Journal of Japanese Management Vol.2, No.1, November 2017

ISSN 2189-9592

Consequences of Emphasizing Feasibility during Budget-Making
Process*
Fumiyoshi Watanabe

Faculty of Business Administration, Tokyo Keizai University
Japan Cost Accounting Association E-mail: watafumi@tku.ac.jp
Abstract
Whether favorable or unfavorable, budget variance, that is, the difference between budgeted performance and actual performance, may result in the inefficient use of resources withina firm. When an organizational unit within a firm incurs a favorable variance, this may seem tobe a beneficial situation at the micro-level; however, the firm allocates the unit additional resources that could have been allocated to other units. Alternatively, when a unit incurs an unfavorable variance, the unit likely has idle capacity that does not create value but rather involves
wasteful costs. Accordingly, when budget variance occurs, firms face the risk of incurring somekinds of losses. This paper demonstrates that when an owner asks a manager to prepare feasible
budgets for avoiding losses due to budget variance, the owner must decrease both the ceilings
for the bonus paid to, and target set for the manager.
Keywords
budgeting, budgetary slack, bonus cap, cost of difference, moral hazard(1) Introduction

then turned into precise drafts through budget

This paper shows that budgets are set

negotiations. This paper models such a budget-loosely when owners require that managers pre-making process, in which budget guidelines arepare feasible budgets by adopting a principal-

viewed as representing the distribution of ex-

agent model. Also, this paper notes that owners

pected profit and managers make effort to nar-

do not pay bonuses to a manager if his or her

row the distribution.1

performance far exceeds expected targets even

Ito (2013) notes that to improve businessthough the performance is measured on the ba-

ability, top management should ask every mem-sis of budget attainment level.

ber of an organization their mission and the way

In many firms, owners communicate

to accomplish it during the planning phase.

budget guidelines to managers and budget

Building upon this idea, this paper shows thatdrafts are authorized after budget negotiations.

an authorized budget is set loosely if an owner

Budget guidelines are just rough plans that areemphasizes the key point stated in Ito (2013).

*I thank two anonymous referees as well as the workshop
participants at the 41st JCAA Annual Meeting and Tokyo
Keizai University. I also thank the financial supports fromJCAA and Tokyo Keizai University.

1 This paper refers to Chen et al. (2010) for modeling sucha budget-making process.

20

Journal of Japanese Management Vol.2, No.1, November 2017

ISSN 2189-9592

This result parallels Ozawa (2010), which notes

strategy, as it can reduce losses that are in-that a budget is set below the expected value ofcurred from differences between budgeted per-performance if inter-departmental coordination

formance and actual performance. For example,

is emphasized. However, this paper shows thaton the one hand, Sharp Corporation reported

a budget is set loosely when inter-departmental

heavy losses in 2011 due to unused capacity atcoordination is not considered, and the budget is

its Sakai factory. Utilization of capacity at thisnot set below the expected value of performance.

factory, which was launched in 2009 and is one

Although this paper considers participa-of the world’s largest factories, fell to aroundtive budgeting, the focus of this paper is differ-

30% in the April-June quarter of 2011 (Nikkei

ent from other related agency studies (e.g.,

Sangyo Shimbun, August 3, 2012). Since actual

Heinle et al., 2014). In their models, an agent

volume did not attain planned volume despite

privately observes a signal and then he reports

having set an aggressive target, the firms in-

it to a principal. Since the agent has an incen-

curred losses because some of employees and fa-tive to make a false report, these previous stud-

cilities were idle. On the other hand, Suntory

ies need incentive compatibility constraints to

Beverage and Foods temporarily halted opera-

avoid such a false report. In contrast, this paper

tions since demand for a certain beverage out-

analyzes the setting that an owner communi-

stripped its supply and Suntory had to modify

cates budget guidelines and a manager makes

its production schedule to ensure a steady sup-effort to prepare feasible budgets during aply (Nikkei MJ, April 22, 2015). In this case,budget-making process, in which the manager

since the actual volume overwhelmed thehas no incentive to make a false report.

planned amount despite conservative target

Rather, this paper is a moral hazard

setting, the firm incurred an opportunity loss

model since the manager makes effort to pre-because some of employees and facilities werepare a feasible budget. In this regard, this paper

idle until it acquired enough resources to deliver

parallels Balakrishnan (1991, 1992) anda steady supply.

Demski and Sappington (1987). These studies

In summary, regardless of whether it isanalyze the setting that an agent has an oppor-

favorable or unfavorable, budget variance in-tunity to acquire information to increase thecreases the risk for losses due to idle capacity. To

probability of high performance before opera-

avoid such losses, firms should prepare feasible

tions, and the incentive that a principal gives anbudgets, even though doing so decreases theagent to acquire such information. However, inpossibility of high performance. For example,

the setting of this paper, when a manager

Subaru, whose car sales in the United States

makes effort to prepare a feasible budget, thehas been strong, decided to increase its manu-

probability of high performance is decreased be-

facturing capacity with careful attention to an

cause the distribution of expected profit is nar-oversupply

rowed.

