.90
0.255
1.43
0.063
0.65
Budgeted volume
Coecient
z-statistic
0.063
0.65
0.505**
5.33
Change in volume
Coecient
z-statistic
0.622**
7.63
0.228**
3.15
0.757**
6.64
0.452**
2.92
Months-to-end-semester
Coecient
z-statistic
0.031***
2.17
0.018
1.33
0.033
1.58
0.071**
2.84
0.378**
4.64
0.031***
2.17
Direct labor
eciency
variance
Freight
eciency
variance
0.044
0.61
0.177*
1.86
0.098
0.98
0.802**
22.31
0.505**
5.33
0.126
0.90
0.255
1.43
0.057***
2.05
0.548**
3.54
0.042*
1.67
0.772**
10.67
0.242***
2.13
0.018
1.33
0.033
1.58
Other
variable costs
eciency
variance
On-time delivery
0.071**
2.84
End of quarter
Coecient
z-statistic
0.041**
2.64
Percentage generic
Coecient
z-statistic
0.137***
2.06
Pseudo-R2
# of observations
0.44
96
0.36
96
0.55
96
0.42
96
0.56
96
0.69
96
0.54
96
0.48
96
0.79
72
Constant
Coecient
z-statistic
Direct labor
variance
Regressions include dummy variables to control for dierences across sites (not reported).
Pseudo R2 is the correlation between the actual dependent variable and the tted values.
*
Signicant at 10%.
**
Signicant at 1%.
***
Signicant at 5%.
603
604
The mechanism for the budgeting model described in Section The budgeting model relies
on variable costs having a xed component to engineer the relationship between unexpected volume
and favorable eciency variance. To examine this
relationship using quantitative data, we examine
the cost behavior assumed during the budgeting
process and the actual cost behavior. For each of
the sites, we performed the following regression:
Actual or budgeted costs
b0 b1 actual or budgeted volume e
We also include an AR(1) error term to control
for serial correlation. We run separate regressions
for each site to fully capture the dierences in cost
structures, for actual versus budgeted costs, and
for total variable costs and its three components
(direct labor, freight costs, and other variable
costs). To assess the signicance of the coecients,
we combined the z-statistics of the four sites into
an overall
z-statistic estimated as Z z=
p
stdevz= N 1 (Greene, 2000). Table 5 reports the average z-statistics for the four sites. 12
While all the components of variable costs are
correctly assumed to be fully variable in the budgeting systemthe xed component of the budgeted costs is not signicant while their variable
part is highly signicantactual costs have a xed
as well as a variable component, both of them
signicant.
Proposition 2 suggests that favorable eciency
variance (as the proxy for budgetary slack) increases with expected volume (budgeted volume).
We nd evidence consistent with this proposition
only for direct labor. When units budgeted are
higher, direct labor costs are lower than budgeted
(and the eciency variance is favorable), suggesting higher budgetary slack when expected volume
is higher. An increase in 1% expected units (over
12
Table 5 does not report the estimated coecients but only

their average signicance (across sites). In the majority of the
regressions, the coecient on budgeted volume is signicantly
larger than the coecient on actual volume, consistent with
Fig. 2.
the logistic site average) improves eciency variance by 0.5%; for example one standard deviation
for North America (231/1174 = 20% from Table 1)
translates into an increase of 11% of the eciency
variance. 13 We do not nd any signicant eect
on freight or other variable costs. Thus budgetary
slack built during the planning process is relevant
for variable costs.
These results indicate that the padding is not
a constant amount per disk drive. While a constant
pad per unit would create more budgetary slack
with higher budgeted volume, it would not increase the relative amount of budgetary slack,
and constant padding would come up in the constant term of the regression, not in the coecient
b4 for budgeted units. 14 The qualitative data suggests that the company allows this budgetary slack
because of the importance of customer service and
product quality. However, the quantitative analysis is uninformative about documenting actual
benets from this policy.
These results must be interpreted with some
care. First, the empirical tests are signicant for
only one component of variable costsdirect labor. Second, besides the multiple-goals argument,
budgetary slack may also be required when there
is more uncertainty about the variable cost per
unit at higher levels of volume. While this argument may have also played a role at the research
site, no evidence in the interviews suggested so.
Proposition 3 predicts that customer service suffers in months with unexpected higher volume (3a)
and in months with high expected volume (3b).
The evidence in Table 4 is consistent with both
propositions. Notice that change in volume is dened such that a higher-than-budgeted volume
13
The magnitude of these changes is quite sizeable. Given

