Analysis of the organizational characteristics related to tight budget goals

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<ul><li><p>Analysis of the organizational characteristicsrelated to tight budget goals*</p><p>ROBERT SIMONS Harvard University</p><p>Abstract. This study extends our knowledge of the role of budgets in complexorganizations. Using survey methods withi a sample of Canadian firms, the analysisexamines the relationship between tight budget goals and firm performance. Additionally,the effects of business strategy and intemal structural characteristics are considered.Statistical tests suggest that tight budget goals are positively related to firm performance,and that business strategy and intemal organizational conditions are associated with tightnessin budget goals.</p><p>Resumi. L'auteur ajoute k notre cormaissance du r61e des budgets dans les organisationscomplexes. A l'aide de m6thodes d'analyse appliqu&amp;s k un Echantillon d'entreprisescanadiennes, il 6tudie la relation entre Ies ohjectifs budg^taires rigoureux et la performancede l'entreprise. II se penche en outre sur les cotisdquences de la strat6gie commerciale et descaracteristiques stnicturales internes de l'entreprise. Les tests statistiques donnent k penserque les objectifs budgetaires rigoureux affichent une relation positive avec la performancede l'entreprise, et que la strat^gie commerciale et la structure organisationnelle interne sontIi6es k la dgueur des objectifs budg^taires.</p><p>IntroductionA budget is an ex ante formal statement, generally determined by negotiation andapproved byimanagement, of the resource infiows and outflows expected duringthe budget period. Thus, it is an explicit contract outlining expectations betweensuperior and ^ subordinate.;</p><p>Budgeting research has investigated the effects of participation in the budgetsetting process (Brownell (1981), Swieringa and Moncur (1975)), the interactionof budgeting with personality variables (Seiler and Bartlett (1982), Collins(1978)), and the value of budget information on decisions and performance (Kenis(1979), Mock (1973)). Questionnaire studies based on contingency theory oforganizations have considered the relatiohship between budgeting and organiza-tional structure (Merchant (1981), Bruns and Waterhouse (1975)); other works</p><p>* I am indebted to Haim Falk, Michael Jensen, Robert Kaplan, Kenneth Merchant, KrishnaPalepu, and two anonymous reviewers for critical comments and suggestions. Fundmg for theresearch was provided by the Division of Research of Harvard Busmess School.</p><p>Contemporary Accounting Research Vol. 5 No. 1 pp. 267-283</p></li><li><p>268 R. Simons</p><p>have used analytic models to examine the implications of budgeting behavior(Magee (1980), Demski and Feltham (1978)).</p><p>The view that tight budget targets are desirable and lead to better organizationalperformance is a common implicit theme in budgeting research. The purposes ofthis study are, first, to investigate whether the tightness of budget goals is in factrelated to firm performance and, second, to analyze the conditions under whichtight budgets are encountered in firms. The analysis indicates a positiverelationship between tight budget goals and the economic performance of the firm.Budgets appear to be tightest for firms following proactive market strategies andwhen budgeted performance is linked to remuneration levels and subject to ex postmonitoring.</p><p>The concept of tight budget goals is common in the practitioner literature(Merchant (1985b p.57)). Interviews with managers during the design stage of thisstudy suggest that the concept of budget goal tightness is of practical interest andconcem to operating managers. Throughout this paper, I use the terms "tightbudget goals" and "budget tightness" interchangeably to refer to predeterminedbudget targets that are perceived to be accurate, important to achieve, and whichrequire serious effort and a high degree of efficiency in accomplishment.Depending on the research perspective, the benefits of tight budgets accrue fromeither or both of positive motivational effects and the elimination of slack.</p><p>BackgroundOne of the first formal investigations of the effects of tight budget standards wasconducted by Stedry( 1960 pp. 61-91). Using students as subjects, Stedry devisedan experiment where the "budget" consisted of solving a predetermined numberof algebraic problems. By altering the tightness of the budget, i.e., the difficulty insolving the required number of problems, and providing economic incentives asmotivation, Stedry concluded that an individual's performance is greatest if thebudget is tight and is provided to the individual prior to the setting of personalaspiration levels.</p><p>The finding that tight budget goals lead to improved individual performance hasbeen replicated in a number of field settings including a study at General Electric(Meyer, Kay and French (1965)) and a study of five industrial companies in TheNetheriands (Hofstede (1968 pp. 104-292)). Other studies, however, have failedto reject the null hypothesis of no relationship between budget tightness andindividual performance (Holstrum (1971); Kenis (1979)).