[http://toyokeizai.net/articles/-/69095], May 10,

While the preparation of feasible budgets(Toyo

Keizai

Online2015). In this case, preparing a feasible budget

reduces the likelihood of high performance, it

led to robust performance.

may still be beneficial to firms to pursue such a

In addition, in many firms, some portion
21

Journal of Japanese Management Vol.2, No.1, November 2017of bonuses to managers are based on their

ISSN 2189-9592

owner.

budget achievement. When budgets are formu-

Before the budget-making process, thelated in the way noted above, managers haveowner communicates budget guidelines to theless opportunity to receive bonuses and they do

profit centers. Budget guidelines typically pro-

not necessarily narrow the distribution. To en-vide only general direction, and this paper

courage managers to do so, firms must adopt abonus cap, placing a ceiling on bonuses to man-chooses to use the distribution of an expected
profit, 𝑥~U[𝑚 − 𝑑𝑝 , 𝑚 + 𝑑𝑝 ], as the main prin-agers whose performance far exceeds theirciples in these budget guidelines. This means

budget.

that although the owner sets a mean target

The remainder of this paper is organized
as follows. Section 2 explains the model of thisprofit 𝑚, the guideline has a range from 𝑚 −𝑑𝑝 to 𝑚 + 𝑑𝑝 based on a set of past profits.

paper. Section 3 shows the results of both sym-Also, this paper assumes that the expected

metric and asymmetric information cases andprofit is uniformly distributed and both 𝑚 and𝑑𝑝 are common knowledge.

Section 4 discusses the results of the analysis.
Finally, Section 5 concludes this paper.

To decrease the cost of difference, theowner must make a plan that narrows the dis-(2) Model

tribution and reduces business risk (hereafter,

This paper considers a budget-making

risk reduction plan). The owner, however, hasprocess in which a risk-neutral owner acting as

scarce time and information and must ask thea principal (she), and a risk-neutral profit center

manager to make the risk reduction plan during

manager acting as an agent (he) negotiate on a

the budget-making process. The manager’s ef-

forthcoming budget. Also, the manager is effort-

fort to make the risk reduction plan is assumed

averse and has no wealth to acquire a firm.

to be unobservable by the owner. With the risk

In the budget-making process, a target
profit for each profit center is decided based on

reduction plan, the distribution is estimated tobe [𝑚 − 𝑑𝑓 , 𝑚 + 𝑑𝑓 ] (𝑑𝑝 > 𝑑𝑓 ); without it, thethe firm-wide aspired profit. Hereafter, various

distribution remains [𝑚 − 𝑑𝑝 , 𝑚 + 𝑑𝑝 ].

kinds of budgets are formulated to realize each

The owner decides the target profit ℎ intarget profit, and resources are allocated to eachthe distribution and pays a bonus calculated us-

profit center. As stated in the Introduction, re-ing the amount of favorable variance. A favora-gardless of whether it is favorable or unfavorable, the difference between a profit center’s ac-

ble variance arises when ℎ ≤ 𝑥 ≤ 𝑚 + 𝑑𝑖 (𝑖 ={𝑝, 𝑓}), and the average favorable variance istual profit and its target profit is assumed to(𝑚 + 𝑑𝑖 − ℎ)⁄2 , since the distribution is uni-cause some kinds of idle losses. This paper no-form. Let the bonus coefficient be denoted as 𝛽tates actual profit as 𝑥, target profit as ℎ, andthe cost of difference, the cost stemming from( 0 ≤ 𝛽 < 1 ) and the average bonus as𝛽(𝑚 + 𝑑𝑖 − ℎ)⁄2. The probability of a favorable

the difference between the target profit and theactual one, as 𝛼|ℎ − 𝑥 | (𝛼 > 0), where the coef-variance is (𝑚 + 𝑑𝑖 − ℎ)⁄2𝑑𝑖 and the expectedbonus is 𝛽(𝑚 + 𝑑𝑖 − ℎ)2 ⁄4𝑑𝑖 . Since firms usu-

ficient of the cost of difference 𝛼 indicates theally cannot pay negative bonuses or decrease

degree to which the owner recognizes the differ-

fixed salaries when managers incur unfavorable

ence as a loss and decreases the utility of thevariances, this paper assumes that the bonus
22

Journal of Japanese Management Vol.2, No.1, November 2017

ISSN 2189-9592

payment to the manager is zero when unfavor-

on payments to employees. So, let this cap be de-able variance occurs.2

noted as 𝑃𝑚𝑎𝑥 and, for analytical ease, it is as-

The manager incurs the effort costs ofsumed that 𝑐̅ ≤ 𝑃𝑚𝑎𝑥 .

making the risk reduction plan and working inThis paper focuses on the budget-making

the mid-term. Let the effort costs of making theprocess, and the utility of each player is shownrisk reduction plan and working in the midterm be denoted as 𝑐1 (𝑐1 = {0, 𝑐̂1 }, 𝑐̂1 = 𝛾⁄𝑑𝑓 ,by the expected utility at the beginning of a pe-