the simple operations performed at the logistic sites, such
changes are very unlikely to come from economies of scale;
rather it is consistent with budgetary slack as manager
described. We further explore this potential explanation in the
section with Results for Proposition 2.
14
The intercept terms for some of the sites (not reported) are
signicant, suggesting that there may be some constant
padding dierent for each site.
605
Table 5
Fixed and variable components of variable cost accounts
Dependent variable
Total variable costs
Variable component of actual costs

Fixed component of actual costs
Variable component of budgeted costs
Fixed component of budgeted costs
Freight costs
3.71
25.61
Direct labor
1.82
7.39
5.20
4.08
6.23
8.30
3.87
1.23
3.44
1.08
3.77
1.27
3.12
0.48
The table reports the average z-statistic of the xed component (constant) and variable component (slope) for the following regression
model: Actual or budgeted costs b0 b1 actual or budgeted volume e. Each z-statistic is estimated using four regressions (one
per site). Each column presents the average z-statistic for two sets of regressions, the top two rows report the results for actual costs and
the bottom two rows for the budgeted costs, for p
total
variable costs (rst column) and its components (remaining columns). The
average z-statistic is estimated as Z z=stdevz= N 1 (Greene, 2000). A signicant average z-statistic indicates that the estimated parameter (b0 for the xed component, and b1 for the variable component) is signicantly dierent from zero (two-tailed tests)
at 10% (*) and 1% (***).
leads to negative change in volume, hence the positive coecient.

The evidence suggests that the company allows
a larger budgetary slack to react to unexpected increases in volume (Proposition 1) and when it expects high demand (Proposition 2). The evidence
regarding Proposition 3 indicates that customer
service suers in both of these circumstances.
However, the question remains whether the
trade-o between customer service and costs exists.
If such a trade-o exists, we expect operational
costs to increase in demanding periods, and site
managers face deteriorating customer service and
increasing costs during these periods leading to
trade-o decisions. To address this question, we
examine whether unexpected increases in volume
or higher expected demand aect variable costs.
Using the same specication as in Table 5:
Actual costs b0 b1 actual volume e
We extended the regression specication with
two interaction terms. The rst one interacts actual
volume with changes in volume. This interaction
term captures whether variable costs (that in Table
5 we assumed to be constant across volume through
b1) is dierent in periods with unexpected demand.
The second term interacts actual volume with
budgeted volume to test whether variable costs
are higher for months with higher expected demand. These two interaction terms capture whether
variable costs (assumed to be constant on a per-unit

basis in Table 5 through b1) change with unexpected surges in demand (changes in volume) and
expected higher demand (budgeted volume). We focus the test on variable costs, controlling for xed
costs, because these costs are expected to vary while
xed costs are more likely to remain stable.
Actual costs
b0 b1 actual volume b2
actual volume changes in volume b3
actual volume budgeted volume e
Table 6 reports the results. Each column reports
the average z-statistic of four regressions (one per
site). The average z-statistic on actual volume * changes in volume is negative and signicant;
this result indicates that when actual volume is larger than budgeted volume, variable costs increase.
Similarly, the average z-statistic on actual volume * budgeted volume is positive and signicant
indicating that those months with higher expected
volume also record higher variable costs. This evidence suggests that site managers face a trade-o
between customer service and operational costs.
It is also consistent with the qualitative evidence
indicating that variable costs depend on volume,
for reasons such as overtime, express shipments,
temporary employees, and rework.
Finally, and as a robustness check, we examine
the importance of the results being driven not only
606
Table 6
Change in the variable component of variable cost accounts
Fixed component of variable actual costs (constant)