</p><p>Some behavioral studies have attempted to assess the extent that participationin budget goal setting leads to positive job attitudes and tightness of budget goals(see Brownell (1982a) for a review of this literature and Brownell and Mclnnes(1986) for a recent study of these phenomena). Budget goal tightness has also beenconsidered from the reciprocal perspective of budget slack (e.g.. Merchant,(1985a)). Budget slack is the outcome of setting easily attainable budget goals sothat individuals receive organizational rewards for performance that is below thelevel that would be expected if goals were tightly set.</p></li><li><p>Organizational Characteristics and Budget Goals 269</p><p>Based on a study of budgeting process in a large retail chain, Lowe and Shaw(1968) concluded that managers, as rational economic individuals, are induced tobias budget goals to protect their personal interests. In a study of budgeting in threedivisions of a large corporation, Schiff and Lewin (1968) estimated that slack mayaccount for as much as 30 percent of operating expenses and personnel costs. Theyconcluded that loose budget goals are created intentionally by managers to achieveattainable budgets and to secure resources for the achievement of personal goals.'</p><p>Most empirical studies of budget slack have focused solely on internalconditions relevant to the creation of slack. For example, Onsi (1973) identified 16factors related to internal conditions ofthe firm that were significant in explainingbudgetary slack. Merchant (1985a) also focused on internal variables as predictorsof slack creation.^</p><p>The foregoing studies have associated budget tightness or budget slack withindjvidMfl/psychological variables and attitudes, individual task performance, andconstructs related to internal organizational characteristics. In this study, I attemptto extend our knowledge of the role of budget standards in two ways. First, 1investigate the relationship between budget goal tightness and firm performance,because this relationship underlies previous studies but has not been tested.Second, I examine competitive strategy, as well as the internal conditions ofthefirm, as a factor that may influence budget tightness.</p><p>HypothesesTight budget goals and firm performance: Previous research on the relationshipbetween tight budget goals and performance has focused on individual per-formance measures only (e.g., Stedry (1960 pp. 63-67), Hofstede (1968 pp.126-127), Brownell (1982b)). It is important, however, to assess the effect ofaccounting design choices, e.g., budget tightness, on firm performance (Merchantand Simons (1986)). Since tight budgets have generally been linked positivelywith individual performance in the literature reviewed above, I expect thisrelationship to hold at the firm level.</p><p>HI: A positive relationship exists between tight budget goals and firm performance.</p><p>Tight budgets and competitive strategy: The product/market strategy of a firmrepresents its effort to position products to satisfy the demand of specified marketniches. The competitive market strategy ofthe firm may affect the extent to whichfirms attempt or are able to create tight budgets.</p><p>How is the strategy of a firm likely to affect the tightness of budget goals? One</p><p>1 While the papers reviewed here focus on budgeting in business firms, arguments related to budgettightness also hold for the budget process in government agencies and departments. See, forexample, Wildavsky (1974 pp. 64-126).</p><p>2 Merehant's (1985a) variables included budget participation, production technology, the importanceof meeting budget targets, and the ability to detect slack. Due to the complexity and interrelation ofOnsi's (1973) factors, the interested reader is referred to the onginal text for a discussion of factorcomponents.</p></li><li><p>270 R. Simons</p><p>argument might predict an inverse relationship between tight budget targetsand dynamic market environments. In this view, tight budget goals may beinappropriate for firms operating in competitive environments that are con-tinuously changing. In these firms, managers may be unable to predict budgetoutcomes accurately due to unforeseen competitive events in the market. Thisargument is related to Merchant's (1985a) hypothesis that the level of budget slackis related inversely to the degree of predictability in the intemal productionprocess.'' This argument ignores, however, the active role of managers ininfonnation processing (Galbraith (1977 pp. 35-57)). Specifically, environmentaluncertainty has been shown to increase information processing through controlsystems' use (Simons, (1987a); Tushman and Nadler (1978); Ashby (1960 pp.80-137)) and to result in tighter control (Kamm (1980); Khandwalla (1972)). Asenvironments become more uncertain, managers may invest more in informationprocessing and control systems thereby resulting in more accurate and tighterbudgets.