𝛾 > 0) and 𝑐2 (𝑐2 = {0, 𝑐̃2 }, 𝑐̃2 = [𝑐2𝑚𝑖𝑛 , 𝑐2𝑚𝑎𝑥 ],𝑐2𝑚𝑖𝑛 > 0 , 𝑐2𝑚𝑎𝑥 = 𝛿 (𝑑𝑓+𝜖) , 𝜖 > 0 , 𝑐2𝑚𝑖𝑛 < 𝛿 𝜖 ),amount remaining after subtracting the ex-riod. The owner’s utility is equal to the residual
pected cost of difference, the fixed salary and therespectively, and 𝑐1 + 𝑐2 = 𝑐 . When 𝑐𝑗 = 0

expected bonus from the expected firm-wide
profit, which can be shown as Ε(𝑥 − 𝛼|ℎ −(𝑗 = {1,2}) it means that the manager does notincur any effort costs. The distribution remains[𝑚 − 𝑑𝑝 , 𝑚 + 𝑑𝑝 ] when 𝑐1 = 0, and the actual𝑥 |) − [𝑆 + 𝛽(𝑚 + 𝑑𝑖 − ℎ)2 ⁄4𝑑𝑖 ] . Conversely,
the manager’s utility is the residual amount remaining after subtracting the effort cost fromprofit is inevitably lim 𝑚 − 𝑑𝑖 + 𝜖 when 𝑐2 =the fixed salary and the expected bonus. As

ϵ→0

0. Thus, when 𝑐2 = 0, since the probability of anoted above, the effort cost is uncertain and thefavorable variance is approaching nil, the ex-manager is also risk neutral. Hence, he evalu-

pected bonus is assumed to be zero for simplicity.
In addition, during the budget-making process,ates his effort cost as 𝑐̅ and his utility is[𝑆 + 𝛽(𝑚 + 𝑑𝑖 − ℎ)2 ⁄4𝑑𝑖 ] − 𝑐̅ . Given the as-

𝑐̂1 is certain and a positive constant, and 𝑐̃2 issumption on the fixed salary and the effort cost,a random variable. As a result, 𝑐 is also a random variable, 𝑐~𝑁(𝑐̅, 𝜎 2 ), and is assumed to be

𝑆 = 𝑐̅ , the utility formula is simplified as𝛽(𝑚 + 𝑑𝑖 − ℎ)2 ⁄4𝑑𝑖 . In addition, his reserva-

common knowledge.

tion utility is assumed to be zero.

In addition to bonuses based on perfor-

The timeline of the events in this model

mance, employees are paid fixed salaries deter-is as follows:mined independently of their performance. According to the 2012 survey on work conditions

1.

Owner and manager observe past profits.

by the Ministry of Health, Labour and Welfare

2.

Owner communicates budget guidelines.

(Shuro Joken Sogo Chosa), fixed salaries are

3.

Owner decides bonus coefficient and target

mainly based on the “substance of work” and the

profit.

“skill of work accomplishment” that indicate an4.

effort cost. During the budget-making process,Manager makes risk reduction plan andworks.

such an effort cost is uncertain. Accordingly, this5.

paper assumes that the fixed salary 𝑆 is equal

Profit is realized. Owner and manager acquire payoffs, respectively.

to the expected value of the effort cost 𝑐̅.3

Firms
have funding constraints and must set a ceiling(3) Results

2 Since this assumption makes limited-liability constraints

data, it may not be generally accepted. However, the main
results of this paper are constant whether the fixed salaryis more than the expected effort cost or not. Moreover, toeconomize space, this paper adopts such an assumption.

satisfied, they are omitted in the following analysis.
3
Although this assumption is surely based on the actual

23

Journal of Japanese Management Vol.2, No.1, November 2017

1. No Hidden Action

ISSN 2189-9592

Since the above function is maximized at ℎ = 𝑚,

This subsection, as a benchmark, shows
the result when the owner can observe the man-ℎ𝐹𝐵 = 𝑚. In this case, the left-hand side of IR is𝛽𝑑𝑓 ⁄4. However, since the owner can zero out it,

ager’s action without any costs. In this case, thewe arrive at 𝛽 𝐹𝐵 = 0. ∎manager always makes a risk reduction planand the distribution is [𝑚 − 𝑑𝑓 , 𝑚 + 𝑑𝑓 ]. The

The above problem is equivalent to a min-problem that the owner solves is as follows.
Problemimization problem of the expected cost of difference. In addition, 𝛼[(𝑚 − ℎ)2 + 𝑑𝑓2 ]⁄2𝑑𝑓

FB

shown in the objective function is the expected
cost of difference. It is minimized at ℎ = 𝑚 andthe minimized cost of difference is 𝛼𝑑𝑓 ⁄2.

2

𝛽(𝑚 + 𝑑𝑓 − ℎ)max Ε(𝑥 − 𝛼 |ℎ − 𝑥 |) − [𝑆 +
]
𝛽,ℎ
4𝑑𝑓
subject to

2. Optimal Set Budget under Moral Hazard
In this subsection, the result is shown for2𝛽(𝑚 + 𝑑𝑓 − ℎ)
≥0
4𝑑𝑓

IR

the case in which the owner cannot observe themanager’s actions. In this scenario, in addition
to IR, the following incentive compatibility con-Constraint IR (individual rationality)straints are needed.

means that the owner must set the expected2

utility of the manager at a level greater than the𝛽(𝑚 + 𝑑𝑓 − ℎ)
𝑆+
− 𝑐̅
4𝑑𝑓

reservation utility. Subsequently, the solution to

IC1

this problem is as follows.
2≥𝑆+

Lemma. Suppose that the distribution is uniform, 𝑥~U[𝑚 − 𝑑𝑓 , 𝑚 + 𝑑𝑓 ] . When the owner𝛽(𝑚 + 𝑑𝑝 − ℎ)
− 𝑐̅
4𝑑𝑝
2

can observe the manager’s action, the target
profit is the mean of the distribution, ℎ𝐹𝐵 = 𝑚,and the bonus coefficient is zero, 𝛽𝐹𝐵 = 0.