Variable component of variable actual costs (actual units)
Variable component of variable actual costs times change
in volume (actual units * change in volume)
Variable component of variable actual costs times
units budgeted (actual units * budgeted volume)
Dependent variable
Total variable costs
Direct labor
Freight costs
7.67***
0.31
9.04***
3.49***
0.63
1.63*
4.71***
2.01**
1.73*
2.52**
1.20
2.49**
1.15
2.56**
1.06
3.27***
The table reports the average z-statistic of the xed component (constant), variable component (slope) and interaction terms for the
following regression model: Actual costs = b0 + b1 * actual volume + b2 * actual volume * changes in volume + b3 * actual volume * budgeted volume + e. Each z-statistic is estimated using four regressions (one per site). Each column presents the average zstatistic for one set of regressionsp
for
total variable costs (rst column) and its components (remaining columns). The average z-statistic
is estimated as Z z=stdevz= N 1. A signicant average z-statistic indicates that the estimated parameter (b0 for the xed
component, and b1 for the variable component) is signicantly dierent from zero (two-tailed tests) at 10% (*) 5% (**) and 1% (***).
by budgetary slack but also by actual improvements in operating eciency. Managers may
increase the operating eciency through day-today decisions like adjusting direct labor more
quickly or optimizing freight. To test for potential
operational eciency gains we regressed the variable cost per unit on actual units shipped (to control
for economies associated with xed costs), end of
quarter, percentage of generic products, and unexpected volume (volume variance). We controlled
for potential serial correlation using an AR(1)
model in the error term. We ran separate regressions for each site and computed the z-statistic
for the coecient on volume variance as we described for Table 5. The z-statistic is 1.20 indicating that higher unexpected volume does not lead
to lower costs, as we would expect if operational
eciency were present.
The fact that on-time delivery deteriorates even
as the budget becomes less demanding does not inform about whether managers are behaving optimally. They may be doing so and providing the
best service, given the resource constraints that they
face. Conversely, they may rely on demanding circumstances to decrease their eort and not deliver
the service that the additional resources provide.
Discussion and conclusions

Budgetary slack is a key concept in the budgeting literature. In previous empirical work, it has
been interpreted as dysfunctional. It insulates

managers from the motivational properties of
budgets leading to lower eort and inecient use
of resources. Previous research has focused on
identifying the conditions leading to the presence
of dysfunctional budgetary slack.
The objective of this study is to empirically test
the prediction, advanced in previous theoretical
work, that budgetary slack can function as a tool
to help management rather than being solely dysfunctional. The company may allow budgetary
slack, not because incentives to remove slack
would be too expensivethe agency perspective
(e.g. Kirby et al., 1991)but as a powerful tool
to inuence how managers allocate their attention
when performance requires balancing multiple
goals (Lillis, 2002; Merchant & Manzoni, 1989;
Van der Stede, 2000).
Using eld data from four logistic sites of a
technology company, we nd that the budgeting
process encourages budgetary slack when the
company expects business processes to be under
demanding conditions and managers may require
exibility to meet non-nancial goals. We also nd
that the budget model itself supports the creation
of budgetary slack when business processes face
unexpected external events. The mechanism
embedded in the budgeting system is based on
the cost accounting assumptions. The budgeting
system is designed to create budgetary slack when
actual volume is above expected volume by assuming semi-variable costs as fully variable during the
budgeting process. This design feature reinforces

the creation of slack when needed, as explained
in Fig. 2.
While previous studies have investigated budget
design in relation to non-accounting factors, such
as uncertainty of the environments or tasks, or
exible management styles, this paper relates
cost-budget design to choices of the accounting
system. We discuss how a rm used two design approachesvariable costs containing xed components and ignoring non-linearity in variable
coststo facilitate managers focusing on other
goals besides costs by reducing budget emphasis
when budgeted or unexpected volume is high.
These results may help to better understand
accounting choices that rms may employ to allow
exible responses to uncertainty.
Our results have implications for the impact of
budgets upon performance. In the face of uncertainty and when multiple short-term goals are
important, budgetary slack enables managers to
remain focused on various short-term goals simultaneously. Organizations can design budgetary
slack to inuence the allocation of organizational
attention. Moreover, the mechanisms can be selfregulating and can adjust the amount of slack to
the particular circumstances facing a decisionmaker. Thus, budgetary slack is not created indiscriminately, but only when attention to alternative
goals demand it. These ideas outline a sophisticated use of budgets that goes beyond the more
traditional applications.
Future research could focus on understanding
how organizations design budget systems that
deliberately incorporate budgetary slack under
certain circumstances. This requires subtle design
decisions, such that cost targets are eased only
when it is particularly dicult to meet all goals
simultaneously. The process of creating budgetary
slack is more ingenious than just allowing relatively high levels of budgeted costs. There is also
a need to better understand the ways in which
organizations maintain the benecial eects of
budget emphasis while, at the same time, allowing
some conditional form of budgetary slack to prevent these managers from overly focusing on
achieving cost targets, at the expense of non-nancial goals.
607
Acknowledgements
We thank participants at the AAA Management Accounting Conference, 2000, European
Accounting Association Conference, 2001, participants at Michigan State University, the London
School of Economics, Joan Luft, Ken Koga, Sander van Triest, Kari Lukka, Wim Van der Stede,
and the reviewers for their many helpful and constructive comments. Marc Wouters appreciates the
nancial support of the Niels Stensen Stichting,
Amsterdam, The Netherlands.
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Accounting, Organizations and Society 30 (2005) 587608