</p><p>According to the arguments advanced above, budgets should be tightest whencompetitive environments are dynamic due to proactive product/market strategies.Therefore, the following hypothesis is advanced:</p><p>H2: Tight budget goals are positively associated with strategies that emphasize frequentproduct/market change.</p><p>Budget tightness and internal conditions: Budgeting procedures in organizationsrepresent an important way of setting contracts between superiors and subordi-nates. Past research (e.g., Schiff and Lewin (1968)) suggests that self-interestedmanagers will attempt to set easy budget goals for themselves. Monitoring andreporting controls can be used by superiors, however, to gather data about past andpresent performance of individuals, departments, and divisions throughout theorganization. This information can be used during negotiation of budget goals tocounter the tendency of subordinates to set easy budget goals.</p><p>H3: Tight budget goals are positively associated with ex post monitoring of budgetedactivity outcomes.</p><p>To the extent that compensation is determined by a formula based on theachievement of budget targets, subordinates will be motivated to create budgetslack. For example, a relatively low revenue budget target allows an individual toachieve the target by less effort than would be necessary with a tight budget goal.Given the rational expectations of managers - that subordinates will act to biasbudget targets to maximize compensation - 1 expect, however, that budgets will berelatively tight in situations where compensation is formula based. In cases whencompensation for subordinates is determined by reference to budget goalachievement, managers will strive to ensure that budget goals are tight andaccurate.</p><p>3 Merchant's results in regard to this hypothesis were inconclusive.</p></li><li><p>Organizational Charactedstics and Budget Goals 271</p><p>H4: Budget goal tightness is associated positively with the use of remuneration formulasbased on achieving budget targets.</p><p>Pardcipation in budgeting has generally been studied by focusing on thepositive effects of participation on personal sadsfaction and individual per-formance (see Brownell (1982a) for a comprehensive review of this literature).Recently, researehers have considered budget participation in an agency perspec-tive (Ramakdshnan (1985); Baiman and Evans (1983); Magee (1980)) andconcluded that the participadon of subordinates in setdng budget targets can bejusdfied economically when the subordinate has better information than thepdncipal. A problem may adse, however, due to the subordinate's desire to createeasily achievable targets through participation in budget setting. In the absence ofmonitodng by supedors, participadon in budget setting is expected to lead to lowbudget targets. Following this reasoning, rational managers can be expected toincrease monitodng and reporting controls if subordinates participate in budgetsetting. The following two hypotheses emerge:</p><p>H5: Budget participation is positively associated with monitodng and reporting controls.H6: Participation in budgeting is inversely associated with tight budget goals aftercontrolling for the effects of monitodng and reporting controls.</p><p>Sample selection and data collectionThe hypotheses of the study were tested by analyzing questionnaire data providedby 86 Canadian firms. The relative importance of the reladonship between budgetgoal tightness and the idendfied intemal and extemal vadables was examinedusing regression procedures. The following section descdbes those procedures.</p><p>Using the Dun and Bradstreet Canadian Key Business Directory, 108 firms inthe Montreal and Toronto areas were selected from 19 industdes for inclusion inthe study (see Appendix I for a descdption of the selecdon procedures). Of thesefirms, 86 agreed to provide data for the analysis. The firms included in the studyreported sales of less than two million dollars to over one billion dollars; meansales were $236 million. The average number of employees was 1,320. No singleindustry represented more than ten percent of the sample.</p><p>Questionnaires were completed in each firm by expedenced senior managers:*respondents had been associated with their businesses an average of 12 years; ninepercent were chief executive officers (CEO); 65 pereent reported directly to theCEO; 26 pereent were two or more levels below the CEO. To ensure thatrespondents understood both the instructions and the questions, each respondentwas contacted by telephone in the week following receipt of the questionnaire, atwhich time any necessary cladficadon was provided.</p><p>4 In 16 firms, two managers independently completed and returned the questionnaire; for flieremaining firms, only one response was received. In the case of duplicate responses, the ratings ofthe most senior officer were used as the firm's response. Where any scale item differed between thetwo respondents by more than two points, responses were averaged (this occurred for 5.0 percent ofduplicate scores). Scores among raters in the same firm correlated at 0.60 or higher for all scales usedin the study. The minimum acceptable level of in...</p></li></ul>