𝛽(𝑚 + 𝑑𝑓 − ℎ)𝑆+− 𝑐̅ ≥ 𝑆 − 𝑐̂1
4𝑑𝑓

IC2

2

𝛽(𝑚 + 𝑑𝑓 − ℎ)𝑆+− 𝑐̅ ≥ 𝑆
4𝑑𝑓(Proof)IC3

Since IR is satisfied with an equation, the objective function is determined as follows. Notethat 𝑆 = 𝑐̅ and ℎ ∈ [𝑚 − 𝑑𝑓 , 𝑚 + 𝑑𝑓 ].
Ε(𝑥 − 𝛼|ℎ − 𝑥 |) − 𝑐̅𝑚+𝑑𝑓
𝑥 − 𝛼 |ℎ − 𝑥 |=∫𝑑𝑥 − 𝑐̅𝑚−𝑑𝑓 (𝑚 + 𝑑𝑓 ) − (𝑚 − 𝑑𝑓 )=𝑚−𝛼[(𝑚 − ℎ)2 + 𝑑𝑓2 ]2𝑑𝑓The left-hand sides of the constraints IC1,
IC2, and IC3 show the manager’s expected utility when he selects the action the owner prefers.
The right-hand side of each constraint shows
the manager’s expected utility for the following
situations: when he does not make a risk reduc-− 𝑐̅tion plan but works hard in the mid-term (IC1);

Let the target profit and the bonus coeffi-

he makes a risk reduction plan but does notcient be denoted as ℎ𝐹𝐵 and 𝛽 𝐹𝐵 , respectively.
24

Journal of Japanese Management Vol.2, No.1, November 2017

ISSN 2189-9592

work hard in the mid-term (IC2); and he does

𝑑𝑓 𝛥𝑑 > 0 and the left-hand side of the above in-

not both make a risk reduction plan and work

equality must be strictly positive. Accordingly,

hard in the mid-term.

the target profit must satisfy any one of the fol-

Having an elaborate plan makes it easier

lowing conditions.

to achieve a desired goal. Similarly, when the
manager makes a risk reduction plan, the effort

1. 𝑚 + 𝑑𝑓 − ℎ > 0 and 𝑚 − 𝑑𝑓 − ℎ > 0

cost of executing operations 𝑐2 is thought to be

2. 𝑚 + 𝑑𝑓 − ℎ < 0 and 𝑚 − 𝑑𝑓 − ℎ < 0smaller. Since the risk-neutral manager recognizes the random variable 𝑐̃2 as its mean, we

When the first condition is satisfied, thecan indicate the mean of 𝑐̃2 when 𝑐1 = 𝑐̂1 and
0𝑐2 , respec-

target profit must be set to strictly less than thelower limit of the distribution since 𝑚 − 𝑑𝑓 > ℎ.

0
< 𝑐2 ). Then, the combined effort cost

However, when the second condition is satisfied,

when the manager both makes a risk reduction

the target profit must be set to strictly more

1plan and works hard in the mid-term is 𝑐̂1 + 𝑐2 ,than the upper limit of the distribution since𝑚 + 𝑑𝑓 < ℎ. Thus, when IC1, IC2, and IC3 are

the one when 𝑐1 = 0 as
1
tively (𝑐2

1
𝑐2

and

and the effort cost when he only works hard in0

the mid-term is 𝑐2 . For ease of analysis, sup-all satisfied, the bonus coefficient is positive,

10
𝑐̂1 + 𝑐2 = 𝑐2 = 𝑐 . As a result, the effort

and the target profit is not set in the distributionpose
costs shown on both sides of IC1 are identical.4

after the creation of a risk reduction plan. ∎Regarding the incentive compatibility constraints, the following result is obtained.

When the owner seeks to satisfy all of the
incentive compatibility constraints, she cannot
set the target profit in [𝑚 − 𝑑𝑓 , 𝑚 + 𝑑𝑓 ]. The

Proposition 1. When IC1, IC2, and IC3 are sat-

isfied, the target profit does not exist in the distribution after the creation of a risk reductionplan.

manager can expect the above situation anddoes not make a risk reduction plan. Thus, hewould make a dummy plan and just report it.
Then, the manager engages in a budget game in(Proof)which he seeks to maximize his own bonus andGiven the assumption 𝑐̂1 > 0, when IC3

minimize the required target by proposing un-

is satisfied, IC2 is satisfied with a strict sign ofrealistic numbers during the budget-making

inequality. Also, when it is assumed that 𝑐̅ > 0,process.

the bonus coefficient must be 𝛽 > 0 to satisfy

However, if the distribution remains[𝑚 − 𝑑𝑝 , 𝑚 + 𝑑𝑝 ] and the target profit is not

IC3. As a result, IC1 is rewritten as follows,
𝛥𝑑 = 𝑑𝑝 − 𝑑𝑓 ,set in [𝑚 − 𝑑𝑓 , 𝑚 + 𝑑𝑓 ], the cost of difference
may increase. Since the owner can expect sucha situation, she must take measures to induce(𝑚 + 𝑑𝑓 − ℎ)(𝑚 − 𝑑𝑓 − ℎ) ≥ 𝑑𝑓 𝛥𝑑.

the manager to make a feasible risk reduction
Since 𝑑𝑝 > 0 and 𝑑𝑓 > 0 , this means thatplan.