Managing budget emphasis through the explicit design

T. Davila, M. Wouters / Accounting, Organizations and Society 30 (2005) 587608

Webb, 2002). The presence of budgetary slack

to balance these dierent goals as external conditions change. 1

T. Davila, M. Wouters / Accounting, Organizations and Society 30 (2005) 587608

through survey methods, we use archival data

ing the interviews and the collection of archival

Literature review and propositions

T. Davila, M. Wouters / Accounting, Organizations and Society 30 (2005) 587608

budget gure (budget proposal) (Lukka, 1988).

2002; Lukka, 1988; Merchant & Manzoni, 1989;

T. Davila, M. Wouters / Accounting, Organizations and Society 30 (2005) 587608

Proposition 1. Unexpected higher levels of activity

T. Davila, M. Wouters / Accounting, Organizations and Society 30 (2005) 587608

Qualitative evidence: Company PCC and its

T. Davila, M. Wouters / Accounting, Organizations and Society 30 (2005) 587608

of moving a unit through the supply chain (cost

T. Davila, M. Wouters / Accounting, Organizations and Society 30 (2005) 587608

Logistic centers pursue multiple objectives

Fig. 1. Percentage dierence in actual versus budgeted volume.

volume from the Fulllment Planning Group that

T. Davila, M. Wouters / Accounting, Organizations and Society 30 (2005) 587608

not usually used and translates into a favorable

quarter-to-date actual expenses, quarter-to-date

T. Davila, M. Wouters / Accounting, Organizations and Society 30 (2005) 587608

These disparities create a mechanism, illustrated in Fig. 2, that speaks to Proposition 1.

Total direct labor costs

Budgeted costs line

Fig. 2. Creation of budgetary slack in the budget setting process.

T. Davila, M. Wouters / Accounting, Organizations and Society 30 (2005) 587608

costs per unit are likely to increase with volume

Quantitative evidence: Research design

Budget cost Actual cost

T. Davila, M. Wouters / Accounting, Organizations and Society 30 (2005) 587608

in expected volume and variances due to price and

Budgeted variable cost

Notice that this variable is negative when actual

to focus on achieving goals other than costs, we

Standardizing the variance leads to empirical tests of the

Total number of shipments

T. Davila, M. Wouters / Accounting, Organizations and Society 30 (2005) 587608

and variable labor. We also include non-nancial

month variances (65.6%) and on average is 5.9%

Fixed labor costs

Other xed costs

Direct labor costs

Other variable costs

Budgeted volume (in th.)

Operational measures (per month)

Cost gures have been multiplied by a constant to preserve condentiality.

T. Davila, M. Wouters / Accounting, Organizations and Society 30 (2005) 587608

Fixed cost variance

Variable cost variance

or a means t-test. On the other hand, variable cost

ing the creation of budgetary slack (Proposition 1).

Variable cost variance

T. Davila, M. Wouters / Accounting, Organizations and Society 30 (2005) 587608

T. Davila, M. Wouters / Accounting, Organizations and Society 30 (2005) 587608

Fig. 3. Budgeted volume over time.

each quarter suggesting that logistic processes may

Eciency variance excludes the eect of volume