Tragedy of the Budgets

*This is part three of The Diseconomies of Scale Series which takes a deeper look into why bigger is not always better.

Organizations try their best to function as a single entity.  They create motto’s, missions, values, and goals to help create their identity.  Everyone is supposed to align to this identity so they can fulfill their purpose, but does this commonality within the organization pose any risk?

This single entity represents a collective effort.  It is made up of many individual people, organized into different groups (business units, departments, functions) who tend to treat the resources of the organization, if given the ability, much like any shared-resource system.

The problem is that regardless of how hard we have tried, people always tend to act within their own self-interest.

One way this plays out is when it comes time to prepare the companies annual budget.  It’s almost like a proactive form of the tragedy of the commons.  The tragedy of the commons is a situation in a shared-resource system where individual users, acting independently according to their own self-interest, behave contrary to the common good of all users by depleting or spoiling the shared resource through their collective action.**  For the tragedy of the commons to occur a resource must be scarce, rivalrous in consumption, and non-excludable. These requirements are all met with company budgets.  They are scarce due to the limitation of funding the budgets (restricted by the actual capital they can raise from operations, debt, or equity).  They are rivalrous in consumption due to these different groups within an organization vying for their part in the allocation of the overall budget.  They are non-excludable in the sense that every group will have budget allocated to them or they will not be able to function.

Typically, there is an overall organizational budget that will be allocated across the organization to smaller responsibility centers (or other org. units like profit centers and cost center depending on the organization’s financial structure).  It is at this point that you will see the responsibility center leaders vying for a bigger piece of that pie.  The savvy ones will be able to justify it with previous year spend and this is where the problem can arise.  Previous year spend rate can be purposefully inflated due to unnecessarily high spend in preparation for the next years budget requirements.

For example, if I know I have an expense budget of $500,000 for the year and I am running at a spend rate that will be lower than that $500,000 for the year, I will make decisions that increase my spend rate instead of being fiscally responsible and come in under budget.

This is actually the plot of an episode of the American version of ‘The Office’.  Michael, the regional branch manager of a smaller paper supplier company, and his Scranton branch actually come under budget for the year. Corporate wants to reward him with a gift card, but Oscar, one of the Scranton branch accountants, effectively explains to Michael using a child’s lemonade stand example, that there is a good chance corporate will lower the branch’s budget for next year because they didn’t need all of their budget for the current year.

It’s also how some justify misappropriating assets of a company. In the auditing world, there is something known as the Fraud Triangle. Each point on the triangle represents the three different components that lead someone to commit fraud.

The first is opportunity. There must be an opportunity to commit fraud. Whether it is the ability to access assets or approve purchases. A lot of internal control design should be tailored around removing the opportunities to commit fraud. Though, one thing companies tend to underestimate is the dynamics of changes within business processes that can obsolete previously well-designed control systems. This is why process improvement must be continual in nature.

The second is motivation. Something typically motivates someone to act in a way that leads them to commit fraud. This can occur due to internal causes like employee unhappiness or resentment, or external causes like when someone becomes overburdened with personal debt.

The third is rationalization. This is the process that the fraudster undertakes to justify their actions. Some times whatever motivated the fraud is also what helps to rationalize it. A disgruntled employee might believe they’ve earned it, or become upset when upper management received a bonus, but they didn’t.

They see the mass amounts of resources available to others in the company and rationalize that there is enough to go around.  If left unchecked, this could significantly and negatively affect the performance and profit of a company.

It only takes a few (sometimes even less) budget cycles for financially savvy managers to realize that they must spend at or more than budget to make their life easier in the future. They will, at the detriment to the overall organization, try to pull more of the resources under their span of control. If many start acting in this way, there can begin a significant leakage of resources towards unprofitable decisions and activities.  This potential problem can only get worse as companies scale up in operations as more managers are given responsibility over parts of the company budgets.

So How Can You Prevent This?

Continuous scrutiny of budgets.  Companies can lose focus throughout the year of comparing actuals to budgeted figures.  They can start focusing only on actuals to forecast figures, but having that variance analysis against the budget can highlight what is necessary spend versus unnecessary spend.

Strict commitment to more granular explanation of the reason’s why the suggested budget components are warranted.  When it comes time to prepare the next year’s budget, don’t let budgeted figures go without a well thought out explanation.  The more thorough the better.  If an adequate explanation cannot be given, there’s a chance that it might not be necessary.

Change the incentive structure.  Rather than having individual’s compensation plans (i.e. bonuses) tied directly to overall company performance and profitability, there should be an element that ties directly to their responsibility center’s performance and profitability.  This incentives them to keep budgets in check.  You can effectively privatize all or at least a portion of the budgets.

The Tragedy of the Budgets is one way that large organizations start to suffer diseconomies of scale.  If left unchecked, it can not only cause losses in profitability, but cash flow issues as well.

**https://en.wikipedia.org/wiki/Tragedy_of_the_commons