4 The following numerical example explains this situation.

𝑐2 = 3 when 𝑐1 = 0. Thus, in each case, the combined effort cost is 𝑐 = 𝑐1 + 𝑐2 = 3.

Assume that 𝑐1 = {0,1}, 𝑐̃2 = [1,3] when 𝑐1 = 1, and𝑐̃2 = [1,5] when 𝑐1 = 0. Then, 𝑐2 = 2 when 𝑐1 = 1 and25

Journal of Japanese Management Vol.2, No.1, November 2017

If the manager makes a feasible risk re-

ISSN 2189-9592

Thus, the solution to this problem is as follows.

duction plan, the upper limit of the distribution
decreases. Accordingly, if the actual profit is in
the range of (𝑚 + 𝑑𝑓 , 𝑚 + 𝑑𝑝 ], it is highly prob-

Proposition 2. Suppose that the distribution is
uniform, 𝑥~U[𝑚 − 𝑑𝑓 , 𝑚 + 𝑑𝑓 ] . When theable that the manager do not make a risk reduction plan. The owner pays no bonus to the manager when the actual profit falls within (𝑚 +owner cannot observe the manager’s action, thetarget profit is ℎ 𝑆𝐵 = 𝑚, and the bonus coefficient is 𝛽 𝑆𝐵 = 4𝑐̅⁄𝑑𝑓 , if and only if 4𝑐̅ < 𝑑𝑓 .

𝑑𝑓 , 𝑚 + 𝑑𝑝 ] to motivate him to make the risk
reduction plan. However, if ℎ = 𝑚 + 𝑑𝑝 , the(Proof)manager is not adequately motivated to attain

Given the assumption 𝑐 > 0, when IC3

a budget. Hence, the owner must manipulate

is satisfied, IR is satisfied with a strict sign ofthe bonus coefficient as follows,inequality. In addition, under the assumption
𝑑𝑓 < 𝑑𝑝 , IC1’ is also satisfied with a strict sign of{inequality. As a result, IC3 is satisfied with a sign𝛽 > 0, 𝑖𝑓 ℎ ≤ 𝑥 ≤ 𝑚 + 𝑑𝑓,
𝛽 = 0,
𝑜𝑡ℎ𝑒𝑟𝑤𝑖𝑠𝑒of equality. Solving it for ℎ, we find thatℎ = 𝑚 + 𝑑𝑓 ± √and IC1 turns out as follows.
2𝛽(𝑚 + 𝑑𝑓 − ℎ)𝛽(𝑚 + 𝑑𝑓 − ℎ)
≥
4𝑑𝑓
4𝑑𝑝

4𝑑𝑓 𝑐
𝛽

.

Note that if ℎ = 𝑚 + 𝑑𝑓 + √4𝑑𝑓 𝑐 ⁄𝛽 , IC3 is not

2

IC1’

satisfied due to the assumption of the bonus coefficient, 0 ≤ 𝛽 < 1 . Accordingly, let the target

profit in the case of asymmetric information be
Then, the problem the owner solves is as follows.
Problemdenoted as ℎ𝑆𝐵 ,ℎ𝑆𝐵 = 𝑚 + 𝑑𝑓 − √

𝑆𝐵

4𝑑𝑓 𝑐
𝛽

.

Substituting it into the objective function, the new2𝛽(𝑚 + 𝑑𝑓 − ℎ)max Ε(𝑥 − 𝛼 |ℎ − 𝑥 |) − [𝑆 +
]
𝛽,ℎ
4𝑑𝑓

objective function is as follows,

subject to

2𝑐

4𝑑𝑓 𝑐

𝛽

𝛽

max 𝑚 − 𝛼 [ − √𝛽+ 𝑑𝑓 ] − 2𝑐̅.

2𝛽(𝑚 + 𝑑𝑓 − ℎ)
≥0
4𝑑𝑓

IR

Let the solution be denoted as 𝛽 𝑆𝐵 . By first ordercondition,2𝛽(𝑚 + 𝑑𝑓 − ℎ)𝛽(𝑚 + 𝑑𝑓 − ℎ)
≥
4𝑑𝑓
4𝑑𝑝

2

IC1’

𝛽 𝑆𝐵 =.

Substituting it into ℎ𝑆𝐵 , we haveℎ 𝑆𝐵 = 𝑚.

2𝛽(𝑚 + 𝑑𝑓 − ℎ)
≥ 𝑐̅
4𝑑𝑓

4𝑐
𝑑𝑓

IC3

Given the assumption of the bonus coefficientand IC3, 0 < 𝛽 < 1, this means 0 < 4𝑐̅⁄𝑑𝑓 < 1.
Thus, the above solutions for 𝛽 𝑆𝐵 and ℎ𝑆𝐵 are26

Journal of Japanese Management Vol.2, No.1, November 2017

ISSN 2189-9592

derived if and only if 4𝑐̅ < 𝑑𝑓. ∎is decreasing. This means that the manager

The cost of difference expected at the beginning of a period is 𝛼[(𝑚 − ℎ)2 + 𝑑𝑓2 ]⁄2𝑑𝑓

must decrease his own expected utility by mak-and is specified by 𝛼 (the degree to which theincrease in effort cost and a decrease in his ex-

owner recognizes the cost of difference as a loss),ℎ (target profit), and 𝑚 and 𝑑𝑓 (mean and de-pected bonus. To reward the manager for in-

viation of the distribution, respectively, after the

manager a bonus that exceeds the acquired

creation of a risk reduction plan). Since 𝛼 andprofit by setting 𝛽 > 1. This does not pay theowner, and she sets the lower limit of 𝑑𝑓 as

ing a risk reduction plan that involves both ancreasing effort cost, the owner must pay the𝑚 are exogenous variables, the owner seeks tominimize the cost of difference by manipulatingℎ and 𝑑𝑓 . Whether there is symmetric infor-4𝑐̅ < 𝑑𝑓 .

mation or asymmetric information, both the dis-the case of asymmetric information is equiva-

tribution and the cost of difference are notlent to information rent under moral hazardchanged. Accordingly, the target profit is theand the owner encounters a trade-off between

mean of the distribution in each case. However,decreasing the cost of difference and increasing

since it is practically impossible to eliminate uncertainty, which means 𝑑𝑓 = 0, the lower limit

the manager’s bonus. Avoiding the diseconomyof the distribution must be 4𝑐̅ < 𝑑𝑓 .
By the assumption 𝑐̂1 = 𝛾⁄𝑑𝑓 , as 𝑑𝑓 isthe manager’s bonus exceeds the increase of her

The expected bonus for the manager inof decreasing the owner’s payoff by increasing
payoff by decreasing the cost of difference; thelower limit of 𝑑𝑓 is needed.

approaching zero, the effort cost of making arisk reduction plan 𝑐̂1 is exponentially increasing. Also, if 𝑑𝑓 could be close to zero, the uncer-

As a result, the manager’s bonus base is
secured and the target profit is equal to thetainty on the effort cost in the mid-term 𝑐̃2mean of the distribution. This means that thewould not be dispelled. Furthermore, by the as-owner prefers a budget that easily causes favorable variances or gives the manager infor-

sumption 𝑐2𝑚𝑎𝑥 = 𝛿 (𝑑𝑓+𝜖) , even though 𝑑𝑓 ismation rent. Agency theory has highlighted

approaching zero,is only gradually decreasing. In sum, as 𝑑𝑓 is decreasing, 𝑐̂1 is in-asymmetric information and opportunisticcreasing but 𝑐̃2 is difficult to decrease, and 𝑐̅ isincreasing. Therefore, 𝑑𝑓 depends on 𝑐̅ asleave information rent (e.g. Antle and Eppen,

stated in Proposition 2, and we find that 4𝑐̅ <𝑑𝑓 . In the case of symmetric information, theysis of this paper reveals that the reduction inlower limit of 𝑑𝑓 is the level at which 𝑆 = 𝑐̅and the owner desires it.

𝑐2𝑚𝑎𝑥

agent(s) as the reason that a principal must1985). In addition to the above factors, the analthe cost of difference causes information rent

and 𝑐̅ ≤ 𝑃𝑚𝑎𝑥

are satisfied.
The reason why the lower limit of 𝑑𝑓 is(4) Discussion

strictly more than 4𝑐̅ is that the owner must

This paper shows that the owner desires

pay a bonus to the manager in the case of asymmetric information. As 𝑑𝑓 decreases, the range

feasible budgets by adding the cost of differencein which the bonus coefficient 𝛽 is positive isanalysis of the previous section, we have the fol-

narrowing and the bonus base for the manager

lowing result: if the owner seeks to decrease theinto her utility function. Moreover, from the27

Journal of Japanese Management Vol.2, No.1, November 2017

ISSN 2189-9592

cost of difference, (1) the bonus paid to the man-to maximize profit. As criticized by Hope andager should be capped, and (2) the target set for

Fraser (2003) and Jensen (2001), the bonus cap

the manager should be loosed. This section ex-

carries the risk of causing dysfunctional behav-

amines the above two points.

ior from having employees not earn profit thatexceeds the upper limit of bonus bases. Alt-

1. Rationality of Bonus Cap

hough the bonus cap helps avoid the problem

A bonus cap, sometimes referred to as acaused by over-investment or out-of-production

bonus scheme (e.g., Healy, 1985), has been criti-

capital, it creates opportunity costs, that is, thecized in some studies (e.g., Hope and Fraser,

profit lost by the bonus cap. In sum, the choice2003). Also, some other studies have advocatedof whether to set a bonus cap mirrors the trade-a liner incentive scheme (e.g., Jensen, 2001, pp.

off when deciding whether to pursue profit max-

98-99; Stewart, 1991, pp. 233-241). To be sure,imization or avoid the cost of difference.

managers strive to maximize their profits if a

However, paying attention to the cost ofliner incentive scheme is adopted and this isdifference has the advantage of decreasing theseemingly favorable. However, managers takecost of capital in addition to avoiding over-in-

the risk to proceed with their operations in an

vestment. Public companies listed in Japan are

infeasible direction if such a scheme is adopted,

required to disclose earnings forecasts, and Mu-

and their strategy is unfavorable in terms oframiya (2005) noted that accurate forecasts con-minimizing the cost of difference. In fact, some

tribute to a decrease in the cost of capital. Also,

firms pursuing profit maximization decline insince such forecasts are based on budgets (Yan-earnings due to over-investment. For example,

agi, 2011, pp.72-88), ordering the manager to

Sumitomo Corporation, which rapidly ex-

make a risk reduction plan during a budget-

panded its natural resources businesses, wasmaking process and motivating him not to at-then required to book huge impairment losses

tain excessive favorable variance by using a bo-

because the capital invested in the businesses

nus cap improves the accuracy of disclosed fore-

was deemed irrecoverable (Nihon Keizai

casts, which then contributes to decreasing the

Shimbun,Also,

cost of capital. In the setting of this paper, if a

Mitsubishi Motors decided to cease its factorybudget is formulated around the upper limit ofoperations in the U.S. and aggregate its produc-

the expected profit distribution and the earn-tion capacity in its Okazaki factory. It was re-ings forecast is disclosed based on the budget, it

ported that this decision would make the Oka-

is inevitable that the forecast gets revised down-

zaki factory operate at nearly 100% capacity

ward. For example, Sony lowered its forecast for(Nihon Keizai Shimbun, August 21, 2015),

2014 several times, which was accompanied bywhich makes this nothing less than effort to de-a fall in its stock price. It was noted that Sony’s

crease the cost of difference, so-called idle capac-

top management required ideal goals evenity.

though Sony’s division managers submitted se-

September

30,2014).

However, as stated in the interpretationcurequantitativeplans(Nikkei

SangyoShimbun, November 5, 2013).

of Proposition 1, if the owner sets a cap on thebonus paid to the manager, he is not motivatedIn addition, several firms set a ceiling on
28

Journal of Japanese Management Vol.2, No.1, November 2017

ISSN 2189-9592

executives’ bonuses, and it has been said that

Also, Anthony and Govindarajan (2007) support

executives in such firms conduct earnings man-this conclusion concerning the tightness of theagement so that the estimated profit is inten-

target. Now, turning to Proposition 2, since thetionally lowered to the ceiling when the profit istarget is set at the mean of the expected profit

expected to exceed it (e.g., Healy, 1985). If such

distribution, the probability of target achieve-

firms do not set a ceiling on managers’ bonuses,

ment is 50%. Therefore, this indicates the valid-

executives would conduct reckless earnings

ity of Proposition 2 although we cannot simply

management because managers pursue highcompare Merchant and Manzoni (1989) and thisprofit to maximize their own bonuses. However,paper.

executives do not prefer this type of earnings

Furthermore, if the owner does not re-

management due to concerns about backlash

gard the cost of difference as a loss, she would

against future earnings. Accordingly, executives

hike a target to the upper limit of the distribu-

must guide managers not to yield profit to suchtion to minimize the bonus paid to the manager.

a degree when executives conduct earnings

In other words, depending on whether the costmanagement. Thus, a bonus cap that does notof difference is regarded as a loss, the tightness

pay a bonus for excessive favorable varianceof the target is subjective. Even though the por-helps prevent the reckless earnings manage-

tion that the target is lowered from the upper

ment.

limit of the distribution is not changed, one perIt has generally been thought that theson may view the target as tight, whereas an-

reason why firms set a ceiling on bonuses is aother may not, or may view it as including budg-

funding constraint. In addition to such a con-etary slack. For example, even if executives set

straint, this paper shows that a bonus cap cana tight target, rational stockholders who ade-

help a firm avoid losses caused by over-invest-

quately spread risk would likewise not deem it

ment, prevent an increase in the cost of capitalas tight. The same holds for conglomerates

following the revision of earnings forecasts, andthe higher people advance in hierarchy, theprevent reckless earnings management.

more they do not regard the cost of difference asa loss, but rather view a target as including

2. Rationality of Budgetary Slackbudgetary slack because the risks they face are

As stated in the interpretation of Propo-

dispersed. Budgetary slack is contingent on

sition 2, the owner aims to set the profit target

some kinds of subjective judgement (Kosuga,

at a level that the manager easily attains. In

1997, pp.196-198). This paper shows that thethis subsection, we examine the effectiveness ofdegree to which the cost of difference is regarded

such a target in terms of tightness. It has been

as a loss is one such subjective factor.

suggested that a tight target is challenging but

Budgetary slack has been thought of as

attainable (e.g., Anthony and Govindarajan

the portion that managers intentionally lower

2007, p.391). Merchant and Manzoni (1989),

budgets from attainable levels to maximize

surveying the profit center managers on the ex-their own bonuses. When a target is set as

ante subjective probability of attaining their tar-stated in Proposition 2, a manager can acquiregets, conclude that the target they can achieve

his bonus. Accordingly, the budget formulatedwith a probability of more than 50% is rational.

as stated in Proposition 2 might be viewed as29

Journal of Japanese Management Vol.2, No.1, November 2017

ISSN 2189-9592

one that includes budgetary slack. However,this paper can be seen as only representing rel-this kind of budgetary slack is not the portion aevant cases in which firms understated the costmanager intentionally lowers but the one anof difference. There must be other firms that pay

owner purposefully accepts. The reason why theattention to the cost of difference and some suchowner accepts budgetary slack is that she ex-

firms must achieve better performance thanpects the decrease in the cost of difference to re-others. To understand the overall trends, it isstore firm management. In other words, budg-

necessary to verify the characteristics on finan-

etary slack is considered to act as an essential

cial statements depending on whether a firmpart of managing a firm.5 Although there haverecognizes the impact of the cost of difference.

already been several studies showing the advantages of budgetary slack (e.g., Dunk, 1995),

References

this paper shows that budgetary slack contrib-

Anthony, Robert N., and Vijay Govindarajan

Management

ControlSys-

utes to a reduction in the cost of difference,(2007).

which is a benefit of budgetary slack that has

tems.(12th edition), New York: McGraw-

not been mentioned in previous studies.

Hill/Irwin.
Antle, Rick, and Gary D. Eppen (1985). Capital(5) Conclusion

Rationing and Organizational Slack in
Capital Budgeting. Management Science,

This paper examines the features of abudget-making process where the owner seeks

31(2), pp.163-174.

to formulate a feasible budget. Also, this paper

Balakrishnan, Ramji (1991). Information Ac-

notes that a bonus cap and a certain level ofquisition and Resource Allocation Deci-budgetary slack are needed when the bonus issions. The Accounting Review, 66(1),based on the degree of budget attainment.

pp.120-139.

Both bonus caps and budgetary slack(1992). The Value of Communication in Re-

have been criticized as causing a loss to firms.

source Allocation Decisions. Contempo-

In contrast, this paper reveals that bonus caps

rary Accounting Research, 8(2), pp.353-

and budgetary slack have the benefit of decreas-373.

ing the costs of difference in some areas such as

Chen, Qi, Brian Mittendorf, and Yun Zhang

idle capacity, acquisition of additional resources,(2010). Endogenous Accounting Bias

increase in the cost of capital, and excessive

When Decision Making and Control Interearnings management that are caused by theAct. Contemporary Accounting Research,difference between budgeted performance and27(4), pp.1063-1091.

actual performance.

Demski, Joel S., and David E. M. Sappington(1987). Delegated Expertise. Journal of

Empirical research on the results derived
from the analysis of this paper should be con-

Accounting Research, 25(1): 68-89.

ducted in future research. Some cases stated in

Dunk, A. S. (1995). The Joint Effects of Budge-

5 Such budgetary slack is equivalent to the well-function-

ing budgetary slack noted in Ri et al (2012).

30

Journal of Japanese Management Vol.2, No.1, November 2017

ISSN 2189-9592

naru, 43(9), pp.83-97.

tary Slack and Task Uncertainty on Subunit Performance. Accounting and Fi-

Ozawa, Hiroshi (2010). Bumon-kan Chosei nonance, 35(2), pp.61-75.

Tame no Yosan Suijun to Yosan Surakku

Healy, Paul M. (1985). The Effect of Bonusno Kanri (Budget for Interdepartmental

Shemes on Accounting Decisions. Jour-

Coordination and Management of Slack).

nal of Accounting and Economics, 7(1-3),

Genka Keisan Kenkyu, 34(2), pp.46-57.

pp. 85- 107.

Ri, Ken, Satoko Matsuki, and Naoki Fukuda

Heinle, Mirko S., Nicholas Ross, and Richard E.

(2012). Yosan Surakku to Nihon-teki Yo-

Saouma (2014). A Theory of Participative

san Kanri (Budgetary Slack and Japa-

Budgeting. The Accounting Review, 89(3),nese-style Budgeting). Kyoto Gakuen

pp. 1025-1050.

Daigaku Keieigakubu Ronshu, 21(2),Hope, J., and R. Fraser (2003). Beyond Budge-

pp.31-53.

ting: How Managers Can Break Free
from the Annual Performance Trap.

Stewart, G. Bennett (1991). The Quest for Value,

Boston: Harvard Business School Press.

Yanagi, Ryuhei (2011). Nihon-teki Datsu Yosan

Ito, Takeshi (2013). Mokuhyo no Sutorecchido toKanri (Japanese-style Beyond Budget-

New York: Harper Business.

Takai Tassei Kanosei wo Ryoritsu Saseruing). Tokyo: Doyukan.

Keikaku Dankai no Keiei Kanri (TheProcess of Setting Stretch Goals and Objectives and Building the Capability of(Received: August 25, 2017)

Achieving Them in Management Control(Accepted: October 22, 2017)

in the Planning Phase). Genka Keisan

Kenkyu, 37(2), pp.148-159.
Jensen, Michael C. (2001). Corporate Budgetingis Broken: Let's Fix It. Harvard Business

Review, 79(10), pp. 94-101.
Kosuga, Masanobu (1997). Kodo-teki Yosan
Kanri Ron. (Zoho Dai 2 Han) (Behavioral
Budgeting. (2nd edition)). Tokyo: Chuo
Keizai Sha.
Merchant, Kenneth A., and Jean-Francois Manzoni (1989). The Achievability of Budget
Targets in Profit centers: A Field Study.

The Accounting Review, 64(3), pp. 539558.
Muramiya, Katsuhiko (2005). Keieisha ga Kohyo Suru Yoso Rieki no Seido to Sihon
Kosuto (Accuracy of Expected Earnings
Announced by Top Management and theCost of Capital). Shoken Anarisuto Ja31